Portfolio construction management protection 5th e robert strong

5th Edition

Portfolio Construction,
Management, and Protection
Robert A. Strong, CFA
University of Maine

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Portfolio Construction, Management, &
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Robert Strong
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To BKKBR and K


SUMMARY OF CONTENTS
PART ONE

Background, Basic Principles, and Investment Policy 1

1
2
3
Appendix
4
Appendix

PART TWO

Portfolio Construction 131

5
6
Appendix
7
8
9
10
11
12
13
14

PART THREE

The Mathematics of Diversification 133
Why Diversification Is a Good Idea 148

Stochastic Dominance 187
International Investment and Diversification 199
The Capital Markets and Market Efficiency 240
Picking the Equity Players 266
Equity Valuation Tools 296
Security Screening 308
Bond Pricing and Selection 329
The Role of Real Assets 372
Alternative Assets 400

Portfolio Management 413
15
16
17
18
19
20

PART FOUR

Revision of the Equity Portfolio 415
Revision of the Fixed-Income Portfolio 444
Principles of Options and Option Pricing 465
Option Overwriting 489
Performance Evaluation 513
Fiduciary Duties and Responsibilities 544

Portfolio Protection and Emerging Topics 567
21
22

23
24
25

Glossary
Index
iv

The Process of Portfolio Management 3
Valuation, Risk, Return, and Uncertainty 14
Setting Portfolio Objectives 54
Mutual Fund Evaluation Term Project 76
Investment Policy 84
Sample Statements of Investment Policy 113

Principles of the Futures Market 569
Benching the Equity Players 592
Removing Interest-Rate Risk 614
Integrating Derivative Assets and Portfolio Management 635
Contemporary Issues in Portfolio Management 656

679
697


CONTENTS
Preface xiii

PART ONE BACKGROUND,
BASIC PRINCIPLES, AND

INVESTMENT POLICY
Chapter 1

The Process of Portfolio
Management

3

Introduction

3

Part One: Background, Basic
Principles, and Investment Policy

Chapter 2

1

Chapter 3

8

Part Three: Portfolio Management

9

Part Four: Portfolio Protection
and Contemporary Issues

11

Internet Exercise

12

Valuation, Risk, Return, and
Uncertainty

14

Key Terms

14

Introduction

14

Valuation

Introduction

54

Why Setting Objectives Can Be
Difficult

55

57

64

Other Factors to Consider in
Establishing Objectives

65

17

Inconsistent Objectives 65
Infrequent Objectives 66
Portfolio Splitting 66
Liquidity 67
The Role of Cash 67

23

Portfolio Dedication

Appendix
36

48
49

68

Cash Matching 68

Duration Matching 68

30

Definitions 36
Properties of Random Variables 40
Linear Regression 45
R Squared and Standard Errors 45

Summary
Questions

54

15

Measurable Return 30
Return on Investment 33

Some Statistical Facts of Life

Key Terms

The Importance of Primary and
Secondary Objectives

Direct Relationship 23
Concept of Utility 24
Diminishing Marginal Utility of Money 24
St. Petersburg Paradox 26

Fair Bets 27
The Consumption Decision 27
Other Considerations 28

The Concept of Return

54

Portfolio Objectives

Choosing Among Risky Alternatives 17
Defining Risk 20

Relationship Between Risk
and Return

Setting Portfolio Objectives

Preconditions 58
Traditional Portfolio Objectives 59
Special Situation of Tax-Free Income 61
Portfolio Objectives and Expected
Utility 63

Growing Income Streams 15

Safe Dollars and Risky Dollars

50
52

53

Semantics 55
Indecision 56
Subjectivity 57
Multiple Beneficiaries 57
Investment Policy versus Investment
Strategy 57

5

Part Two: Portfolio Construction

Problems
Internet Exercises
Further Reading

Summary
Questions
Problems
Internet Exercises
Further Reading

70
71
72
74
75

Mutual Fund Evaluation

Term Project

76

Key Terms

76

Introduction

76

Classification of Mutual Funds

76

Open End versus Closed End 76
Net Asset Value versus Market Value 77
Load versus No Load 77

v


Contents

vi

Management Fees 79
Buying Mutual Fund Shares 79
Mutual Fund Objectives 80

Term Assignment
Part
Part
Part
Part
Part

Chapter 4

III. Spending Policy 116
IV. Asset Allocation Strategy 116
V. Investment Guidelines 116
VI. Administrative and Review
Procedures 117
VII. Investment Responsibility 117

80

One 81
Two 81
Three 81
Four 82
Five 82

Statement of Investment Objectives
and Policy Guidelines for Eastern
Maine Healthcare Systems
118

Further Reading

82

Investment Policy

84

Key Terms

84

Introduction

84

The Purpose of Investment Policy

85

Pension Plan Endowment Fund Self
Insurance Trust April 1998 118
Last Amended by Eastern Maine
Healthcare Systems Board of Directors
February 28, 2006 118
I. Purpose 118
II. Endowment Fund Spending Policy 119
III. Objectives 120
IV. Asset Allocation/Manager
Structure 121

V. Investment Guidelines 122
VI. Performance Standards 125
VII. Defined Contribution Pension
Plans 126
VIII. Responsibilities 128
IX. Amendments 130

Outline Expectations and Responsibilities 85
Identify Objectives and Constraints 87
Outline Eligible Asset Classes and
Their Permissible Uses 91
Provide a Mechanism for Evaluation 91

