The Complete Guide to Portfolio Construction and Management E-Book

Lukasz Snopek

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 445

Veröffentlichungsjahr: 2012

Beschreibung

In the wake of the recent financial crisis, many will agree that it is time for a fresh approach to portfolio management. The Complete Guide to Portfolio Construction and Management provides practical investment advice for building a robust, diversified portfolio. 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.

Leseprobe

Table of Contents

Series Page

Title Page

Copyright

Foreword

About the Author

Acknowledgements

Introduction

Part I: Investors and Risk

Chapter 1: Basic Principles

1.1 Investors

1.2 Inflation

1.3 Choices for Investors in Terms of Investments

Chapter 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

Chapter 3: Asset Classes and Associated Risks

3.1 Money Market Investments

3.2 Bonds

3.3 Stocks

3.4 Real Estate

3.5 Commodities and Metals

3.6 Private Equity

3.7 Other Asset Classes

Chapter 4: Particular Forms of Investment within Asset Classes

4.1 Hedge Funds

4.2 Structured Products

4.3 Options

Chapter 5: Classification of Asset Classes According to their Degree of Risk

5.1 Selected Criteria for Classification of Asset Classes

5.2 Classification of the Different Asset Classes

Part III: The Market

Chapter 6: Market Efficiency

6.1 Weak Form Market Efficiency

6.2 Semi-Strong Form Market Efficiency

6.3 Strong Form Market Efficiency

6.4 Conclusion on Market Efficiency

Chapter 7: Fundamental Analysis

7.1 Discounted Cash Flow

7.2 Relative Measures

7.3 Strategic Analysis

7.4 Criticism of Fundamental Analysis

Chapter 8: Technical Analysis

8.1 The Three Fundamental Principles of Technical Analysis

8.2 Conclusion on Technical Analysis

Chapter 9: Investment Approach Based on “Psychological Principles”

Part IV: Valuation of Financial Assets

Chapter 10: Valuation of Money Market Investments

Chapter 11: Valuation of Bonds

Chapter 12: Valuation of Stocks

Chapter 13: Valuation of Options

Chapter 14: Valuation of Real Estate

Chapter 15: Valuation of Commodities and Metals

Chapter 16: Conclusion on Valuation

Part V: Three Practical Approaches to Security Selection: Buffett, Graham and Lynch

Chapter 17: Warren Buffett's Value Investing Approach

Chapter 18: Benjamin Graham's Approach

18.1 The Defensive Investor

18.2 The Enterprising Investor

18.3 Security Analysis

18.4 The Margin of Safety Concept

Chapter 19: Peter Lynch's Approach

19.1 Stock Categories

19.2 The Perfect Company According to Lynch

19.3 Earnings and Earnings Growth

19.4 Selection Criteria

19.5 Conclusion on Peter Lynch's Approach

Part VI: Behavioural Finance

Chapter 20: Investors in Behavioural Finance

Chapter 21: Heuristics and Cognitive Biases

21.1 Information Selection

21.2 Information Processing

21.3 The Use of Assets

Chapter 22: Investment Approach Based on Behavioural Finance

22.1 Momentum Strategy

Chapter 23: Criticism of Behavioural Finance

Part VII: Forecasting Market Movements

Chapter 24: Investment Approach Based on Probabilities

Chapter 25: Random Walk Theory

Chapter 26: Market Timing

Chapter 27: Macroeconomic Investment Approach

27.1 State Interventions

27.2 The Major Macroeconomic Forces

27.3 Sectorial Analysis

27.4 Peter Navarro's Approach

27.5 Criticism of the Macroeconomic Approach

Part VIII: Modelling Market Movements

Chapter 28: Suggested Investment Approach

Chapter 29: The Forces

29.1 The Macroeconomic Force

29.2 The Fundamental Force

29.3 The Technical Force

29.4 The Behavioural Force

29.5 The Luck Force

Chapter 30: The Forces' Strength

Chapter 31: The Beauty of the Approach

Part IX: Portfolio Construction and Management

Chapter 32: Modern Portfolio Theory According to Markowitz

32.1 David Swensen's approach

Chapter 33: The Capital Asset Pricing Model (CAPM)

