Portfolio Policy and Theory

1
Portfolio Policy and Theory

• Markowitzs portfolio selection
• Portfolio with various types of assets

2
Portfolio Policy

• Set an investment goal
• Life cycle investment
• ????
• Age below 25, age 25-50, and age above 50
• Yesterday, today, and tomorrow
• Investment and consumption
• Safety and Happiness
• Financial Independence
• Constraints

3
Portfolio Policy

• Cash-inflow assets versus cash-outflow
  liabilities
• Income from working (salary), income from
  investment (cash dividends and capital gains),
  and unexpected income
• Managing assets and liabilities
• Cash match and Duration match
• Right now, lifetime and afterlife

4
Markowitzs Portfolio Selection

• Optimal portfolio selection
• Maximize return for a given risk
• Minimize risk for a given return
• Covariance analysis
• Efficient frontier
• Market portfolio
• Risky assets
• Utility function indifference curve

5
Capital Asset Pricing Model

• CAPM measures the required rate of return of an
  asset
• If a stock had declined to a price that makes the
  valuation of 4 million instead of 8 million,
  its beta would have been greater given the
  market constant.
• To people who think beta to measure risk, the
  cheaper price would have made this stock riskier.

6
Arbitrage Pricing Theory

• Multi-factors model
• Three-factor model

7
Sharpes Optimal Portfolio

• Capital market line
• Optimal market portfolio
• Risky assets and risk-free assets
• Short selling and lending or borrowing
• Co-movement with the market beta

8
Required Return and Risk Premium

• Risk actual loss anticipated fear
• Capital asset pricing model
• Excess return, risk-free rate, risk premium,
  and error term
• Performance measure Sharpes ratio
• The myth of beta the underlying assumptions
• The problem of searching the optimal market
  portfolio global market with all classes of
  assets

9
Risk and Return

• Risk falls into these broad categories
• Volatility
• Momentum
• Size
• Liquidity
• Earnings growth
• Value ratios of earnings, dividends, cash flows,
  book value, sales to price
• Earnings volatility
• Financial leverage

10
Return Anomalies

• Expected return, Benchmark return, Excess return
• Size effects
• Neglected effects
• Momentum effects
• Contrarian effects
• Low price-to-earnings effect
• Low price-to-book effect
• Monday effects
• January effects

11
Portfolio Construction

• Portfolio construction requires several inputs
• The current portfolio
• Alphas benchmark and cash neutral alphas
• Covariance estimates
• Transactions cost estimates the cost of moving
  from one portfolio to another
• An active risk aversion

12
Portfolio Implementation

• Portfolio revision How often should you revise
  your portfolio whenever you receive new
  information?
• What portfolio would we choose given inputs
  (alphas, covariance, active risk aversion, and
  transaction cost) unreasonable and noisy?
• Alpha analysis can adjust the alphas into line
  with managers desires for risk control and
  anticipated source of value added.

13
Portfolio Implementation

• Portfolio construction techniques include
  screening, stratified sampling, linear
  programming, and quadratic programming.
• Screens Rank the stocks by alpha and rebalance
• Stratification Split the list of followed stocks
  into exclusive categories (risk control)

14
Anchors Lifetime Portfolio

• Markowitzs portfolio
• Anchors portfolio
• - Relationship between happiness and pain
• - Maximize happiness or minimize pain
• - Optimal lifetime portfolio consisting of
  lifetime events within and after life
• How to measure happiness and pain?
• How to define lifetime events?
• Whats the constraints?
• Percentage of risky assets equal to (100- Age)1

15
Design a Portfolio by Peter Lynch

• Whats wrong with high expectation of 30 return?
• How do you design a portfolio to get 12-15
  return?
• How many stocks should you own?
• A foolish diversity There is no use diversifying
  into unknown companies just for the sake of
  diversity.

16
Diversification under An Edge

• Its best to own as many stocks as there are
  situations in which
• (a) youve got an edge and
• (b) youve uncovered an exciting prospect that
  passes all the tests of research.
• Since there is no way to anticipate when pleasant
  surprise of various kinds might happen, you
  increase your odds of benefiting from one by
  owning several stocks (5-10 stocks).

17
Watering the Weeds

• Buying and selling as it relates to portfolio
  management
• Constantly recheck stocks and stories, add and
  subtract to your investments as things change
• Stay in the market forever and rotate stocks
  depending on the fundamental situations
• Rotate in and out of stocks depending on what has
  happened to the price as it relates to the story
• If you decide that a certain amount youve
  invested in the stock market will always be
  invested in the stock market, youll save
  yourself a lot of mistimed moves and general
  agony.

18
A Price Drop in a Good Stock

• If you cant convince yourself When Im down 25
  percent, Im a buyer and banish forever the
  fatal thought When Im down 25, Im a seller,
  then youll never make a decent profit in stocks.
• Detest stop orders When you put it in a 15
  stop order, youre admitting that youre going to
  sell the stock for less than its worth today,
  but with the volatility in todays market, a
  stock almost always hits the stop.

19
A Price Rise in A Good Stock

• The belief of Sell when its a double will
  never let you benefit from a big winner.
• Stick around to see what happens as long as the
  original story continues to make sense, or gets
  better, and youll be amazed at the results in
  several years.
• Be cause about the momentum effect and
  Cinderellas shining shoes