Elements of a Useful Investment
Policy

92

Return 92
Risk 93
Constraints 94

Risk and Return Considerations:
Different Investors

97

Individual Investors 97
Institutional Investors 97

Critiquing and Revising the
Investment Policy Statement

PART TWO PORTFOLIO
CONSTRUCTION
Chapter 5

101

Characteristics of a Good Statement 101
Revising the Policy 102

Appendix

Summary
Questions
Problems
Internet Exercise
Further Reading

103
103
104
112
112

Sample Statements of
Investment Policy

113

The Philadelphia Foundation, Inc.
Investment Policy
115
APPROVED — November 15, 2006 115
I. Mission 115
II. Investment Goals 115

The Mathematics of
Diversification

133

Key Terms

133

Introduction

133

Linear Combinations

134

Return 134
Variance 135

Single-Index Model

140

Computational Advantages 140
Portfolio Statistics with the
Single-Index Model 142

All Souls Congregational Church 113
All Souls Congregational Church Endowment
Fund Investment Policy March 2003 113
General Purpose and Philosophy 113
Responsibilities 114
Objectives 114
Constraints 114
Reporting 115

131

Chapter 6

Multi-Index Model

143

Summary
Questions
Problems
Internet Exercise
Further Reading

143

144
144
147
147

Why Diversification Is a
Good Idea

148

Key Terms

148

Introduction

148

Carrying Your Eggs in More
Than One Basket

148


Contents

vii

Investments in Your Own Ego 149
The Concept of Risk Aversion Revisited 149

Multiple Investment Objectives 150

Role of Uncorrelated Securities

150

Variance of a Linear Combination:
The Practical Meaning 150
Portfolio Programming in a Nutshell 151
Concept of Dominance 152
Harry Markowitz: The Founder of
Portfolio Theory 156

Lessons from Evans and Archer

Practical Problems with Stochastic
Dominance 197

Chapter 7

163

197
197
198

International Investment
and Diversification

199

Key Terms

199

Introduction

199

Why International Diversification
Makes Theoretical Sense
200

Methodology 163
Results 164
Implications 165
Words of Caution 167

Remembering Evans and Archer 200
Remembering Capital Market Theory 201

Diversification and Beta

167

Foreign Exchange Risk

Capital Asset Pricing Model

168

Business Example 204
An Investment Example 205
Whence Cometh the Risk? 205
Dealing with the Risk 210
The Eurobond Market 215
Combining the Currency and Market
Decisions 215
Key Issues in Foreign Exchange Risk
Management 217

Systematic and Unsystematic Risk 168
Fundamental Risk/Return
Relationship Revisited 168

Equity Risk Premium

171

Using a Scatter Diagram to
Measure Beta

172

Correlation of Returns 172
Linear Regression and Beta 173

Importance of Logarithms
Arbitrage Pricing Theory

Investments in Emerging Markets 217

175

APT Background 177
The APT Model 177
Example of the APT 179
Comparison of the CAPM and the APT 179
Future Prospects for APT 180

Summary
Questions
Problems
Internet Exercises
Further Reading

180
181
182
184
185

Stochastic Dominance

187

Key Terms

187

Introduction

187

Efficiency Revisited

187

First-Degree Stochastic
Dominance

188

Second-Degree Stochastic
Dominance

192

Stochastic Dominance and
Utility

194

Stochastic Dominance and Mean
Return 196
Higher Orders of Stochastic
Dominance 196

204

Background 218
Adding Value 219
Reducing Risk 219
Following the Crowd 219
Special Risks 220
Asymmetric Correlations 224
Market Microstructure
Considerations 225

175

Statistical Significance 175

Appendix

Summary
Problems
Further Reading

Political Risk

227

Factors Contributing to
Political Risk 228
Subclasses of Political Risk 229
Dealing with Political Risk 229

Other Topics Related to
International Diversification

231

Multinational Corporations 231
American Depository Receipts 231
International Mutual Funds 232

Chapter 8

Summary
Questions
Problems
Internet Exercises
Further Reading

233
234
235
237
237

The Capital Markets and
Market Efficiency

240

Key Terms

240

Introduction

240

Role of the Capital Markets

240


Contents

viii

Economic Function 241
Continuous Pricing Function 241
Fair Price Function 242

Efficient Market Hypothesis

Chapter 10

253

Summary
Questions
Problems
Internet Exercise
Further Reading

261

262
262
263
263

Picking the Equity Players

266

Key Terms

266

Introduction

266

Stock Selection Philosophy:
Fundamental and Technical
Analysis

267

Dividends and Why They
Really Do Not Matter

267

Types of Dividends 267
Why Dividends Do Not Matter 273

Theory versus Practice 274
Stock Splits versus Stock Dividends 276

Investment Styles

280

Value Investing 280
Growth Investing 284
Capitalization 285
Integrating Style and Size 287

Categories of Stock

288

Blue-Chip Stock 288
Income Stocks 289
Cyclical Stocks 289
Defensive Stocks 290
Growth Stocks 290
Speculative Stocks 290
Penny Stocks 291
Categories Are Not Mutually Exclusive 291
A Note on Stock Symbols 291

