Portfolio Management Theory, Portfolio Development, and Asset Allocation

Stock risk premium formula

(rm- rf) bi rm= market return rf= risk-free return Bi= beta coefficient of the stock

Four primary factors have been found under APT to affect a stock's return.

1. Inflation 2. Industrial production (or changes in GDP) 3. Risk premiums 4. Yield curves (interest rates)

an IPS serves four basic purposes:

1. Setting objectives. This includes establishing and defining client expectations concerning risk and return, and providing guidelines on how the assets are to be invested. 2. Defining the asset allocation policy. This requires identifying various asset classes that will be used to achieve the investor's objectives, and determining how best to allocate the assets to achieve a diversified portfolio. 3. Establishing management procedures. A guide needs to be put in place as far as selecting and monitoring the investments, and making changes as necessary. There also needs to be a way to evaluate the performance of whoever is in charge of the investment process. 4. Determining communication procedures. A concise method of communication needs to be in place so that all parties involved are aware of the process and objectives, and responsibility must be assigned for implementation

EXAMPLE: CAPM expected return

Assume that the return on the market is currently 10%, the 90-day Treasury bill rate of return is 4.5%, and the beta coefficient of Stock X is 1.2. Therefore, the expected return on Stock X using the CAPM is 11.1%, calculated as follows: ri = 0.045 + [(0.10 − 0.045) × 1.2] = 0.045 + (0.055 × 1.2) = 0.045 + 0.066 = 0.111, or 11.1%

Arbitrage Pricing Theory (APT)

Proponents of APT assert that the expected returns on securities are based on various unexpected or unanticipated factors. In turn, these factors affect the amount of risk premium that an investor will demand to entice him to make a potential investment.

capital market line (CML)

Rp= rf + op (rm - rf / om) rp= expected return of the portfolio rf= risk free rate of return rm= market rate of return op= standard deviation of the portfolio om= standard deviation of the market

Efficient Frontier

The universe of these portfolios is, in turn, plotted on a risk-return parabola known as the efficient frontier. Specifically, this curve represents that set of portfolios that has the maximum rate of return for every given level of risk.

Monte Carlo simulation (MCS)

This simulation is an analytic and risk management tool widely used in finance. The MCS incorporates computer programming to generate stochastic (probability) random value inputs in simulating thousands of iterations. In an MCS, each of the variables is also given a probability distribution to allow for real-world uncertainty.

Investment Policy Statement

a key component of a client's investment strategy, is a written document that sets forth a client's objectives, placing boundaries on the portfolio's asset allocation and investment guidelines as well as limitations on the investment manager. This statement gives guidance to the investment manager and provides a means for evaluating investment performance. An allocation among asset classes (and their respective weights) that is congruent with the client's primary investment objective is a part of any credible investment policy. In addition, review guidelines and rebalancing frequency are commonly included.

capital asset pricing model (CAPM)

allows the investor to determine an asset's expected rate of return, a form of risk-adjusted return encapsulating how much risk the investor should assume to obtain a particular return from an investment.

In the CAPM, a single factor—a security's

beta with respect to the market portfolio—is used to value assets. The APT, on the other hand, is a multifactor model that is an alternative to the CAPM. Under the APT, the market portfolio no longer plays a pivotal role in pricing assets.

Tactical Asset Allocation (TAA)

continuously adjusts the asset allocation and class mix in an attempt to take advantage of changing market conditions and overall investor sentiment. In TAA, portfolio adjustments are driven solely by perceived changes in the market values of the asset classes, and very little consideration, if any, is given to the long-term financial goals of the client. In essence, TAA is a market timing approach to portfolio management that is intended to take advantage of perceived market inefficiencies (and opportunities for investor profit).

Security Market Line

depicts the relationship of risk and return for individual efficient portfolios and has the same formula as that for the CAPM.

Weak-form EMH

holds that current stock prices have already incorporated all historical market data and that historical price trends are, therefore, of no value in predicting future price changes. Although fundamental analysis and insider information may produce above-market returns under the weak form, technical analysis is of no value.

Semistrong-form EMH

holds that current stock prices not only reflect all historical price data but also reflect data from analyzing financial statements, industry, or current economic outlook. Thus, even fundamental analysis is of no value in this form, and only insider information may produce above-market returns. Technical analysis is also of no value

Strong-form EMH

holds that current stock prices reflect all public and private information. Therefore, even insider traders are unlikely to consistently outperform the market. In addition, neither technical analysis nor fundamental analysis is of any value. (You should note that this form has effectively been negated in recent years, given the considerable illegal profits made by investors who possess insider trading information.)

Core and Satellite

investment strategy invests in both broad market indices (core) and higher-risk alternatives (satellite). Core investments may include U.S. stocks, U.S. fixed-income, and developed international equities. Generally, these investments track a major market index such as the S&P 500, Russell 3000, and MSCI EAFE. This part of the portfolio uses a passive investment philosophy to achieve market-based returns. Satellite investments may include REITs, emerging markets, and high-yield bonds. These investments attempt to achieve above-market returns through high risk and global exposure. Investors may choose to implement a core and satellite strategy through a portfolio of mutual funds. The goals of this strategy are to reduce portfolio risk through diversification, generate higher returns commensurate with required returns, minimize transaction costs, and manage taxes.

Stochastic Modeling

is a method of financial analysis that attempts to forecast how investment returns on different asset classes vary over time by using thousands of simulations to produce probability distributions for various outcomes.

Sensitivity Analysis

is used to evaluate the risk associated with a given investment and assesses the impact of different variables on an investment's returns. When evaluating a particular investment, investors may use forecasted cash flows to estimate its intrinsic value. However, many variables (e.g., business cycle) may either negatively or positively impact the forecasted cash flows and resulting valuation with varying degrees of sensitivity. Generally, investors, while performing sensitivity analysis, will calculate both the net present value (NPV) and the internal rate of return (IRR) of the forecasted cash flows. This calculation will be performed on the basis of three different assumptions: pessimistic, expected, and optimistic.

Strategic Asset Allocation

once the allocation is determined, it remains constant until (typically) some life-changing event occurs. Because the investment performance of the selected asset classes is different, rebalancing must take place to bring the portfolio in line with the strategic mix.

Indifference Curves

represent the risk-reward tradeoff that the investor is willing to make, will cross the efficient frontier in two locations, lie tangent to the efficient frontier, or not intersect the efficient frontier at all.

capital asset pricing model (CAPM) Formula

ri= rf + (rm-rf) Bi

Market risk premium

rm-rf rm= market return rf= risk-free return

random walk hypothesis

states that future stock prices are random and do not follow any preestablished trend or path. This hypothesis does not mean that the security prices themselves are randomly determined; rather, it indicates that all the information up to this point in time has been priced into the security, and any future price movement will be based on any future information.

Efficient Market Hypothesis

suggests that investors are unable to outperform the market on a consistent basis. The fundamental assumption of the theory, which was developed by Professor Eugene Fama of the University of Chicago, is that current stock prices reflect all available information for a company and that prices rapidly (or immediately) adjust to reflect any new information.

Recall that if an asset does not plot along the SML, the asset is considered to be either

undervalued (i.e., asset plots above the SML) or overvalued (i.e., asset plots below the SML), and an investment opportunity or mistake results. Ultimately, market forces will drive the price of the asset either down or up to the SML.