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PORTFOLIO MANAGEMENT

LOS 49.a Describe the steps in the portfolio management process, and explain the reasons for a policy statement.

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Four steps in the portfolio management process: (1) Construct a policy statement. (2) Examine current and anticipated conditions. (3) Implement the plan by constructing the portfolio. (4) Monitor investor needs and capital market conditions. Reasons for having a policy statement: (1) Guides the investment process. (2) Provides discipline to the process and helps avoid inappropriate decisions. (3) Helps the investor decide on realistic goals. (4) Provides a benchmark for judging the performance of the portfolio.

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LOS 49.b Explain why investment objectives should be expressed in terms of risk and return, and list the factors that may affect an investors risk tolerance.
Key Term: Risk tolerance

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Investors are risk averse, which means that they gain more satisfaction from higher expected return and lower risk. The relationship between risk and returns requires that goals not be expressed only in terms of returns but in terms of risk as well. In short, investors maximize expected return subject to their risk tolerance constraint.

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PORTFOLIO MANAGEMENT

LOS 49.c Describe the return objectives of capital preservation, capital appreciation, current income, and total return.
Key Terms: Capital preservation; Capital appreciation; Current income;

Total return

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Return objectives: (1) Capital preservation: the desire to minimize the risk of losing capital while maintaining purchasing power. (2) Capital appreciation: the goal of growing over time in real terms. (3) Current income: focuses on generating income rather than capital gains. (4) Total return: the objectives of producing capital gains and reinvesting income are balanced.

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PORTFOLIO MANAGEMENT

LOS 49.d Describe the investment constraints of liquidity, time horizon, tax concerns, legal and regulatory factors, and unique needs and preferences.
Key Terms: Liquidity needs; Fiduciary role

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Investment constraints: (1) Liquidity needs: when an investor needs assets that can be quickly converted into cash at a fair price. (2) Time horizon: the amount of time funds will be invested. (3) Tax factors: ordinary income versus capital gains, the tax basis of an investors investments, unrealized capital gains, etc. (4) Legal and regulatory constraints: the tax status of different investment vehicles (e.g., U.S. IRA and 401(k) plans). Regulations also affect advisors who are serving in a duciary role. (5) Unique needs and preferences: investor-specific desires such as charitable giving.

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PORTFOLIO MANAGEMENT

LOS 49.e Describe the importance of asset allocation, in terms of the percentage of a portfolios return that can be explained by the target asset allocation, and explain how political and economic factors result in differing asset allocations by investors in various countries.
Key Term: Asset allocation

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Asset allocation is the strategic decision concerning (1) which asset classes are included in a portfolio, and (2) the weights assigned to each class. Research finds that about 90% of a portfolios return over time is explained by its target asset allocation policy. Investors in various countries make their asset allocation decisions in light of different social, economic, political, and tax environments.

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PORTFOLIO MANAGEMENT

LOS 50.a Define risk aversion and discuss evidence that suggests that individuals are generally risk averse.
Key Term: Risk aversion

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Investors are, on average, risk averse, meaning they like return and dislike risk. Risk aversion implies that the more risk an asset has, the higher the expected return must be to encourage investment in the asset. Evidence supporting the notion that most investors are risk averse includes the purchase of insurance and the difference in promised yields for bonds of dierent risk classes (bond ratings).

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PORTFOLIO MANAGEMENT

LOS 50.b List the assumptions about investor behavior underlying the Markowitz model.
Key Term: Markowitz efficient

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Assumptions of Markowitz portfolio theory: (1) Each investment alternative is represented by a probability distribution of expected returns over a given holding period. (2) Investors want to maximize one-period expected utility, and their utility curves exhibit diminishing marginal utility of wealth. (3) Investors estimate the risk of portfolios based on the variability of expected returns. (4) Investors make decisions only on expected return and risk. (5) For a given risk level, investors prefer higher returns to lower returns. For a given level of return, investors also prefer lower risk to higher risk. Such investments are considered Markowitz efcient.