Summary
Questions

Equity Valuation Tools

296

Key Terms

296

Introduction

296

The Stock Price as a
Present Value

296

The Present Value as a Ratio 297
The Numerator: Future Earnings 297
The Denominator: Uncertainty,
Confidence, Inflation, and
Psychology 300

Low–PE Effect 253
Low-Priced Stocks 254
Small-Firm and Neglected-Firm Effects 255
Market Overreaction 256
January Effect 257
Day-of-the-Week Effect 258
Turn-of-the-Calendar Effect 259
Persistence of Technical Analysis 259

Chaos Theory 260

Chapter 9

294
295
295

243

Types of Efficiency 243
Weak Form 244
Semi-Strong Form 248
Strong Form 249
Semi-Efficient Market Hypothesis 250
Security Prices and Random Walks 253

Anomalies

Problems
Internet Exercise
Further Reading

293
293

Changes in the Stock Price
and Relative Valuation

302

Short and Long Term 302
Equity Risk Premium 303
Greenspan Model 303
Changing PE Multiples 304

Chapter 11

Summary
Questions
Problems
Internet Exercise
Further Reading

305
306
306
307
307

Security Screening

308

Key Terms

308

Introduction

308

Why Screening Is Necessary

308

Time Constraints 308
Everyday Examples of Screens 309

What Constitutes a Good Screen? 310
Ease of Administration 310
Relevance and Appropriateness 310
Acceptance by the User 311
Ordinal Ranking of Screening Criteria 311

Screening Processes

311

Multiple-Stage Screening 311
Subjective Screening 312
Positive and Negative Social Screens 315
Popular Screening Variables 316
A Quick Risk Assessment Screen
with the Stock Report 319

Library Information

319

Value Line 320
Standard & Poor’s 321
Mergent 322

Internet Resources

322

Morningstar 322
Yahoo! 323
WSJ.com 323

Summary

326


Contents

Chapter 12

ix

Questions
Problems
Internet Exercise
Further Reading

326
327

328
328

Bond Pricing and Selection

329

Key Terms

329

Introduction

329

Review of Bond Principles

330

Bond Pricing and Returns

Timberland in Particular

Real Estate Investment Trusts

Chapter 14
346

Types of Real Estate Value

387

Gold

388

Summary
Questions
Internet Exercise
Further Reading

396
397
397
398

Alternative Assets

400

Key Terms

400

Introduction

400

Infrastructure

400

Investment Characteristics 402

Hedge Funds
354

Commodities

407

Private Equity

408

Forms of Private Equity 408
J Curve 409

355

Client Psychology and Bonds Selling
at a Premium 355
Call Risk 356
Constraints 357

359

The Problem 359
Unspecified Constraints 360
Finding Bonds 360

Solving the Problem 360

Opportunistic Real Estate

410

Summary
Questions
Problems
Internet Exercise
Further Reading

410
411
412
412
412

PART THREE PORTFOLIO
MANAGEMENT
365
366
367
370
370

403

Long/Short Portfolio 404
Hedge Fund-of-Funds 406

Default Risk 354
Dealing with the Yield Curve 354
Bond Betas 355

Chapter 13

386

Motivation for Gold Investment 389
Determinants of the Price of Gold 390
The London Fix 392
Investing in Gold 394

Price Risks 346
Convenience Risks 348
Malkiel’s Interest Rate Theorems 349
Duration as a Measure of Interest-Rate
Risk 352

Summary
Questions
Problems
Internet Exercise
Further Reading

376

Institutional Interest in Timberland 376
A Timberland Investment Primer 377

334

Bond Risk

Example: Monthly Retirement
Income

373

Types of REITs 387

Valuation Equations 335
Yield to Maturity 336
Realized Compound Yield 337
Current Yield 338
Term Structure of Interest Rates 339
Spot Rates 341
The Conversion Feature 343
The Matter of Accrued Interest 344

Choosing Bonds

372

Real Estate in General

Investment Characteristics 373
Developed and Undeveloped Property 374
Pension Fund Investment in Real Estate 375

Identification of Bonds 330
Classification of Bonds 330
Terms of Repayment 332
Bond Cash Flows 333
Convertible Bonds 333
Registration 334

The Meaning of Bond
Diversification

Introduction

Chapter 15

413

Revision of the Equity
Portfolio

415

Key Terms

415

Introduction

415

The Role of Real Assets

372

Active Management versus Passive
Management
415

Key Terms

372

The Manager’s Choices 416


x

Contents

Tactical Asset Allocation

426

Sources of Profits and Losses with
Options 472

What Is Tactical Asset Allocation? 426
How TAA Can Benefit a Portfolio 428
Designing a TAA Program 429
Caveats Regarding TAA Performance 430

Costs of Revision 430
Contributions to the Portfolio 435

When Do You Sell Stock?

