Portfolio of Investments

The process of investing in securities can be visualized in terms of three problems. The first problem is choice—which of the individual assets will be acquired. The second problem is allocation—how the assets will be combined into a portfolio. The final problem is one of timing—how to respond to changing market conditions. This description is helpful in understanding the process, but in practice all three problems are interrelated and must be solved together.

Problem of choosing Analysis

The problem of choosing among the many securities is called security analysis. The traditional advice of "Buy low, sell high" does not answer the question of what is high and what is low—security analysis attempts to answer this question. While three general philosophies can be identified, few investors adhere solely to one philosophy. All three are relevant in some way, and there are in reality as many approaches to security analysis as there are investors.

Fundamental Analysis

The origin of fundamental analysis is often identified with J. B. Williams' suggestion that securities could be valued as the present value of the anticipated cash flows. This suggestion prompted the application of quantitative economic analysis to securities. Fundamental analysis is based on the belief that it is possible to identify incorrectly priced securities on the basis of the underlying conditions in the economy, industry, and company—the fundamentals. Analysts using this approach gather and evaluate information about all facets of a firm and its industry. This includes sources such as accounting data, items published in the financial press, information from trade publications, and almost any other source that can be accessed. Professional security analysts usually specialize in one industry or sector of the economy, often maintaining a relationship with the management of the firms under analysis. Using this information and forecasts of economic conditions, fundamental analysts attempt to evaluate the intrinsic value, or the economically rational, correct value for the firm. This intrinsic value is often indirectly expressed on the basis of expected return, rather than on price. The approach is optimal as a technique for comparison across similar firms, where the intent is to identify incorrectly priced assets. Statistical concepts can be applied to provide probabilistic estimates of value or return.

Outside this common philosophy, there is often little in common among the techniques or strategies applied. One common approach is to analyze "P/Es," or price-earnings ratios. The difficulty of this approach is that it requires specification of the suitable P/E ratio, which is in turn a function of the fundamentals. Somewhat more specific are the discounted cash flow (or DCF techniques). Essentially, these techniques estimate the future cash flows from the asset, and take the intrinsic value of the asset as the present value of the cash flows. The present value is the amount that, if invested today at the required rate of return on the investment, would just recreate the estimated cash flows. This in turn raises the question of the required rate of return, which is defined as the rate of return on other, similar securities. There are numerous variations of these approaches Another classification of fundamental analysis is based on management style, which is based on the strategy followed. Value managers, for instance, attempt to identify undervalued firms, while growth managers attempt to identify firms that will grow more rapidly than average.

Indexing

This approach is identified with the efficient markets hypothesis arising from portfolio management theory. Indexing is based on the belief that analysts not only can correctly identify mispriced assets but also are so efficient at this endeavor that very few stocks will be mispriced, and then only fleetingly. This implies that at any given time the best estimate of the value of an asset is the market price, and the expensive search for incorrectly priced stocks will be unlikely to produce unusually high returns. Under this belief, the optimal course is to purchase a well-diversified portfolio of assets. The approach is called indexing because the portfolio is usually created in such a way as to mimic some market index, such as the Standard & Poor's 500. This approach is most often used for those common stocks that are widely traded.

Technical Analysis

Technical analysis has its origins in the Dow theory. It agrees with the belief that stock values depend on the fundamentals. Due to the complexity of the relationships, the constantly changing conditions, and uncertain investor psychology, however, technicians believe that fundamental analysis is futile. Instead, this approach assumes that prices and investor sentiment adjust slowly, producing trends in security prices over time. The emphasis of technical analysis is thus on the detection of trends based on observance of price and trading data. The original theory has over time come to encompass a wide array of possible detection devices.

Allocation

This is the problem of portfolio management. The idea of diversification—holding multiple assets—has always been stressed as correct investment procedure. Historically, however, this was based on an intuitive reasoning such as "Don't put all of your eggs into one basket." and diversification was primarily a matter of the number of different assets to be held. A more exact, quantitative analysis of the nature of was first provided by Harry M. Markowitz in the early 1950s. Markowitz noted that a combination of assets that are not perfectly correlated produces risk and return combinations that are superior to those available from the individual assets. The lower the correlation between the assets, the larger the effect For example, all other things being equal, the owner of a ski resort would be betteroff investing in a beach resort than in another ski resort. The reason is the relationship of the pattern of earnings of the invest-ment as compared to the earnings of the ski resort. If the owner acquires another ski resort, in cold years with good snow both would do well; in warm years with poor snow both would do poorly. The result would be a highly variable, risky total-earnings stream. If the beach resort is purchased, however, it will do well in warm years and poorly in cold years. This pattern of earnings would balance out the fluctuations of the ski resort earnings, and produce a predictable, less risky total earnings flow.

