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An Introduction to Portfolio Management

2017-06-20 02:05 [INVESTING] Source:Netword

Developing an Investment Philosophy: The Step

            If every investor needs an investment philosophy, what is the process that you go through to come up with such a philosophy? While portfolio management is about the process, we can lay out the three steps involved in this section.

Step 1: Understand the fundamentals of risk and valuation

            Before you embark on the journey of finding an investment philosophy, you need to get your Financial toolkit ready. At the minimum, you should understand

-       how to measure the risk in an investment and relate it to expected returns.

-       how to value an asset, whether it be a bond, stock or a business

-       the ingredients of trading costs, and the trade off between the speed of trading and the cost of trading

We would hasten to add that you do not need to be a mathematical wizard to do any of these and it is easy to acquire these basic tools.

Step 2: Develop a point of view about how markets work and where they might break down

            Every investment philosophy is grounded in a point of view about human behavior (and irrationality). While personal experience often determines how we view our fellow human beings, we should expand this to consider broader evidence from markets on how investors act before we make our final judgments.

            Over the last few decades, it has become easy to test different investment strategies as data becomes more accessible. There now exists a substantial body of research on the investment strategies that have beaten the market over time. For instance, researchers have found convincing evidence that Stocks with low price to book value ratios have earned significantly higher returns than Stocks of equivalent risk but higher price to book value ratios. It would be foolhardy not to review this evidence in the process of developing your investment philosophy.  At the same time, though, you should keep in mind three caveats about this research:

Since they are based upon the past, they represent a look in the rearview mirror. Strategies that earned substantial returns in the 1990s may no longer be viable strategies now. In fact, as successful strategies get publicized either directly (in books and articles) or indirectly (by portfolio managers trading on them), you should expect to see them become less effective.

Much of the research is based upon constructing hypothetical portfolios, where you buy and sell Stocks at historical prices and little or no attention is paid to transactions costs. To the extent that trading can cause prices to move, the actual returns on strategies can be very different from the returns on the hypothetical portfolio.

A test of an investment strategy is almost always a joint test of both the strategy and a model for risk. To see why, consider the evidence that Stocks with low price to book value ratios earn higher returns than Stocks with high price to book value ratios, with similar risk (at least as measured by the models we use). To the extent that we mismeasure risk or ignore a key component of risk, it is entirely possible that the higher returns are just a reward for the greater risk associated with low price to book value Stocks.

Since understanding whether a strategy beats the market is such a critical component of investing, we will consider the approaches that are used to test a strategy, some basic rules that need to be followed in doing these tests and common errors that are made (unintentionally or intentionally) when running such tests. As we look at each investment philosophy, we will review the evidence that is available on strategies that emerge from that philosophy.

Step 3: Find the philosophy that provides the best fit for you

            Once you understand the basics of investing, form your views on human foibles and behavior and review the evidence accumulated on each of the different investment philosophies, you are ready to make your choice. In our view, there is potential for success with almost every investment philosophy (yes, even charting) but the prerequisites for success can vary. In particular, success may rest on:

Your risk aversion: Some strategies are inherently riskier than others. For instance, venture capital or private equity investing, where you invest your funds in small, private businesses that show promise is inherently more risky than buying value Stocks – equity in large, stable, publicly traded companies. The returns are also likely to be higher. However, more risk averse investors should avoid the first strategy and focus on the second. Picking an investment philosophy (and strategy) that requires you to take on more risk than you feel comfortable taking can be hazardous to your health and your portfolio.


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