Option Pricing

435

Rebalancing 436
Upgrading 436
Sale of Stock via Stop Orders 436
Extraordinary Events 437
Final Thoughts 438

Summary
Questions
Problems
Internet Exercise
Further Reading

Chapter 16

439
439
440
442
442

Revision of the Fixed-Income

Portfolio
444

Chapter 18

Summary
Questions
Problems
Internet Exercise
Further Reading

485
485
487
488
488

Option Overwriting

489

Key Terms

489
489

Key Terms

444

Introduction

Introduction

444

Using Options to Generate Income 489

444

Writing Calls to Generate Income 489
Writing Puts to Generate Income 493
Writing Index Options 497
A Comparative Example 501

Passive versus Active
Management Strategies
Passive Strategies 444
Active Strategies 445
Risk of Barbells and Ladders 449
Bullets versus Barbells 451
Swaps 451
Forecasting Interest Rates 452
Volunteering Callable Municipal
Bonds 453

Chapter 17

473

Determinants of the Option
Premium 473
Black-Scholes Option Pricing Model 477
Development and Assumptions
of the Model 478
Insights into the Black-Scholes
Model 481
Delta 481
Theory of Put/Call Parity 482
Stock Index Options 484

Combined Hedging/Income
Generation Strategies

505

Writing Calls to Improve on the Market 505
Writing Puts to Acquire Stock 507
Writing Covered Calls for Downside
Protection 507

Bond Convexity (Advanced Topic) 453

Multiple Portfolio Managers

The Importance of Convexity 453
Calculating Convexity 454
An Example 457
Using Convexity 458

Separate Responsibilities 508
Distinction Between Option Overwriting
and Portfolio Splitting 508
Integrating Options and Equity
Management 509

Summary
Questions
Problems
Internet Exercise
Further Reading

460
461
461
463
463

Principles of Options and
Option Pricing

465

Key Terms

508

Summary
Questions
Problems

Internet Exercise
Further Reading

510
510
511
512
512

Performance Evaluation

513

465

Key Terms

513

Introduction

465

Introduction

513

Option Principles

466

Importance of Measuring
Portfolio Risk

513

Why Options Are a Good Idea 466
What Options Are 466
Standardized Option Characteristics 467
Where Options Come From 468
Where and How Options Trade 469
The Option Premium 470

Chapter 19

A Lesson from History: The 1968 Bank
Administration Institute Report 514
A Lesson from a Few Mutual Funds 515
Why the Arithmetic Mean Is Often
Misleading: A Review 516


Contents

xi

Why Dollars Are More Important Than
Percentages 517

Traditional Performance

Measures

517

Sharpe and Treynor Measures 517
Jensen Measure 521
Performance Measurement
in Practice 521

PART FOUR PORTFOLIO
PROTECTION AND EMERGING
TOPICS
567
Chapter 21

Dollar-Weighted and
Time-Weighted Rates of Return

527

Performance Evaluation with
Cash Deposits and Withdrawals

528

533

Fiduciary Duties and
Responsibilities

544

Key Terms

544

Introduction

544

History

545

Prudent Man Rule 546
The Spitzer Case 547
Prudent Expert Standard 548
Uniform Management of Institutional
Funds Act 549
Uniform Prudent Investor Act 549

550

Care 550
Loyalty 551
Prohibited Transactions 553

555

Due Diligence 555

Social Investing 555
Proxy Voting 555
Soft Dollars 560

Summary
Questions
Internet Exercise
Further Reading

Introduction

569

Futures Contracts

570

573

The Clearing Process

579

Matching Trades 579
Accounting Supervision 581
Intramarket Settlement 581
Settlement Prices 582
Delivery 582

539

539
540
542
542

Emerging Areas

569

Market Mechanics

Summary
Questions
Problems
Internet Exercise
Further Reading

Fiduciary Duties

Key Terms

The Marketplace 573
Creation of a Contract 575
Market Participants 576

Incremental Risk-Adjusted Return
from Options 533
Residual Option Spread 538
Final Comments on Performance
Evaluation with Options 539

Chapter 20

569

What Futures Contracts Are 570
Why We Have Futures Contracts 571
How to Fulfill the Futures Contract
Promise 571

Daily Valuation Method 528
Modified Bank Administration
Institute (BAI) Method 531
An Example 531
An Approximate Method 532

Performance Evaluation When
Options Are Used

Principles of the Futures
Market

Principles of Futures Contract
Pricing

583

Expectations Hypothesis 583
Normal Backwardation 584
Full Carrying Charge Market 585

Reconciling the Three Theories 586

Foreign Currency Futures

587

Hedging and Speculating with
Foreign Currency Futures 587
Pricing of Foreign Exchange
Futures Contracts 588

Chapter 22

Summary
Questions
Problems
Internet Exercise
Further Reading

589
589
590
591
591

Benching the Equity Players

592

Key Terms

592

Introduction

592

Using Options

592

Equity Options with a Single Security 592
Index Options 596

Using Futures Contracts
563
564
565
565

Importance of Financial Futures 598
Stock Index Futures Contracts 598
S&P 500 Stock Index Futures
Contracts 599
Hedging with Stock Index Futures 599
Calculating a Hedge Ratio 601

598

xii

Contents

Summary
Questions
Problems
Internet Exercise
Further Reading

Hedging in Retrospect 604
Single Stock Futures 605
Hedging with SSF 605

Dynamic Hedging

606

Dynamic Hedging Example 606
The Dynamic Part of the Hedge 608
Dynamic Hedging with Futures
Contracts 608

