Description
Book SynopsisIn 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.
Table of ContentsForeword 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