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PORTFOLIO MANAGEMENT

LOS 50.c Compute and interpret the expected return, variance, and standard deviation for an individual investment and the expected return and standard deviation for a portfolio.
Key Terms: Expected return; Variance; Standard deviation

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The expected return on an individual security is the weighted average of the possible asset returns (Ri), where each is weighted by its given probability of occurrence (pi). E 1 Ri 2 5 a piE 1 Ri 2
i51 n

The expected return on a portfolio is the weighted average of the individual assets expected returns E(Ri), where the weights (Wi) are the percent of each asset in the portfolio. E 1 R p 2 5 a Wi E 1 R i 2
i51 n

The variance (and standard deviation) is a measure of the dispersion of the set of possible rates of return from the expected return. Variance 5 s2 5 a 3 Ri 2 E 1 Ri 2 4 2 pi
i51 n

The standard deviation is the square root of variance.


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PORTFOLIO MANAGEMENT

LOS 50.c
Equation 50.1

E 1 Ri 2 5 a piE 1 Ri 2
i51

where pi = Probability of return i E(Ri) = Expected return on i Use this equation to calculate the expected return on an asset given a probability distribution describing possible returns and their probabilities.

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For example: Given the probability distribution indicated here, what is the expected return on the stock? Return 35% 15% 5% Probability 25% 50% 25%

E 1 Ri 2 5 1 35% 2 1 25% 2 1 1 15% 2 1 50% 2 1 1 25% 2 1 25% 2 5 15.0%

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PORTFOLIO MANAGEMENT

LOS 50.c
Equation 50.2

E 1 Rp 2 5 a WiE 1 Ri 2
i51

where Wi = Weight of asset i E(Ri) = Expected return on asset i Use this equation to calculate the expected return on a portfolio of stock given the expected return and weight of each stock in the portfolio.

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For example: Given the following stocks, their weights, and their expected returns, what is the expected return on the portfolio? Stock A B C Weight 30% 45% 25% Expected Return 19% 12% 26%

E 1 Rp 2 5 1 30% 2 1 19% 2 1 1 45% 2 1 12% 2 1 1 25% 2 1 26% 2 5 17.6%

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PORTFOLIO MANAGEMENT

LOS 50.c
Equation 50.3
n

Variance 5 s2 5 a 3 Ri 2 E 1 Ri 2 4 2 pi
i51

where Ri = Possible return on asset i E(Ri) = Expected return on asset i pi = Probability of realizing return i Use this equation to calculate the variance of the returns on an asset from a probability distribution describing the possible returns and their probabilities.

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For example: Given the probability distribution indicated here, what is the variance of the return on the stock (the expected return was already calculated at 15.0%)? Return 35% 15% 5% Solution: Return 35% 15% 5% Probability 25% 50% 25% [Ri E(Ri)]2 pi (0.35 0.15)2 (0.25) (0.15 0.15)2 (0.50) (0.05 0.15)2 (0.25) g 5 0.020
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Probability 25% 50% 25%

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PORTFOLIO MANAGEMENT

LOS 50.c
Equation 50.4

sp 5 "w2 s2 1 w2 s2 1 2w1 w2Cov1,2 1 1 2 2 where w = Weight of each asset = Standard deviation of each asset Cov1,2 = Covariance between the return on the assets Use this equation to calculate the standard deviation of a two-asset portfolio.

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For example: Find the standard deviation of a portfolio consisting of 40% invested in Stock A with a variance of 0.0036, and 60% invested in Stock B with a variance of 0.0049. The covariance between the returns on the two stocks is 0.003. sp 5 " 1 0.4 2 2 1 0.0036 2 1 1 0.6 2 2 1 0.0049 2 1 2 1 0.4 2 1 0.6 2 1 0.003 2 = 0.061

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PORTFOLIO MANAGEMENT

LOS 50.d Compute and interpret the covariance of rates of return, and show how it is related to the correlation coefficient.
Key Terms: Covariance; Correlation coefficient