Summary
Questions
Problems
Internet Exercise
Further Reading

Chapter 23

Chapter 25 Contemporary Issues in
Portfolio Management

656

Key Terms

656

Introduction

656

Exchange-Traded Funds

656

610
610
611
612
612

Removing Interest-Rate Risk

614

Key Terms

614

Introduction

614

Interest-Rate Futures Contracts

614

Chapter 24

657
658

Certificateless Trading

664

Proxy Voting

665

Majority Voting 665
Separation of Chairman and CEO 665

Role of Derivative Assets
621

Portfolio Margining

667

Islamic Finance

667

Principles-based versus Rules-based
Financial Oversight
668

632
632
633
633
634

Structured Products

669

The Chartered Financial Analyst
Program

669

History 669
The CFA Program Exams 670
CFA Program Themes 671

Integrating Derivative Assets
and Portfolio Management

635

Key Terms

635

Regulation Fair Disclosure

Introduction

635

Setting the Stage

635

The SEC Position 673
The Industry Position 674
CFA Institute Response 674
The Future of the Regulation 674

Portfolio Objectives 635
Portfolio Construction 636

Meeting an Income Constraint

Summary

Questions
Problems
Internet Exercise
Further Reading

640

Determining Unmet Income Needs 640
Writing Index Calls 640

Risk Management

642

Stock Portfolio 642
Hedging Company Risk 645
Fixed-Income Portfolio 646

Managing Cash Drag

651

666

Process of Education 666
Getting Board Approval 666

Duration Matching 621
Immunizing with Interest-Rate Futures 626
Immunizing with Interest-Rate Swaps 627

Disadvantages of Immunizing 631

Summary
Questions
Problems
Internet Exercise
Further Reading

Security Analyst Objectivity
Stock Lending
Mechanics of a Short Sale 659
How a Stock Lending Transaction
Works 661
Stock Lending’s Lucrative Nature 662
Regulatory Concerns 663

Categories of Interest-Rate Futures
Contracts 615
U.S. Treasury Bills and Their Futures
Contracts 615
Treasury Bonds and Their Futures
Contracts 618

Concept of Immunization

652
653
653
654
654

Glossary 679
Index 697

673

675
676
676
677
677


PREFACE

T

he trend in investment management is to emphasize portfolio construction and to reduce the time spent on security selection. Though all
money managers should be familiar with the specific components of
their portfolios and should know why they own them, overwhelming evidence
proves that asset allocation is what matters in the long run, with security selection playing a secondary role.
Prior study in investments is not a prerequisite for use of this book, but I
do assume that the reader has had a course in managerial or corporate finance.
In schools without a “pure” portfolio course, this book will accomplish the
objectives of both a traditional investments course and a portfolio management course. The investments instructor who chooses to emphasize portfolio
management rather than security selection will find the organization and spirit
of this book especially appealing.
In schools that offer separate investments and portfolio courses, Portfolio
Construction, Management, and Protection, Fifth Edition, enables the portfolio management instructor to develop a very rich course in which the students
can discover the beauty, logic, and potential of modern portfolio management.

I believe the strengths of this book are its application orientation and the transitions from theory to practice.
Although principles of portfolio construction and management have been
taught at the university level for many years, students may find the subject
uncomfortably quantitative, laden with mathematical proofs, intellectually inaccessible, and generally “user unfriendly.” This book provides an alternative
to the course’s stereotypical approach.

The Approach of This Edition
Some aspects of my own background helped form my ideas about what a
useful course on portfolio management would need to cover. I am a firm
believer in the utility of financial derivatives: five chapters of this book
contain material on the sensible use of futures and options in portfolio management. I am also a Chartered Financial Analyst, have been chairman of
a retail brokerage firm, serve on various investment committees responsible
for more than $12 billion, and am on the trust committee of a bank board
of directors. My experience with these activities is largely responsible for
two special chapters in this book. Chapter 4, “Investment Policy,” covers an
extremely important subject to which we often do not give sufficient attention in portfolio management courses. In order to manage money properly,
money managers must have a statement of investment policy to guide their
actions. They must also understand that investment policy is different from
investment management, and that different people have responsibility for
these two functions.
Chapter 20, “Fiduciary Duties and Responsibilities,” also discusses material that does not get much playing time in the classroom. I believe that
instructors and students alike will find this material fascinating, and that for
xiii


xiv

Preface

many people it will change their way of thinking about the investment process.

The evolution of legal doctrine regarding proper fiduciary conduct is especially
thought provoking.
There are two new chapters in the fifth edition. At the request of some
long-time users of the book, I have added a second chapter on stock selection.
This chapter discusses a variety of valuation models that will be helpful to the
instructor who wants to expand the stock-picking part of the course. There
is also a new chapter dealing with alternative assets, including infrastructure,
hedge funds, private equity, commodities, and specialized real estate. Some
of the largest U.S. investment funds are devoting an increasing proportion of
their money to these assets. This is an important current topic area, and our
students are better served if they are up to speed on the basics of this emerging
asset class.
I am a staunch advocate of the Chartered Financial Analyst program
and have included some actual questions from recent CFA exams in a few
chapters. Participation in the CFA Program is rapidly becoming a condition
of employment at many firms, and I believe we should expose our students to
the CFA Institute, its Code of Ethics, and its Standards of Practice throughout
their studies.
Many adopters of the book have told me they find the Mutual Fund
Evaluation Term Project (the appendix to Chapter 3) to be quite useful. I personally like the appendix on Stochastic Dominance (which follows Chapter 6)
for the intellectual discussion it seems to promote.