Chapter 34: The Minimum Variance Portfolio

Chapter 35: Value-at-Risk (VaR)

Chapter 36: Discretionary Mandates

Chapter 37: The Dollar-cost Averaging Approach

Chapter 38: Our Portfolio Construction Method

38.1 Basic Principles of Portfolio Construction

38.2 The Portfolio Construction Process

38.3 A Practical Example of Portfolio Construction

Part X: Attractiveness of the Different Asset Classes

Chapter 39: Asset Classes

39.1 Money Market Investments

39.2 Bonds

39.3 Stocks

39.4 Real Estate

39.5 Commodities and Precious and Industrial Metals

Chapter 40: The Four Forces of the Investment Model

40.1 The Macroeconomic Force

40.2 The Fundamental Force

40.3 The Technical Force

40.4 The Behavioural Force

Chapter 41: Table Summarising the Different Forces

Chapter 42: A Final Example: Analysis of the Subprime Crisis

Conclusion

Bibliography

Index

For other titles in the Wiley Finance series

please see www.wiley.com/finance

This edition first published 2012

© 2012 Lukasz Snopek

Translated by Jessica Edwards from the original French edition: Guide Complet de Construction et de Gestion de Portefeuille published in 2010 by Maxima Laurent du Mesnil Editeur, Paris.

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Library of Congress Cataloging-in-Publication Data

Snopek, Lukasz.

The complete guide to portfolio construction and management / Lukasz Snopek.

p. cm.

Includes bibliographical references and index.

ISBN 978-1-119-97688-2 (hardback)

1. Portfolio management. I. Title.

HG4529.5.S63 2012

332.6—dc23

2011039046

A catalogue record for this book is available from the British Library.

ISBN 978-1-119-97688-2 (hardback) ISBN 978-1-119-95304-3 (ebk)

ISBN 978-1-119-95305-0 (ebk) ISBN 978-1-119-95306-7 (ebk)

Foreword

Since the mid-1990s, the world of asset management has seen a large number of its main principles, both quantitative and qualitative, collapse one after the other, leaving investors and their portfolios at the mercy of market fluctuations. At the risk of sounding somewhat cynical, it can be said without regret that it was high time. Most of these grand principles had in fact been suggested in the mid-1950s in a very different financial world from the one we know today. The tools available were simpler and the markets more segmented. Volatility remained contained and crises—excepting the odd occasion in a few emerging countries—were rare. Good diversification in stocks combined with a few good choices of securities or markets, plus a few government bonds, were enough to avoid the main pitfalls. A few measures of risk taken from the Greek alphabet and some probabilities based on normal distribution were usually enough to convince any diehard sceptics.

Today, the financial universe is very different. Portfolio management has become global—as have its crises and its tools. The equity risk premium has been negative for the last 10 years and interest rates are at record lows. Volatility regularly experiences violent explosions sparked by investor sentiment and macroeconomic news. “Accidents” supposed to occur once in a thousand years in a normally distributed world can now be observed several times a decade. Correlations between assets are weak, except when they should be weak in order to limit the damage. Finally, the most exotic and undesirable risks are securitised, then carefully hidden in products that are sold on to the general public. As for the ability of the big States of yesteryear to honour their debt, this is—and will be—more and more often called into question, while emerging countries seem to be making a better go of it. But for how long?

