Applied portfolio management – Flashcards
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1. Establish investment goals and constraints 2. Develop investment strategy 3. Construct portfolio 4. Execute portfolio decisions 5. Monitor portfolio performance 6. Monitor investor and market performance 7. Rebalance and adjust
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Portfolio management definition
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A. Planning 1. Establish investor objectives and constraints 2. Create investment policy statement (IPS) 3. Form capital market expectations 4. Create strategic asset allocation B. Execution 1. Portfolio managers and traders implement strategy C. Feedback 1. Monitor and rebalance 2. Portfolio evaluation
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Portfolio management process
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people tend to have mental accounts for different economic decisions. People view money in savings accounts different than brokerage accounts.
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mental accounting
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a theory of investor behavior that attempts to explain why investors refuse to admit to themselves that they have made a poor investment decision so they don't have to face the unpleasant feelings associated with that decision. This causes investors to not correct bad decisions, which can make those decisions worse
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regret avoidance/prospect theory
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the use of irrelevant information as a reference for evaluating or estimating some unknown value or information. People base decisions or estimates on events or values known to them, even though these facts may have no bearing on the actual event or value
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anchoring
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when we arrive at a conclusion based on the facts that suggest (represent) it without delving deeper into it. A good example would be investing in a company because you feel it is a good company with an ethical outlook. However, the fact that the company's image is good does not represent the fundamental soundness of the firm
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representativeness bias
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where stock market participants evaluate their portfolio performance based on recent results or on their perspective of recent results and make incorrect conclusions that ultimately lead to incorrect decisions about how the stock market behaves.
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recency effect
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confidence implies realistically trusting in one's ability, while overconfidence implies an overly optimistic assessment of one's knowledge or control over the situation
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overconfidence
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a. distill thesis into few key points: many companies often focus on earnings growth and P/E multiple. The main thesis points are supported by information you present in other sections of the report b. describe other positive characteristics of the company that make it an attractive investment c. Identify and address key risks to your thesis and to the company's earnings
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Steps to building a buy thesis
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crated to pool money with hundreds of other people who also want to invest. Diversified portfolio: starting with at least 30 different stocks across economic sectors. Investors buy mutual funds at net present value can be both active or passive
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mutual funds
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diversification access to a professional manager lower transaction fees due to economies of scale record keeping an administration
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Advantages of pooled investment vehicles
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essentially boils down to revenues-costs=net income. Companies often overstate income, they take an aggressive stance towards income. They recognize revenues to early instead of spreading them out, manipulate working capital ( inventory, accounts payable/receivables) to maximize current period income.
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Income statement
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boils down to assets-liabilities=equity Due to the flexibility of GAAP, companies often overstate assets and understate liabilities
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balance sheet
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beginning cash+cash provided by operating activities+cash used for investment activities+cash provided by/used for financing activities=ending cash statement of cash flow is used to investigate balance sheet and income statement
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Cash flow
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growth at a reasonable price, pioneered by Peter Lynch other types of investment styles include: stocks vs bonds large cap vs small cap
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GARP
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looking for a bargain, seeking a below average P/E. Looking for firms that are being mismanaged, market over penalized firm for short term event. Typically are looking for a higher dividend yield (average is around 1.5-2%), every other ratio can be lower. Value investors spend a lot of their time buying low, undervalued stocks. Look for stocks that the market has very low expectations for. They will buy the undervalued stocks with hopes of eventually selling them at fair/over value
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value investing
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revenue and earnings are up, stock is expensive, and investor is hoping that the stock will continue to grow at an above average rate. Growth investors are willing to pay a higher multiple, willing to pay an above average P/E,P/CF/, P/B and P/S. Stocks have very high expectations. Growth investors can tolerate a lower dividend yield since the company is reinvesting its earnings to support future growth (companies like tesla). Spend a lot of time on eventual goal of selling high.
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growth investors
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natural grouping of investment disciplines that has some predictive power in explaining the future dispersion in returns across portfolios.
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Investment style
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Financial ratios a.valuation metric used to determine under/overvalued companies b. how much am I paying for sales and growth? c. earnings are volatile and unpredictable, tells us info about value of assets (under/overvalued) and its return on assets
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Financial Ratios a.P/CF b.P/S c.P/B
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Beta- how does this stock correlate with the returns of the market. How does this stock change the overall risk of the portfolio? Beta is a more important measure of risk than standard deviation
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risk of stock
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a simple statistic that describes the variability of asset returns to other assets for the purpose of asset allocation. Perfectly negatively correlated securities' prices move in the opposite direction from each other by the same exact amount. For examples, if stock a increases by 10%, stock b will decrease by 10%. Perfectly negatively correlated assets/investments would provide 100% diversification, as they would form a portfolio with zero variance (in the real world this does not exist). There are a few assets that tend to be negatively correlated to most other asset classes, these assets provide excellent diversification.