Supplements
Website (www.cengage.com/finance/strong)
The text website contains instructor and student resources, Internet applications from the text, links to relevant financial websites, and other useful features. The instructor’s companion website includes the Instructor’s Manual,
which features Key Points, Teaching Considerations, Answers to Questions,
and Answers to Problems. The instructor’s site also includes a test bank of
qualitative and quantitative multiple-choice questions. There are several Excel
spreadsheet templates available on the text website. These are primarily time
savers that can be incorporated into homework assignments or used as a takehome portion of an exam. PowerPoint slides to accompany the text, prepared

by Tom Krueger of the University of Wisconsin, are available to qualified
instructors as downloads from the website.

Acknowledgements
I received a great deal of help in writing this book from my academic and
practitioner colleagues. At Cengage Learning, I have worked with Mike
Reynolds, my Acquisition Editor, for many years on various projects. He
is a reasonable man, sympathetic to the individual nuances of his many authors. For the fifth edition, my two Jennifers (King and Ziegler) provided
just enough prodding to keep me on schedule without becoming annoying. I
appreciate their friendly demeanor and teamwork. Also at Cengage, I’d like
to thank Nate Anderson, marketing manager; Suellen Ruttkay, marketing
coordinator; Michelle Kunkler, art director; and Scott Fidler, technology
project manager.


Preface

xv

In addition, the book has received thorough reviews from the following
colleagues over the current and previous editions:
S.G. Baldrinath
Northeastern University

Jon Hooks
Albion College

Laurence E. Blose
Grand Valley State University

Philip A. Horvath
Bradley University

James Buck
East Carolina University

John S. Howe
Louisiana State University

John Burnett
University of Alabama in Huntsville

Riaz Hussain
University of Scranton

Kam C. Chan
Western Kentucky University

Jau-Lian Jeng
Azusa Pacific University

Natalya V. Delcoure
University of South Alabama

Keith H. Johnson
University of Kentucky

Thomas W. Downs
University of Alabama

Douglas Kahl
University of Akron

Jim Estes
California State University,
San Bernardino

Peppi M. Kenny
Western Illinois University

Howard Finch
University of Tennessee—
Chattanooga
H. Swint Friday
University of South Alabama
Phillip R. Fuller
Jackson State University
Bruce Grace
Morehead State University

Tom Krueger
University of Wisconsin, LaCrosse
Malek Lashgari
University of Hartford
Jeong W. Lee
University of North Dakota
Ralph Lim
Sacred Heart University
David Louton
Bryant University

David Hall
Chicago Board of Options
Exchange

Linda J. Martin
Arizona State University

Robert Hartwig
Worcester State College

Byron Menides
Worcester Polytechnic Institute

William Hecht
Western International University

Mehdi Mohaghegh
Norwich University


xvi

Preface

Robert W. Moreschi
Virginia Military Institute
Edgar Norton
Fairleigh Dickinson University
Dr. Dong Nyonna

Christian Brothers University
Prasad Padmanabhan
San Diego State University
Daniel E. Page
Auburn University
Luis Rivera
Dowling College

Thoms V. Schwartz
Southern Illinois University—
Carbondale
Bill Swales, Esq.
Bangor Savings Bank Trust
Department
Calvin True, Esq.
Eaton Peabody
Bret Vicary
James W. Sewall Company
Mahmoud S. Wahab
University of Hartford

Mark Schaub
Texas A&M University
Dr. Robert A. Strong, CFA
University of Maine
Orono, ME
July, 2008


PA R T O N E

Background, Basic Principles,
and Investment Policy
Chapter 1

The Process of Portfolio Management

Chapter 2

Valuation, Risk, Return, and Uncertainty

Chapter 3

Setting Portfolio Objectives

Chapter 4

Investment Policy

1


This page intentionally left blank


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

1

The Process of Portfolio Management
Introduction

Portfolio management
primarily involves
reducing risk rather than
increasing return.

The traditional investments course covers two principal topics: security analysis
and portfolio management. Security analysis involves estimating the merits of
individual investments while portfolio management deals with the construction and maintenance of a collection of investments.
Investment professionals often describe security analysis as a three-step
process. First, the analyst considers prospects for the economy, given the stage
of the business cycle. Second, the analyst determines which industries are
likely to fare well in the forecasted economic conditions. Finally, the analyst
chooses particular companies within the favored industries. Many people call
this procedure EIC analysis for economy, industry, and company.1
In recent years the trend has been to move away from stock picking and
toward portfolio management (Figure 1-1). Most of the academic literature
from the last two decades generally supports the efficient markets paradigm.
Market efficiency means that on a well-developed securities exchange, asset
prices accurately reflect the trade-off between the relative risk and potential
return associated with the security. Markets are kept reasonably efficient
because of the vast number of market participants who are quick to take advantage of security mispricing. This means that efforts to identify undervalued
securities are generally fruitless. In other words, free lunches are difficult to
find, and any quest for them is likely to wind up at a dead end.
The fact that markets are efficient does not mean that investment managers can just throw darts when making their investment decisions. Not all
portfolios are created equal; some are clearly better than others. 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.
By reducing the dispersion of an investment’s returns while holding the
mean return constant, the investor fares better. This is an important point.
Figure 1-2 compares two $10,000 investments. One earned 10 percent per year
for each of ten years, growing to a terminal value of $25,937. The arithmetic
1

This is a top-down approach, beginning with a large security universe and winding up with a smaller,
more manageable number.

3


4

Part One Background, Basic Principles, and Investment Policy

FIGURE 1-1
The Trend in Managerial
Time and Focus

FIGURE 1-2
$10,000 Initial
Investment
24

19

14

9
97

98

99

00

01

02
Year

Both investments have a mean return of 10 percent.