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Covariance is the degree to which two variables move together over time. Covariance is an absolute or unscaled measure of the degree of association between two variables. Covi,j 5 g 5 3 Ri 2 E 1 Ri 2 4 3 Rj 2 E 1 Rj 2 46 The correlation coefcient is a relative measure of the relationship between security returns, and it ranges between 1 and +1. It is calculated as follows: Corrij 5 Covij sisj

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PORTFOLIO MANAGEMENT

LOS 50.d
Equation 50.5

Corrij 5

Covij sisj

Use this equation to calculate the correlation coefficient when given the covariance and the standard deviation of the two assets. Alternatively, you can calculate the covariance given the correlation coefficient and the standard deviation of the two assets.

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For example: The covariance between the returns on the two stocks is 0.00375 and the standard deviations of the two stocks are 0.060 and 0.070. Calculate the correlation between the returns on the two assets. CorrAB 5 0.00375 5 0.893 1 0.060 2 1 0.070 2

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PORTFOLIO MANAGEMENT

LOS 50.e List the components of the portfolio standard deviation formula, and explain the relevant importance of these components when adding an investment to a portfolio.

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Total portfolio risk (standard deviation or variance) has two components:


(1) The weighted variances of the individual securities. (2) The weighted covariances of all pairwise combinations of the securities in the portfolio.

sp 5 "w2 s2 1 w2 s2 1 2w1w2 Cov1, 2 1 1 2 2 The covariance is the most important component to consider when adding a new security to a portfolio.

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PORTFOLIO MANAGEMENT

LOS 50.f Describe the efficient frontier, and explain the implications for incremental returns as an investor assumes more risk.

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An efficient portfolio has the largest expected return for a given level of risk or the smallest risk for a given level of return. The efficient frontier is a curve portraying all the best combinations of assets, which are the set of portfolios with the highest rate of return for every given level of risk, or the minimum risk for every level of return. An investor who accepts greater portfolio risk should expect a higher incremental expected portfolio return.

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PORTFOLIO MANAGEMENT

LOS 50.g Explain the concept of an optimal portfolio, and show how each investor may have a different optimal portfolio.
Key Term: Optimal portfolio

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An optimal portfolio is the efficient portfolio with the highest utility for a given investor. It is the point of tangency between the efficient frontier and the set of indifference curves for the investor. The shape of an investors utility curve reflects his or her risk tolerance and influences the specific portfolio on the efficient portfolio that is considered optimal.
E(R p) Investor #2s preference curves Efficient Frontier

Investor #1s indifference curves

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PORTFOLIO MANAGEMENT

LOS 51.a Explain the capital market theory, including its underlying assumptions, and explain the effect on expected returns, the standard deviation of returns, and possible risk/return combinations when a riskfree asset is combined with a portfolio of risky assets.
Key Terms: Capital market line (CML); Market portfolio (M)

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Assumptions of capital market theory: (1) all investors want the most suitable portfolio on the efficient frontier; (2) investors can borrow or lend unlimited amounts at the risk-free rate; (3) all investors have the same expectations; (4) all investors have the same one-period time horizon; (5) all investments are innitely divisible; (5) no taxes or transactions costs exist; (6) there is no ination or inflation is perfectly forecasted; and (7) capital markets are in equilibrium. Adding a risk-free asset (zero standard deviation) to the efficient frontier results in a new risk/return trade-off: a straight-line tangent to the efficient frontier at the market portfolio (point M) and a vertical intercept at the riskfree rate of return (RF). This line is called the capital market line (CML).

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PORTFOLIO MANAGEMENT

LOS 51.b Identify the market portfolio, and describe the role of the market portfolio in the formation of the capital market line (CML).

