The Complete Guide to Portfolio Construction and Management
The Wiley Finance Series

Written by a high-profile investment adviser, this book reveals a practical portfolio management framework and new approach to portfolio construction based on four key market forces: macro, fundamental, technical, and behavioural. It is an insight that takes the focus off numbers, looking instead at the role of risk and behavior in finance.

As we have seen with the recent finance meltdown, traditional portfolio management techniques are flawed. Investors need to understand those flaws and learn how to incorporate risk management and behavioral finance into their asset management strategies.

With a foreword by industry leader Francois-Serge L'habitant, this is your one-stop guide, with new ways for you to manage, grow and preserve your investment portfolio, even in uncertain markets.

Foreword xiii

About the Author xv

Acknowledgements xvii

Introduction xix

Part I Investors and Risk 1

1 Basic Principles 3

1.1 Investors 3

1.2 Inflation 3

1.3 Choices for Investors in Terms of Investments 5

2 Measures of Risk 7

2.1 Volatility or Standard Deviation 7

2.2 Beta as a Measure of Risk 11

2.3 Value-at-Risk (VaR) 13

2.4 Investor Behaviour Towards Risk 14

Part II Asset Classes and Their Degree of Risk 17

3 Asset Classes and Associated Risks 19

3.1 Money Market Investments 19

3.1.1 Definition 19

3.1.2 Risks associated with money market investments 20

3.2 Bonds 22

3.2.1 Definition 22

3.2.2 Risks associated with bonds 26

3.3 Stocks 33

3.3.1 Definition 33

3.3.2 Risks associated with stocks 36

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

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

19.3 Earnings and Earnings Growth 143

19.4 Selection Criteria 144

19.4.1 The sales percentage 144

19.4.2 The P/E ratio 145

19.4.3 Liquid assets 145

19.4.4 Debt 145

19.4.5 Dividends 146

19.4.6 Hidden assets 146

19.4.7 Cash flow 146

19.4.8 Inventories 146

19.4.9 Growth rate 146

19.4.10 Gross profits 146

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

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

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

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