03

04

05

06

07


Chapter 1 The Process of Portfolio Management

5

average of its annual returns is, of course, 10 percent. A second investment
shows dispersion in its returns (9, Ϫ11, 10, 8, 12, 46, 8, 20, Ϫ12, and
10 percent), but it still has a 10 percent arithmetic average return. The terminal
value of this investment, however, is only $23,642. It is a mathematical fact
that the lower the dispersion in the returns, the greater the accumulated value
of otherwise equal investments.
Before the portfolio manager can do the job, however, there needs to be a
statement of investment policy. This outlines the return requirements, the investor’s risk tolerance, and the constraints under which the portfolio must operate.
It is absolutely essential for an investment manager to have this information
before going about the business of asset allocation and security selection.
The portfolio management process has six steps, which are highlighted in
Figure 1-3 and in the marginal notes. The remainder of this chapter previews
things to come later in the book.

Part One: Background, Basic Principles, and
Investment Policy
Step 1: Learn the basic
principles of finance.

A person cannot be an effective portfolio manager without a solid grounding
in the basic principles of finance. This is the first aspect of portfolio management. At one time it may have been possible to get away with an ad hoc
approach to managing money, but this is no longer the case. Modern portfolio
management is too complex.2

FIGURE 1-3
Learn the basic
principles of finance
(chapters 1 – 2).

Six Steps of Portfolio
Management

Set portfolio objectives
(chapters 3 – 4).
Evaluate the
performance
(chapters 19 – 20).
Protect the
portfolio when
appropriate
(chapters 21 – 25).

Formulate an
investment strategy
(chapters 5 – 14).

Have a game plan for
portfolio revision
(chapters 15 – 18).

2

Also, our society is quite litigious these days, and investment managers sometimes have to explain
their actions (or inaction) in court.


6

Part One Background, Basic Principles, and Investment Policy

Talk is cheap in the
investment business.

Most people who read this book will have previously studied the fundamentals of finance. Finance is a very logical discipline with basic principles
that are not difficult. The danger is that egos sometimes get involved, and
people may be reluctant to spend much time reviewing “simple” material.
One of the curious things about investment management is that the public’s
perception of its own competence seems bimodal: people are likely to believe
that they know either a lot or only a little about this topic. Talk is cheap in
the investment world. People can say that they know how to do something,
but in the final analysis, it is deeds, not dialogue, that count.
The passage that follows is one of my favorite quotations. It is attributed
to the Roman consul Lucius Aemilius Paulus as he addressed the people of
Rome before the Pydna campaign (167 B.C.) of the Third Macedonian War:
In every circle, and, truly at every table, there are people who lead armies
into Macedonia; who know where the camp ought to be placed; what
posts ought to be occupied by troops; when and through what pass that
territory should be entered; where magazines should be formed; how
provisions should be convoyed by land and sea; and when it is proper to
engage the enemy, and when to lie quiet.
And they not only determine what is to be done but if anything is
done in any other manner than what they have pointed out, they arraign
the consul, as if he were on trial before them.
These are the great impediments to those who have the management
of affairs; for everyone cannot encounter injurious reports with the same
constancy and firmness of mind as Fadius did; who chose to let his own
ability be questioned through the folly of the people, rather than to mismanage the public business with a high reputation.
I am not one of those who think that commanders at no time ought to
receive advice; on the contrary, I should deem that man more proud than

wise, who regulated every proceeding by the standard of his own single
judgment. What then is my opinion?
That commanders should be counseled. Chiefly, by persons of known
talent; by those who have made the art of war their particular study, and
whose knowledge is derived from experience; from those who are present
at the scene of action; who see the country, who see the enemy; who see
the advantages that occasions offer, and who, like people embarked on the
same ship are sharers of the danger. If, therefore, anyone thinks himself
qualified to give advice respecting the war I am to conduct, which may
prove advantageous to the public, let him not refuse his assistance to the
state, but let him come with me into Macedonia.
He shall be furnished with a ship, a horse, a tent; even his traveling
charges shall be defrayed. But if he thinks this too much trouble, and prefers the repose of a city life to the toils of war, let him not, on land, assume
the office of a pilot.
The city, in itself, furnishes abundance of topics for conversation; let
it confine its passion for talking within its own precincts, and rest assured
that we shall pay no attention to any councils but such as shall be framed
within our camp.3
In this quotation Paulus is emphasizing the fact that deeds are what count.
This is good advice to modern portfolio managers as they do battle with the

3

Victor Duruy, History of Rome and of the Roman People (Boston: C.F. Jewett, 1883), 169–170.


Chapter 1 The Process of Portfolio Management

A good company is not
necessarily a good

investment.

The whole point of investment management is to
get more of what you like
and get rid of what you
dislike.

