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The Life of every man is a diary in which he

means to write one story, and writes another;
and his humblest hour is when he compares
the volume as it is with what he vowed to
make it.

- J.M. Barrie

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 Introduction
 Part one: Background, Basic Principles, and
Investment Policy
 Part two: Portfolio construction
 Part three: Portfolio management
 Part four: Portfolio protection and
contemporary issues

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 Investments
 Security analysis
 Portfolio management
 Purpose of portfolio management
 Low risk vs. high risk investments
 The portfolio manager’s job
 The six steps of portfolio management

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 Traditional investments covers:
◦ Security analysis
 Involves estimating the merits of individual
investments
◦ Portfolio management
 Deals with the construction and maintenance of a
collection of investments

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 A three-step process
1) The analyst considers prospects for the
economy, given the state of the business cycle
2) The analyst determines which industries are
likely to fare well in the forecasted economic
conditions
3) The analyst chooses particular companies within
the favored industries
◦ EIC analysis (a top-down approach)

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 Literature supports the efficient markets
paradigm
◦ On a well-developed securities exchange, asset
prices accurately reflect the tradeoff between
relative risk and potential returns of a security
 Efforts to identify undervalued securities are
fruitless.
 Free lunches are difficult to find.

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 Market efficiency and portfolio management
◦ A properly constructed portfolio achieves a given
level of expected return with the least possible
risk
 Portfolio managers have a duty to create the best
possible collection of investments for each
customer’s unique needs and circumstances

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 Portfolio management primarily involves
reducing risk rather than increasing return
◦ Consider to $10,000 investments:
1) Earns 10% per year for each of ten years (low risk)
2) Earns 9%, -11%, 10%, 8%, 12%, 46%, 8%, 20%, -12%,
and 10% in the ten years, respectively (high risk)

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 $30,000
$25,937

$23,642
$20,000
Low
Risk
High
$10,000
$10,000 Risk

$0
'92 '94 '96 '98 '00 '02

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1) Earns 10% per year for each of ten years
(low risk)
◦ Terminal value is $25,937
2) Earns 9%, -11%, 10%, 8%, 12%, 46%, 8%,
20%, -12%, and 10% in the ten years,
respectively (high risk)
◦ Terminal value is $23,642

 The lower the dispersion of returns, the

greater the terminal value of equal
investments

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 Begins with a statement of investment
policy, which outlines:
◦ Return requirements

◦ Investor’s risk tolerance

◦ Constraints under which the portfolio must

operate

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1) Learn the basic principles of finance
2) Set portfolio objectives
3) Formulate an investment strategy
4) Have a game plan for portfolio revision
5) Evaluate performance
6) Protect the portfolio when appropriate

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 Learn the Basic
Principles of Finance
(Chapters 1 – 3)

Set Portfolio Objectives

(Chapters 4 – 5) Evaluate
Performance
(Chapters 19 - 20)
Protect the Formulate an
Portfolio When Investment Strategy
Appropriate (Chapters 6 – 14)
(Chapters 21 – 25)

Have a Game Plan for

Portfolio Revision
(Chapters 15 – 18)

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PART ONE: Background, Basic
Principles, and
Investment Policy.
PART TWO: Portfolio Construction
PART THREE: Portfolio Management.
PART FOUR: Portfolio Protection and
Contemporary Issues.

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 A person cannot be an effective portfolio
manager without a solid grounding in the
basic principles of finance
 Egos sometimes get involved
◦ Take time to review “simple” material
◦ Fluff and bluster have no place in the formation
of investment policy or strategy

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 There is a distinction between “good
companies” and “good investments”
◦ The stock of a well-managed company may be
too expensive
◦ The stock of a poorly-run company can be a
great investment if it is cheap enough

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 The two key concepts in finance are:
1) A dollar today is worth more than a dollar
tomorrow
2) A safe dollar is worth more than a risky dollar

 These two ideas form the basis for all

aspects of financial management

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 Other important concepts
◦ The economic concept of utility

◦ Return maximization

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 Setting objectives
◦ It is difficult to accomplish your objectives
until you know what they are.

◦ Terms like growth or income may mean

different things to different people.

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 Investment policy
◦ The separation of investment policy from
investment management is a fundamental
tenet of institutional money management.
 Board of directors or investment policy
committee establish policy.
 Investment manager implements policy.

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 Formulate an investment strategy based
on the investment policy statement
◦ Portfolio managers must understand the basic
elements of capital market theory
 Informed diversification
 Naïve diversification
 Beta

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 International investment
◦ Emerging markets carry special risk

◦ Emerging markets may not be informationally

efficient

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 Stock categories and security analysis
◦ Preferred stock
◦ Blue chips, defensive stocks, cyclical stocks

 Security screening
◦ A screen is a logical protocol to reduce the
total to a workable number for closer
investigation

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 Debt securities
◦ Pricing

◦ Duration
 Enables the portfolio manager to alter the risk
of the fixed-income portfolio component

◦ Bond diversification

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 Pension funds
◦ Significant holdings in gold and timberland
(real assets)

◦ In many respects, timberland is an ideal

investment for long-term investors with no
liquidity problems

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 Subsequent to portfolio construction:
◦ Conditions change.

◦ Portfolios need maintenance.

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 Passive management has the following
characteristics:
◦ Follow a predetermined investment strategy
that is invariant to market conditions or-

◦ Do nothing,

◦ Let the chips fall where they may.

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 Active management:
◦ Requires the periodic changing of the
portfolio components as the manager’s
outlook for the market changes

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 Options and option pricing
◦ Black-Scholes Option Pricing model

◦ Option overwriting
 A popular activity designed to increase the
yield on a portfolio in a flat market.

◦ Use of stock options under various portfolio

scenarios.

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 Performance evaluation
◦ Did the portfolio manager do what he or she
was hired to do?
 Someone needs to verify that the firm followed
directions
◦ Interpreting the numbers
 How much did the portfolio earn?
 How much risk did the portfolio bear?
 Must consider return in conjunction with risk

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 Performance evaluation (cont’d)
◦ More complicated when there are cash
deposits and/or withdrawals
◦ More complicated when the manager uses
options to enhance the portfolio yield

 Fiduciary duties
◦ Responsibilities for looking after someone
else’s money and having some discretion in
its investment

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 Portfolio protection
◦ Called portfolio insurance prior to 1987

◦ A managerial tool to reduce the likelihood

that a portfolio will fall in value below a
predetermined level

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 Futures
◦ Related to options
◦ Use of derivative assets to:
 Generate additional income
 Manage risk

 Interest rate risk

◦ Duration

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 Contemporary issues
◦ Derivative securities
◦ Tactical asset allocation
◦ Program trading
◦ Stock lending

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