Common Errors in Portfolio Management Essay Example

into account the risk preferences, cash needs, and tax status of the individual investor when determining asset allocation. The manager must decide on an asset mix that maximizes after-tax returns, while considering risk and cash flow constraints. This is the core of a passive approach to asset allocation, where the investor's traits are the primary factors in selecting the appropriate asset mix. Market timing is a critical and dynamic aspect of asset allocation, which enables portfolio managers to diverge from passive strategies and adjust asset mixes accordingly.

The act of predicting market trends is known as ‘market timing’. Investment managers use this technique to anticipate which markets are likely to perform above or below expectations. Based on these predictions, they will adjust the composition of the portfolio’s assets and change the passive mix accordingly. For example, if an investment manager believes that the stock market is overvalued and headed for a correction while real estate is undervalued, they may reduce the exposure to stocks and redirect funds towards real estate. Despite denying their involvement in market timing, most portfolio managers engage in some form of this practice.

According to professional market strategists, making the decision on asset allocation is significant. This is because achieving impressive outcomes can only be done by those who are successful and expert market timers. However, it is important to note that successful stock selection is more advisable than merely depending on successful market timings as it has been observed that deriving differential advantage from market timing is difficult compared to selecting stocks. The ability to time the market well can greatly ease the process of selecting individual investments.

It is not always feasible

to trust market timing, necessitating the wise selection of individual assets within each asset class to earn excess returns. Asset selection can be active or passive, similar to asset allocation. The passive approach involves randomly selecting investments within each asset class or diversifying fully across investments within each class.

When an investor uses passive asset allocation, they rely on the market value of each asset to determine the proportion within each asset class. This approach, also known as "indexing," can yield a return that matches the level of risk taken without the need for aggressive trading. It is a less costly strategy in terms of transaction costs, time, and taxes. On the other hand, active asset allocation involves selecting individual assets within an asset class that are expected to perform better than the rest by buying undervalued and selling overvalued assets.

Both market timing and identifying mis-valued assets are important strategies for investors. To find mis-valued assets, investors use a combination of technical and fundamental analysis. Technical analysis involves analyzing charts and indicators of price and volume of assets, while fundamental analysis involves researching publicly available information.

Regarding investment results, there is evidence to suggest that both analysis approaches are effective. Despite employing diverse strategies, investment managers do not seem to generate the same level of excess returns overall, which may be due to an undisciplined adoption of investment techniques. In fact, research suggests that selecting assets on the basis of confidential information is a reliable method of earning superior returns. However, at present, this practice is regarded as insider trading and is subject to corresponding regulations and legal provisions.

Despite differentiating private information from

inside information, investors and portfolio managers still strive to accumulate data that will provide them with a competitive edge over other market participants.