Step 2: Set portfolio
objectives

7

forces that would keep them from achieving their investment goals. If someone
has a worthy idea to contribute, then let us hear it, but fluff and bluster have no
place in the formation of investment policy or strategy. Many of those who feel
that they know a lot about the investment business share the genes of the people
Paulus was addressing. It is unlikely that someone who has never constructed a
portfolio is qualified to give advice on the subject, and it is certain that a futures
and options neophyte cannot speak intelligently on the prudent use of derivatives in portfolio protection. In the same fashion, a junior security analyst soon
learns that a good company is not necessarily a good investment. The stock of
a well-run company may simply be too expensive at the current price.
This is true of anything we buy. The price tag hanging from an elegant business suit at a high-end clothing store may be $2,500. No one will argue that the
suit is snazzy, but not everyone would consider it a good investment. At $350,
however, the same suit would be a much more attractive investment. The same
is true of a share of stock in a well-managed company. If the stock price comes
down, it may become a good investment while remaining a good company.
Similarly, poorly run companies can be great investments if they are cheap
enough. People buy old, beat-up stuff at yard sales because it is inexpensive,
not because its quality is high. While most of us have a reasonably good understanding of value shopping, many people never figure out the distinction
between good companies and good investments.

Part One of this book reviews the fundamental principles of finance and statistics that an analyst must understand before moving on to portfolio construction
and management. Much of this material will be generally familiar to most readers, but virtually everyone will learn something from a review of these topics.
The two key concepts in finance are (1) a dollar today is worth more than a
dollar tomorrow and (2) a safe dollar is worth more than a risky dollar. These
two ideas form the basis for all aspects of financial management. In reviewing
these two key concepts and some basic statistics in Chapter 2, readers will also
get a refresher course on the importance of the economic concept of utility as it
relates to risk and return. The whole point of investment management is for investors to get more of what they enjoy and get rid of what they dislike. Investors
like return, be it in dollars or in intangible form, and they dislike risk. The goal is
to get as much of the “good” while suffering as little of the “bad” as possible.
All of finance stems from the basic concepts of the risk/return trade-off
and the time value of money. It is difficult to truly comprehend new investment products and risk-management practices without fluency in these principles. These first two chapters are a good review for every reader.
According to an old saying, “It is difficult to accomplish your objectives
until you know what it is you want to accomplish.” Step 2 in portfolio management is setting portfolio objectives. Chapters 3 and 4 deal with setting
objectives and determining investment policy. People think they understand
words such as growth or income, but these terms often mean different things to
different people. For some people reading this book, the discussion of the importance of objective setting will make the most lasting impression. Chapter 3
describes the difficulty people have in finding a balance between risk and expected return and provides a framework for determining portfolio objectives.
Chapter 4 focuses on investment policy. The separation of investment
policy from investment management is a fundamental tenet of institutional
money management. One group of people, such as a board of directors or
an investment policy committee, establishes the rules of the game and hires
someone to play the game. These people establish policy. The investment
manager is the person who implements the plan. It is a mistake (sometimes a


8

Part One Background, Basic Principles, and Investment Policy

Investment policy is
distinct from investment
management.

very serious one) and possibly a breach of legal duty to allow the investment
manager also to set the rules and, by default, the investment policy.
A formal statement of investment policy is a very useful tool. This document clearly outlines responsibilities and procedures. It is an important part
of the investment process to make sure such a document exists.

Part Two: Portfolio Construction

Step 3: Formulate an
investment strategy.

Once a person has been through financial boot camp and has a policy statement, it is time to begin formulating an investment strategy and constructing
the portfolio itself. This involves more than simply buying a handful of securities so that all your eggs are not in one proverbial basket. There are many
different things to consider and to monitor.
Portfolio managers need to understand the basic elements of capital market
theory. The mathematical relationships underlying portfolio theory might seem
forbidding, but their basic substance is not difficult. Unfortunately, concepts
such as covariance and the appearance of double summation signs scare away
many people. A special effort is made to keep Chapter 5 user-friendly and to
help readers appreciate the logical beauty of portfolio theory. Diversification is
a good idea, both mathematically and logically. Chapter 6 discusses the riskreduction benefits that accompany informed diversification. Portfolio construction deals with diversification. It surprises many people to learn that diversification is not oriented toward increasing return; its purpose is to reduce risk.
One of the most consequential pieces of academic research regarding
portfolio construction is a paper by Evans and Archer showing the powerful
risk-reduction benefits obtained through the naive diversification that comes
from common sense in investment selection as opposed to some mathematical
technique.4 The implications of this research continue to be very important,
even for the most sophisticated portfolio manager.

Chapter 6 then extends the basic principles of risk and return to a more general capital market theory. There the focus is on unavoidable risk, which is the
type of risk that counts and the only type for which investors can reasonably expect additional return. Whereas naive diversification is beneficial, the informed
portfolio manager can do even better with theoretical best-practice investing.
International investment is an important part of modern portfolio management. In Chapter 7 you will see why foreign securities are appealing and why
the manager should think about the currency market as well as the global stock
markets. Emerging markets, such as those in Central Europe, the Pacific Rim,
and South America, carry special risks that investors should study before committing any money. Institutional portfolios frequently contain at least 15 percent
foreign investments with at least a small portion in emerging markets; a money
manager should be conversant with key aspects of this asset class.
Unlike the emerging markets, the U.S. financial markets are informationally very efficient but not completely so. Chapter 8 explains the implications
of this to the investor and the portfolio manager. The chapter also reviews the
beta statistic arising from capital market theory, the way a portfolio manager
might use it, and potential pitfalls with the number.
Chapters 9 and 10 deal with stock selection. Most portfolios contain some
equities, and the particular stocks the investment manager picks are quite
4

John Evans and Stephen Archer, “Diversification and the Reduction of Dispersion,” Journal of
Finance, December 1968, 761–77.