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The market portfolio, M, consists of all risky assets. It is at the point of tangency of the capital market line (CML) and the old efficient frontier. The combination of the market portfolio, M, and riskless assets offers investors a range of risk/return possibilities. Each investor would choose a point on the SML that corresponds to his or her risk preferences.
E(Rp) M RF CML

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LOS 51.b
Equation 51.1

E 1 Rp 2 5 WRf 1 RRf 2 1 1 1 2 WRf 2 E 1 RM 2 where WRf = Weight of risk-free assets in the portfolio RRf = Expected return on risk-free assets RM = Expected return on the market portfolio Use this equation to find the expected return on a two-asset class portfolio consisting of risk-free and risky assets.

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For example: An investor invests 40% of his assets in a risk-free portfolio at 3.8% and 60% of his assets in a risky portfolio with an expected return of 14.0%. What is the expected return on the portfolio? E 1 RP 2 5 1 0.40 2 1 3.8% 2 1 1 1 2 0.40 2 1 14.0% 2 5 9.92%

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LOS 51.b
Equation 51.2

E 1 sport 2 5 1 1 2 WRf 2 sM where WRf = Weight of risk-free assets in the portfolio M = Standard deviation of the market portfolio Use this equation to determine the expected standard deviation of a portfolio that lies on the capital market line.

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For example: An investor places 30% of her portfolio in risk-free assets and 70% in the market portfolio. If the standard deviation of the market portfolios returns is 9.5%, what is the standard deviation of the portfolio? E 1 sp 2 5 1 1 2 0.30 2 9.5% 5 6.65%

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LOS 51.c Define systematic and unsystematic risk, and explain why an investor should not expect to receive additional return for assuming unsystematic risk.
Key Terms: Systematic risk; Unsystematic risk; Diversification;

Total portfolio risk

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Systematic risk is the variability of a securitys return that is associated with overall movements in the general market or economy. Unsystematic risk is the variability of a securitys return that is firm-specific (not related to moves in the overall market). Because investors can eliminate unsystematic risk through diversication, the relevant risk measure for assets is systematic risk (there is no reward for assuming unsystematic risk). The sum of systematic risk and unsystematic risk is total portfolio risk (portfolio standard deviation).

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PORTFOLIO MANAGEMENT

LOS 51.d Explain the capital asset pricing model, including the security market line (SML) and beta, and describe the effects of relaxing its underlying assumptions.
Key Terms: Capital asset pricing model; Security market line; Beta; Zero-

beta portfolio

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The capital asset pricing model (CAPM) is used to determine the required rate of return on risky assets. The security market line (SML) graphically represents the relationship between the systematic risk (beta) of assets and their required rate of return. The CAPM makes a series of assumptions that are generally violated. The general effect of violations is to render the SML a band rather than as a singular line (securities plot close to the SML, but not exactly on it). For example, CAPM assumes that investors can borrow and lend any amount at the risk-free rate. This violated assumption is addressed by respecifying the CAPM using the zero-beta portfolio approach. Other commonly violated assumptions are that there are no transactions costs, all investors have the same expectations, and all investors have a single-period investment horizon.

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LOS 51.d
Equation 51.3

E 1 Ri 2 5 RF 1 b 3 E 1 RM 2 2 RF 4 where E(Ri) = Required rate of return on a security RF = Risk-free rate E(RM) = Expected return on the market i = Measure of systematic risk (beta) Use this equation to estimate the required return on a stock to be added to an efficiently diversified portfolio.
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For example: The risk-free rate is 4.5% and the expected return on the market is 14.0%. What return do you require on a stock with a beta of 1.2? E 1 Ri 2 5 4.5% 1 1.2 1 14.0% 2 4.5% 2 5 15.9%

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PORTFOLIO MANAGEMENT

LOS 51.e Calculate, using the SML, the expected return on a security, and evaluate whether the security is overvalued, undervalued, or properly valued.

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A security that does not lie on the SML is presumably mispriced. (1) Calculate the required rate of return using the CAPM. (2) Determine the market-implied expected rate of return using an alternative methodology such as the dividend discount model. (3) Compare the two returns. If the market-implied expected return > the CAPM required return, the security is undervalued. If the CAPM required return > the market-implied expected return, the security is overvalued.

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