The Most Important Part of the Portfolio
This past weekend, I chatted with two friends who took a financial economics class with me at Cal for one of our upper division electives. We spent a short amount of time reminiscing about our Econ days and studying together for Econ exams.
From that financial economics class (Econ 136), the two practical terms I remember the most were risk aversion and diversification. The description for the course (from the Course Catalog):
Analysis of financial assets and institutions. The course emphasizes modern asset valuation theory and the role of financial intermediaries, and their regulation, in the financial system.
A few weeks ago, I happened to browse through my old course textbook Investments, 4th edition by Bodie, Kane, and Marcus (the class is still using the same book, but a more updated version).
Chapter Twenty-Six — The Process of Portfolio Management — has some useful points, but they didn’t seem familiar from the class until I realized that according to the syllabus, we never covered it. We did play the stock market with fake money, though.
In a nutshell, the important considerations for a portfolio are the goals and restrictions:
| Objectives | Constraints | Policies |
|---|---|---|
| Return requirements Risk tolerance |
Liquidity Horizon Regulations Taxes Unique needs |
Asset allocation Diversification Risk positioning Tax positioning Income generation |
Which determines the strategy:
The first step is to determine the investor’s objectives. The second step is to identify all the constraints, this is, the qualifications and requirements of the resultant portfolio. Finally, the objectives and constraints must be translated into investment policies. … Objectives and constraints are greatly affected by the investor’s stage in the life cycle.
—p810
The most important part of the strategy is figuring out the asset allocation:
By far the most important part of policy determination is asset allocation, that is deciding how much of the portfolio to invest in each major asset category.
—p817
So that’s what academia advises investors, though often in reality that’s not what happens.
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Comments
Diversification is non-sense! It’s like betting on black and red at the same time. The House always wins because of zero and double zero, which in investment, the House symbolizes investment firms and banks.
Posted by: lw | January 6th, 2009 19:03
Actually, diversification makes good sense; that’ why mutual funds do so well. Since a single mutual fund invests in anywhere from a few hundred to a few thousand individual stocks it minimizes risk. All your eggs are not in one bucket. The concept of 0 and 00 don’t necessarily apply since there isn’t a situation where the investment firms “win it all.” Even if all your mutual funds lost money, you would still receive dividends. Although, I agree that investment firms/brokerages/banks all charge fees or expense ratios (for mutual funds) this is actually one of the few things that you CAN control when investing. When it comes to mutual funds you have your choice of actively managed funds with high loads and expense ratios vs your low cost index funds with no loads.
Posted by: AN | January 7th, 2009 13:16
I was in that class with you! I’m actually using the 9th edition of BKM in my MBA finance class now. Diversification works, but it doesn’t shield you from systemic risk, which is what’s been happening.
Posted by: VH | May 19th, 2009 09:10