Faced with such an environment, it has become crucial for investors to give thought to their true objectives and, especially, the best way of meeting them. One could reasonably suppose that most investors aim above all to preserve their capital and, if possible, to generate a certain amount of capital growth if investment opportunities present themselves. But opportunities and growth also mean taking risks and therefore risking losses. When establishing their portfolio, wise investors should be principally concerned with their exposure to the risk of losses. Unfortunately, there are a whole set of questions that most models ignore, or cover only partially. How do you adequately measure these risks, if we assume that volatility is only an approximation of risk, solely valid in a symmetrical and Gaussian world? Furthermore, a company's true risk profile should not be based on the volatility of its shares, but on whether or not the company is well run. How can we succeed in analysing the various asset classes in terms of the nature of the risks being run, instead of according to an arbitrarily imposed classification? How can we include hedge funds and private equity, which are not new asset classes but different ways of investing in traditional assets? Finally, how can we reconcile the old approaches to investment, which were based solely on the analysis of fundamentals—profits or the development of macroeconomic data—with new theories such as those issuing from behavioural finance and which admit the influence of irrational factors, such as excessive confidence, mimicry, misperceptions, and investors' other psychological biases, on the formation of stock prices?

Lukasz Snopek's book seeks to answer all these questions. Challenging the dogmas of yesterday is never easy, and he or she who tries runs the risk of destroying without trying to rebuild. Very fortunately, the author has carefully avoided this trap. Not only does he discuss and illustrate perfectly the limits of existing investment models, he suggests a new framework for portfolio construction based on strategic long-term allocation combined with “multi-force” tactical allocation. Thanks to this last aspect in particular, the whole range of macroeconomic, fundamental, technical and behavioural factors that can influence prices in a financial market can be included. Therefore, it offers an overall framework for reflection that is applicable to all types of investment and portfolio.

As Warren Buffett liked to say, “Over his lifetime, it is impossible for an investor to make hundreds of good decisions. One a year is enough.” For many investors, reading this book will no doubt be it for 2012.

Francois-Serge Lhabitant

Chief Investment Officer, Kedge Capital

Professor of Finance, Edhec Business School

About the Author

Lukasz Snopek has been working for many years as a wealth manager and investment consultant in the private banking sector. His qualifications include a Master of Law and a Master's degree in Business Administration (HEC), the Swiss Federal Diploma for Experts in Finance and Investments and the International Wealth Manager Certificate (CIWM). Lukasz Snopek is also a corrector for the Swiss Financial Analysts Association and teaches portfolio construction and management at the Institut Supérieur de Formation Bancaire (ISFB) in Geneva.

Acknowledgements

I would like to thank the following people, without whom this book would not have existed:

my wife Jennifer for her support throughout the writing process, and especially for her advice and attentive reading of the manuscript;my friend Antoine Courvoisier for our innumerable discussions, his advice and the time he was kind enough to devote to reading these many pages;my friend Marc Munz for reading and commenting on the manuscript;M. Thierry Lacraz for reading and commenting on the manuscript;Professor Thorsten Hens, and Martin Vlcek for his comments on the Behavioural Finance chapter;Professor Martin Hoesli for his comments on the Real Estate chapter;my friend Thomas Lufkin for his comments on the Macroeconomic section;Jessica Edwards for the translation of the manuscript into English;all the people at John Wiley & Sons who contributed to the English version;

and, of course, Professor François-Serge Lhabitant for his wonderful foreword.

Their pertinent and constructive remarks helped to improve both the content and the presentation of this book.

Introduction

In managing their assets, investors seek above all to preserve the capital invested by trying to generate a level of growth higher than or equal to average inflation. Various approaches exist in practice, but recent financial crises—with their often dramatic consequences for individuals and their wealth—argue for a more flexible process, no longer based on rigid asset allocation but, as we will see, on the attractiveness of asset classes.

The approach to portfolio construction and management suggested in this book favours risk-based management rather than a focus on expected returns, which are difficult to predict. To help investors fully optimise their returns and minimise risks, deep and intrepid reflection was called for.

It is not easy to question what we have been taught and have acted upon for many years. Can this be put down to conviction, habit, loyalty to a certain philosophy or just to facility? Or is it rather due to a lack of courage, curiosity or pragmatism?

Of course, the answer depends on each individual. But in a world that demands constant adaptation and review, it is necessary now more than ever to reconsider the way we invest, and to cast a critical eye over financial theories frequently based on fragile assumptions. Today, it seems increasingly clear that market movements cannot be satisfactorily explained by these theories and that new paths must be explored.

