The Complete Guide to Portfolio Construction and Management Liikasz Snopek A John Wiley and Sons, Ltd, Publication
Contents Foreword About the Author Acknowledgements Introduction Xlll xv xvii xix PART I INVESTORS AND RISK 1 Basic Principles 1.1 Investors 1.2 Inflation 1.3 Choices for Investors in Terms of Investments 2 Measures of Risk 2.1 Volatility or Standard Deviation 2.2 Beta as a Measure of Risk 2.3 Value-at-Risk (VaR) 2.4 Investor Behaviour Towards Risk PART II ASSET CLASSES AND THEIR DEGREE OF RISK 3 Asset Classes and Associated Risks 3.1 Money Market Investments 3.1.1 Definition 3.1.2 Risks associated with money market investments 3.2 Bonds 3.2.1 Definition 3.2.2 Risks associated with bonds 3.3 Stocks 3.3.1 Definition 3.3.2 Risks associated with stocks 3 3 3 5 7 7 11 13 14 17 19 19 19 20 22 22 26 33 33 36
vi Contents 3.4 Real Estate 45 3.4.1 Definition 45 3.4.2 Risks associated with real estate 46 3.5 Commodities and Metals 48 3.5.1 Definition 48 3.5.2 Risks associated with commodities and metals 51 3.6 Private Equity 54 3.6.1 Definition 54 3.6.2 Risks associated with private equity 54 3.7 Other Asset Classes - 56 4 Particular Forms of Investment within Asset Classes 59 4.1 Hedge Funds 59 4.1.1 Definition 59 4.1.2 Risks associated with hedge funds 60 4.2 Structured Products 63 4.2.1 Definition 63 4.2.2 Risks associated with structured products 64 4.3 Options 65 4.3.1 Definition 65 4.3.2 Risks associated with options 66 5 Classification of Asset Classes According to their Degree of Risk 71 5.1 Selected Criteria for Classification of Asset Classes 71 5.2 Classification of the Different Asset Classes 75 PART III THE MARKET 77 6 Market Efficiency 79 6.1 Weak Form Market Efficiency 79 6.2 Semi-strong Form Market Efficiency 80 6.3 Strong Form Market Efficiency 80 6.4 Conclusion on Market Efficiency 81 7 Fundamental Analysis 83 7.1 Discounted Cash Flow 83 7.2 Relative Measures 85 7.2.1 Price to Earnings Ratio (P/E) 85 7.2.2 Price to Book 85 7.3 Strategic Analysis 86 7.3.1 The business model 86 7.3.2 External analysis 88 7.3.3 Internal analysis 95 7.3.4 The SWOT table (Strengths, Weaknesses, Opportunities and Threats) 97 7.4 Criticism of Fundamental Analysis 98
Contents vii 8 Technical Analysis 101 8.1 The Three Fundamental Principles of Technical Analysis 101 8.1.1 Prices reflect all available information 101 8.1.2 Prices move in trends 102 8.1.3 History repeats 104 8.1.4 Criticism of technical analysis 105 8.2 Conclusion on Technical Analysis 106 9 Investment Approach Based on "Psychological Principles" 109 PART IV VALUATION OF FINANCIAL ASSETS 111 10 Valuation of Money Market Investments 113 11 Valuation of Bonds 115 12 Valuation of Stocks 117 13 Valuation of Options 119 14 Valuation of Real Estate 121 15 Valuation of Commodities and Metals 123 16 Conclusion on Valuation 125 PART V THREE PRACTICAL APPROACHES TO SECURITY SELECTION: BUFFETT, GRAHAM AND LYNCH 127 17 Warren Buffett's Value Investing Approach 129 18 Benjamin Graham's Approach 133 18.1 The Defensive Investor 133 18.2 The Enterprising Investor 134 18.3 Security Analysis 135 18.3.1 Bond selection 135 18.3.2 Stock selection 135 18.4 The Margin of Safety Concept 136 19 Peter Lynch's Approach 137 19.1 Stock Categories 138 19.1.1 Slow growers 138 19.1.2 The stalwarts 138 19.1.3 The fast growers 139 19.1.4 Cyclicals 139 19.1.5 Turnarounds 140 19.1.6 The asset plays 140 19.2 The Perfect Company According to Lynch 140
viii Contents 19.3 Earnings and Earnings Growth 19.4 Selection Criteria 19.4.1 The sales percentage 19.4.2 The P/E ratio 19.4.3 Liquid assets 19.4.4 Debt 19.4.5 Dividends 19.4.6 Hidden assets 19.4.7 Cash flow 19.4.8 Inventories 19.4.9 Growth rate 143 144 144 145 145 145 19.4.10 Gross profits 19.5 Conclusion on Peter Lynch's Approach 147 PART VI BEHAVIOURAL FINANCE 149 20 Investors in Behavioural Finance 151 21 Heuristics and Cognitive Biases 153 21.1 Information Selection 153 21.1.1 Availability heuristic 153 21.1.2 Herding 153 21.1.3 Ambiguity aversion 154 21.1.4 Wishful thinking 154 21.2 Information Processing 154 21.2.1 Representation bias 154 21.2.2 Confirmation bias 154 21.2.3 Narrative fallacy 155 21.2.4 Gambler's fallacy 155 21.2.5 Anchoring 155 21.2.6 Framing 155 21.2.7 Probability matching 155 21.2.8 Wearing blinkers 156 21.2.9 Overconfidence bias 156 21.2.10 Illusion of control 157 21.3 The Use of Assets 157 21.3.1 Mental accounting 157 21.3.2 Disposition effect 158 21.3.3 House money effect 158 21.3.4 Endowment effect 158 21.3.5 Home bias 158 21.3.6 No go's 158 21.3.7 Sunk costs 158 21.3.8 Lack of control 159 21.3.9 Pride and regret 159