This analysis led to the development of what is called modern portfolio management (or portfolio management theory) and the understanding that asset correlations strongly affect the diversification process. The implication is that the decision to include an asset in a portfolio depends not only on the asset but also on its relationship with the other assets in the proposed portfolio. Finally, for a given set of assets there are many combinations, and the risk and return of the combinations can vary greatly. The task of the portfolio manager is thus to choose both assets and proportions that will result in a portfolio with a suitable risk and return profile.

For an example of this, return to the example of "risk return space" shown in Figure 1. The portfolio manager will avoid a portfolio such as F because portfolio F is "dominated" by portfolios and D. Portfolio F is said to be dominated because there are alternatives that are unarguably better. In this case. Portfolio has less risk but provides the same return, portfolio provides more return for less risk, and portfolio D has more return for the same risk. An economically rational investor would always prefer B, C, or D to F. None of the other portfolios can be said to dominate one another. Portfolio E has higher return than portfolio A, but it also has higher risk. While a young doctor might prefer portfolio E because of its high return, and a widow with several children might prefer portfolio A because of its low risk—this is a matter of personal choice, not of dominance. Portfolios A, B, C, D. and E are said to be efficient, where an efficient portfolio is simply a portfolio which is not dominated. The role of the portfolio manager, then, is to choose asset proportions that produce an efficient portfolio with appropriate risk and return.

Study of the effect of diversification led to a new way of thinking about risk itself. It became apparent that the risk of an asset had two components. Part of the risk, called diversifiable risk, could be reduced or elimi nated through diversification. The reduction of risk through diversification has a natural limit. Although risks that affect individual assets or limited groups of assets can be reduced or eliminated by diversification, risks that affect all assets cannot be diversified. These nondiversifiable risks are those that cause entire capital markets to go through bull and bears phases — i.e., they affect the entire economic system. Another name for the nondiversifiable risk is thus systematic risk, while another name for diversinable risk is nonsystematic risk. If an investor holds a well-diversified portfolio, it is only the nondiversifiable, systematic risk that is of concern. This systematic risk is measured by the beta of the asset. Portfolio management theory suggests that the beta of a security is the determinant of the required return on an asset. This analysis, and the use of beta as a risk measure, is most often applied to common stock analysis. The underlying analysis of the nature of diversification, however, is applicable to all investment problems. Finally, this analysis points out a major reason for the growth of international investing. Foreign economies do not move directly with the domestic economy, and provide the opportunity to diversify beyond the domestic systematic risk.

Timing

Given that the market exhibits bull and bear stages, timers focus on buying and selling according to the market stages. Thus, a timer who anticipates a bull market would increase the proportion of stocks in the portfolio and decrease the amount of cash, and vice versa for a bear market. Cash in this usage is taken to mean money market securities rather than cash itself, since these securities provide return with nearly the liquidity and safety of cash itself. The timer might use either fundamental analysis of economic variables or technical analysis to form expectations. A pure timer would buy or sell an index portfolio, but the strategy is more often combined with fundamental or technical analysis. Timing may also take other forms. A bond portfolio manager might lengthen the maturity of the portfolio if interest rates are expected to decrease, or shorten the maturity if interest rates are expected to increase. Another version of timing is to attempt to buy stocks ahead of the business cycle, or sector rotation.

Professional Designation for Securities Analysis

There are a number of professional designations in the field of securities analysis. These include:

1. Registered representative stockbroker.
Brokers are essentially the salespeople of the securities industry. Brokers must successfully complete the Series Seven examination given by the National Association of Security Dealers (NASD). The examination covers the basics of securities and markets, and is roughly equivalent in content to a college-level investments course.

2. Certified financial planner.
This designation is relevant to professionals who provide financial guidance to individuals. This includes brokers, insurance representatives, and others dealing in investment products. The designation is granted by the College of Financial Planners, and requires successful completion of a ten-part examination covering an array of topics relevant to financial planning for individuals. The content would be equivalent to several college-level courses.

3. Chartered financial analyst.
This designation has become widely accepted as a requirement in the investment management industry. The designation is granted by the Institute of Chartered Financial Analysts after successful completion of three six-hour examinations covering various aspects of securities analysis and portfolio management, plus three years of experience in investment decision making. The content is equivalent to a master's degree.