What if volatility were not an appropriate measure of risk? And what if Markowitz's modern portfolio theory and other financial models were outdated? What if fundamental analysis and technical analysis were complementary rather than opposing?

And, finally, what if it were impossible to predict market movements, making all models or attempts at modelling obsolete?

As the mathematician Mandelbrot observed, “we must understand, in a more realistic way, how different types of prices develop, how risk is measured and how money is made or lost. Without this knowledge, we are destined to undergo crashes again and again.”1 The time is ripe to give these issues serious consideration.

Part I defines the objectives sought by any investor and the risks to which they expose their capital, before examining the various risk measures used in finance. At the end of this analysis, a more appropriate measure of risk is suggested.

In Part II, we define the different asset classes and the various risks associated with each, culminating in a classification according to their degree of risk.

The notion of market efficiency is dealt with in Part III, as are fundamental and technical analysis. The valuation of each asset class previously defined is covered in Part IV.

Next, three practical approaches are presented in Part V, namely those of Warren Buffett, Benjamin Graham and Peter Lynch.

Part VI addresses behavioural finance, with an exploration of the different investor biases in terms of information selection and processing, as well as in the use of assets.

Part VII considers whether it is possible to anticipate market movements, by examining various approaches including the macroeconomic approach. We will then suggest in Part VIII an investment model that takes into account the conclusions reached throughout our analysis.

The second to last section presents a study of portfolio construction and management including, first of all, the different approaches used in finance, such as Markowitz's modern portfolio theory, the Capital Asset Pricing Model (CAPM) and Value-at-Risk (VaR). Finally, a new, simple and practical path is suggested based on the model developed beforehand.

The relative attractiveness of different asset classes for investors is examined in the tenth and last part. The objective here is to suggest a new framework for portfolio construction and management, thus helping investors to achieve their goal of preserving and growing their capital in the best possible conditions.

1 Mandelbrot, Preface, V.

Part I

Investors and Risk

Chapter 1

Basic Principles

1.1 Investors

Before beginning our analysis, it is worthwhile noting that this book ultimately aims to help a particular type of individual: investors.

These individuals, who have capital to invest deriving from various sources (savings, inheritance, proceeds from the sale of real estate, etc.), are those most concerned by what follows.

They want to invest this sum of money so it yields a profit, thereby increasing their capital over time. So investors look first and foremost for a return, which may take the form of regular income, capital gains, or both at once.

At this stage, it should be noted that the expected return for the given time horizon must be positive in order to achieve the desired growth. It must also be higher than average inflation so that investors can preserve their purchasing power over time, and therefore their real wealth. Furthermore, net return—that is return after tax—should ideally be taken into account.

So, along with the risk of capital loss, inflation is one of the two greatest risks for investors, as it can seriously affect their capital over time. As such, it is worth defining more precisely.

1.2 Inflation

Inflation can be defined as an increase in general price level, with the chief consequence of a decrease in consumer purchasing power. Conversely, deflation is defined as a decrease in general price level.

Salaries, retirement pensions and other social security benefits are generally indexed to inflation, thus enabling consumers to maintain their purchasing power over time. As Marc Faber suggests, “to explain inflation to your children, buy a $100 US bond and frame it, then watch its value diminish to almost nothing over the next 20 years”.1

As shown by the graph below (Figure 1.1), inflation can indeed strongly affect the value of assets over time. Excluding any investment generating annual interest and considering an inflation rate of only 2%, the capital's value is halved in about 35 years. With an inflation rate of 3%, this period drops to 23 years and at a rate of 4%, “only” 17 years are necessary to halve the initial capital. The importance of investing money at a rate which covers at least that of inflation is obvious.

Figure 1.1 Impact of inflation over time with an interest rate of 2%, 3% and 4%.

The objective generally fixed by central banks for inflation is around 2%. However, in absolute terms, this figure should be revised upwards from an investor's point of view, considering the product categories most relevant to consumers in the price index. Indeed, when focusing on price increases for food, housing, energy or health-related spending, the average rate of inflation appears to be much higher.