Contents ix 22 Investment Approach Based on Behavioural Finance 161 22.1 Momentum Strategy 161 23 Criticism of Behavioural Finance 165 PART VII FORECASTING MARKET MOVEMENTS 167 24 Investment Approach Based on Probabilities 169 25 Random Walk Theory 171 26 Market Timing 173 27 Macroeconomic Investment Approach 177 27.1 State Interventions 179 27.1.1 Tax and fiscal policy 180 27.1.2 Monetary policy 181 27.1.3 The appropriate policy 181 27.2 The Major Macroeconomic Forces 182 27.2.1 Inflation 182 27.2.2 Economic growth 185 27.2.3 Recession 192 27.2.4 Productivity and technological change 195 27.2.5 Regulations and taxes 197 27.3 Sectorial Analysis 197 27.4 Peter Navarro's Approach 198 27.4.1 Trends and stock picking 199 27.4.2 Sector rotation 200 27.5 Criticism of the Macroeconomic Approach 202 PART VIII MODELLING MARKET MOVEMENTS 203 28 Suggested Investment Approach 207 29 The Forces 209 29.1 The Macroeconomic Force 209 29.2 The Fundamental Force 209 29.3 The Technical Force 209 29.4 The Behavioural Force 210 29.5 The Luck Force 210 30 The Forces' Strength 211 31 The Beauty of the Approach 213 PART IX PORTFOLIO CONSTRUCTION AND MANAGEMENT 215
x Contents 32 Modern Portfolio Theory According to Markowitz 217 32.1 David Swensen's Approach 219 33 The Capital Asset Pricing Model (CAPM) 221 34 The Minimum Variance Portfolio 223 35 Value-at-Risk (VaR) 227 36 Discretionary Mandates 229 37 The Dollar-cost Averaging Approach 231 38 Our Portfolio Construction Method 233 38.1 Basic Principles of Portfolio Construction 233 38.1.1 10 rules for protecting your capital 234 38.1.2 The 12 rules of risk management 235 38.2 The Portfolio Construction Process 238 38.2.1 The investor's life objectives 238 38.2.2 The investor's life cycle and investment time horizon 238 38.2.3 Choosing a reference currency 238 38.2.4 Evaluating the risk profile 238 38.2.5 Estimating a return target 239 38.2.6 The investor's tax rate 240 38.2.7 Determining the proportion of risky assets 240 38.2.8 Evaluating the expected degree of liquidity (share of illiquid assets) 240 38.2.9 Portfolio construction and management 240 38.3 A Practical Example of Portfolio Construction 249 PART X ATTRACTIVENESS OF THE DIFFERENT ASSET CLASSES 253 39 Asset Classes 255 39.1 Money Market Investments 255 39.2 Bonds 255 39.3 Stocks 256 39.4 Real Estate 257 39.5 Commodities and Precious and Industrial Metals 258 40 The Four Forces of the Investment Model 259 40.1 The Macroeconomic Force 259 40.1.1 The Macroeconomic Force and money market investments 259 40.1.2 The Macroeconomic Force and bonds 259 40.1.3 The Macroeconomic Force and stocks 260 40.1.4 The Macroeconomic Force and real estate 261 40.1.5 The Macroeconomic Force and commodities, precious and industrial metals 262 40.2 The Fundamental Force 262
Contents xi 40.2.1 The Fundamental Force and money market investments 262 40.2.2 The Fundamental Force and bonds 263 40.2.3 The Fundamental Force and stocks 263 40.2.4 The Fundamental Force and real estate 269 40.2.5 The Fundamental Force and commodities, precious and industrial metals 269 40.3 The Technical Force 269 40.3.1 The Technical Force and money market investments 269 40.3.2 The Technical Force and bonds 270 40.3.3 The Technical Force and stocks. 270 40.3.4 The Technical Force and real estate 270 40.3.5 The Technical Force and commodities, precious and industrial metals 271 40.4 The Behavioural Force 271 40.4.1 The Behavioural Force and money market investments 271 40.4.2 The Behavioural Force and bonds 271 40.4.3 The Behavioural Force and stocks 271 40.4.4 The Behavioural Force and real estate 272 40.4.5 The Behavioural Force and commodities, precious and industrial metals 272 41 Table Summarising the Different Forces 273 42 A Final Example: Analysis of the Subprime Crisis 277 Conclusion 281 Bibliography 283 Index 285