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correlation coefficient of a portfolio
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for a given set of data, the standard deviation measure hows spread out numbers are from an average value. Standard deviation can be calculated by taking the square root of the variance. For example, a customer who is able to handle a standard deviation of 16%- this tells us how volatile an asset is and how far it strays away from the mean. By taking the standard deviation of a portfolio's annual rate of return, you can better measure the consistency with which returns are generated. Larger standard deviations indicate larger degrees of risk.
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risk measured in terms of standard deviation
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a conservative method of portfolio allocation aimed at minimizing risk. Entails a regular portfolio rebalancing, buying high quality short maturity bonds and blue chip stocks ) industry leaders that have been operating successfully for many years). Maintaining cash and cash equivalents in down markets. Stocks to invest in for a defensive approach: SHUTS (staples, healthcare, utilities, and telecommunications services)
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defensive investing
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a portfolio strategy that attempts to maximize returns by taking more risk, this type of strategy puts a substantial weight on stocks and a smaller allocation to fixed income and cash. Usually suitable for young adults because of their very long time horizon
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aggressive investing
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Invest passively using low cost index funds or ETF's
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What to invest in if the market is efficient?
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manager's approach to investment analysis and security selection-in a broad sense, investment strategies are normally passive, active, or semi active
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investment strategy
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manager will respond to changes in capital market expectations. Its holding differ from the portfolio's benchmark or comparison portfolio in an attempt to produce positive excess risk adjusted returns, also known as positive alpha.
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active
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a portfolio does not respond to react to changes in capital market expectations. Indexing: holding a portfolio of securities designed to replicate the returns of a specified index another passive strategy: a strict buy and hold strategy
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passive
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seeks positive alpha while keeping tight control over relative risk relative to the portfolio's benchmark
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semi active
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the efficient market hypothesis (EMH) is an investment theory that states it is impossible to beat the market because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments.
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efficient market hypothesis
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weak- stock prices already reflect all available information contained in historical prices, trading volume, and short interest. If this is true, technical analysis is not worth doing semi strong- that implies all public information is calculated into a stock's current share prices. Neither fundamental nor technical analysis can used to achieve superior gains. Strong-stock prices reflect all available information- all public and private (insider) information. Most agree that the strong form odes not hold. Trading on insider info is illegal
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forms of EMH theory
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concern the risk and return chracteristics of capital market instruments such as bonds and stocks
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Capital market expectations
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research historical record specify the method or model that will be used and its inputs determine the best source for information needs asses the current investment environment and use experience and judgement to make any necessary adjustments to forward looking estimates
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how to form capital market expectations
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more statistical and numbers based
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historical statistical approach
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polls take of market participants as to what their expectations are for the economy
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survey and panel
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adjusting estimated based on economic, historic, and psychological insights
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judgement
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high liquidity means that a customer cannot have as much risk; high liquidity requirements are directed towards fixed income assets, while low liquidity requirements are directed towards equity markets
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liquidity
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refers to the time period associated with the investment objective. A time horizon of more than 10 years is normally long term, examples of time horizon include kids going to college, change it health etc. The longer the time horizon, the more risk an investor can take
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time horizon
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what tax bracket do they fall under? Tax concerns arise because tax payments reduce the amount of the total return
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tax consideration
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ERISA limits the acquisition and holding of employer securities by certain pension funds. Other countries limit how much I can invest in certain asset classes
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legal and regulatory factors
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socially conscious: weapons, oil, alcohol, drugs, and gold (for labor conditions
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unique circumstances
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minimum amount of risk per unit of return
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optimal portfolio
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a written document that clearly sets out a client's return objectives and risk tolerance over that client's relevant time horizon, along with applicable constraints such as liquidity needs, tax considerations, regulatory requirements, and unique circumstances
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IPS
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provides foundation for the overall portfolio management process, it serves as the governing document for all investment decision making. The IPS should also include the following info, a client description, purpose, statement of investment goals, objectives, constraints, and review of investment performance, performance measures and benchmarks, and guidelines for rebalancing
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IPS
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Russel 2000 for US small cap equities S&P 500 for US large cap equities
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Benchmarks