In general, a market basket is used to calculate price changes. This basket includes a representative selection of goods and services consumed by private households. It is subdivided into various categories of expenditure, and each main category is weighted according to the share it represents in household expenditure. The following examples are of the consumer price index calculation for Switzerland2 and England3 (Table 1.1).

Ultimately, the impact of inflation depends on the category of the population being considered and its type of consumption. In light of this, an interesting tool has been made available in the UK. Individuals can make use of a personal inflation calculator4 to calculate inflation specifically based on their own personal expenditure, which can then be compared to national inflation.

Table 1.1 Allocation of items to IPC and CPI divisions in 2010

ItemsIPC weightCPI weightFood and non-alcoholic beverages11.063%10.8%Alcohol and tobacco1.784%4.0%Clothing and footwear4.454%5.6%Housing and household services25.753%12.9%Furniture and household goods4.635%6.4%Health13.862%2.2%Transport11.011%16.4%Communication2.785%2.5%Recreation and culture10.356%15%Education0.669%1.9%Restaurants and hotels8.426%12.6%Miscellaneous goods and services5.222%9.7%

Generally speaking, an annual rate of 2% is the minimum conceivable threshold and a rate of 3% is more realistic.

By setting a target rate of return of 2%, investments may only just cover inflation, while a target of 3% will begin to generate a certain level of growth. It is interesting to note that Graham, in his work written in the 1950s, already believed “that it is reasonable for an investor […] to base his thinking and decisions on a probable (far from certain) rate of future inflation rate of, say, 3% per annum”.5

So investors must bear in mind that their final return, which we will call the real rate, should be calculated in the following way:

Example:

Our Advice

Given that periods of deflation also exist, we ultimately suggest allowing for an average inflation rate of 2%. The important thing is to take this minimum threshold into account in the investment process.

1.3 Choices for Investors in Terms of Investments

Investors may choose to invest in an asset with virtually no risk. This investment, commonly known as a risk-free rate investment, offers a very low return, usually only partially covering inflation, except of course during periods of deflation.

However, a feature of this type of investment is that it is always positive, generating capital growth which, though modest, is stable over time. Some investors settle for this type of low return investment, even though their purchasing power may be affected over time.

For other investors, a risk-free rate investment is not enough. Investment in other asset classes must therefore be considered in order to improve returns and avoid capital being affected by inflation in the long term. As we will see further on, domestic stocks (national firms), for example, provide good protection against inflation.

Investors can turn to risky assets such as stocks, bonds or real estate. They certainly generate higher returns than risk-free rates, but they may be either positive or negative. Because of fluctuations in their price over time, the possibility of capital loss is the main risk for investors here.

It is now time to begin our analysis by examining how this risk is defined in finance, and determining how well this is adapted to reality.

1 Marc Faber. Interview with Tom Dannet. “Five Books: Marc Faber on Investment.” 23.10.2009 (www.fivebooks.com/interviews/marc-faber-on-investment).

2 Source: www.bfs.admin.ch.

3 Source: www.statistics.gov.uk.

4www.statistics.gov.uk.

5 Graham, p. 50.

Chapter 2

Measures of Risk

2.1 Volatility or Standard Deviation

As we have just mentioned, the price of certain assets can fluctuate over time, either upwards or downwards. The amplitude of these variations around the mean was the first tool used to define risk, particularly by Markowitz in establishing the foundations of modern portfolio theory. According to this approach, the greater the variation around the mean, the riskier the asset.

In finance, the standard deviation is often used to measure the risk of a financial asset. This is an index of dispersion around the expected result (mean). The higher this variation from the mean, the riskier the financial asset is considered to be, given the variability of its outcome.

Based on historical data for the price of a financial asset, it is possible to determine the frequency of occurrence of a certain profitability, or of a return interval, and to obtain what is called a probability distribution.

These same data allow the expected return and the aforementioned standard deviation to be calculated. Given the shape of the distribution and for practical reasons, a particular distribution called is used, which has the following characteristics: