Chapter 13

Managing Your
Own Portfolio

Managing Your Own Portfolio

Learning Goals
1. Explain how to use an asset allocation scheme
to construct a portfolio consistent with investor
objectives.
2. Discuss the data and indexes needed to
measure and compare investment performance.
3. Understand the techniques used to measure
income, capital gains, and total portfolio return.

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Managing Your Own Portfolio

Learning Goals (contd)
4. Use the Sharpe, Treynor, and Jensen measures
to compare a portfolios return with a riskadjusted, market-adjusted rate of return, and
discuss portfolio revision.
5. Describe the role and logic of dollar-cost
averaging, constant-dollar plans, constant-ratio
plans, and variable-ratio plans.
6. Explain the role of limit and stop-loss orders in
investment timing, warehousing liquidity, and
timing investment sales.
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Constructing a Portfolio
Using Asset Allocation
Individual investor characteristics and
objectives determine relative income needs
and ability to bear risk
Investor characteristics to consider:

Level and stability of income, net worth

Age and family factors
Investment experience and ability to handle risk
Tax considerations

Investor objectives to consider:

High level of current income
Significant capital appreciation

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Portfolio Objectives and Policies

Current Income/Capital Preservation Objective
Low-risk, conservative investment strategy
Emphasis on current income and capital preservation
Normally contains low-beta securities

Capital Growth Objective

Higher-risk investment strategy
Emphasis on more speculative investments
Normally contains higher-beta securities

Tax Efficient Objective

Emphasis on capital gains and longer holding periods to
defer income taxes

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Constructing a Portfolio
Using Asset Allocation
Asset Allocation is the process of dividing
an investment portfolio into various asset
classes to preserve capital by protecting
against negative developments while taking
advantage of positive ones.
In other words, dont put all of your
eggs in one basket, and choose your
baskets carefully.

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Constructing a Portfolio
Using Asset Allocation
An asset allocation scheme must be developed
before buying any investment vehicles.
Focus is on investment in various asset classes,
rather than emphasis on selecting specific
securities.
As much as 90% or more of a portfolios return
comes from asset allocation between various asset
classes.

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Approaches to Asset Allocation

Fixed-Weightings Approach: asset allocation
plan in which a fixed percentage of the portfolio is
allocated to each asset category
Flexible-Weightings Approach: asset allocation
plan in which weights for each asset category are
adjusted periodically based on market analysis
Tactical Approach: asset allocation plan that uses
stock-index futures and bond futures to change a
portfolios asset allocation based on market
behavior

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Table 13.1 Alternative Asset Allocations

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Applying Asset Allocation

Consider impact of economic and other factors on
your investment objective
Design your asset allocation plan for the long haul
(at least 7 to 10 years)
Stress capital preservation
Provide for periodic reviews to maintain
consistency with changing investments goals
Consider using mutual funds, especially for
portfolios under $100,000

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Evaluating Performance
of Individual Investments
Step 1: Obtain Needed Data
Returns on owned investments
Economic and market activity

Step 2: Compare Returns with Broad-Based

Market Measures
DJIA, S&P 500, Nasdaq Composite Index, Lipper indexes

Step 3: Compare Performance to Investment Goals

Am I getting the proper return for the amount of investment
risk I am taking?
Do I have a problem investment?

Step 4: Determine appropriate action on each investment

Keep, sell, or monitor closely

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Calculating Return:
Holding Period Return
Returns include current income and capital
gains/losses
Return for specific holding period

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Table 13.2 Calculation of Pretax

HPR on a Common Stock

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Measuring Portfolio Return:

Holding Period Return
Returns include current income and capital
gains/losses for all investments held
in portfolio

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Measuring Portfolio Return:

Sharpes Measure
Compares the risk premium on a portfolio
to the portfolios standard deviation
of return
In general, the higher the Sharpes
measure, the better

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Measuring Portfolio Return:

Treynors Measure
Uses the portfolio beta to measure the
portfolios risk
In general, the higher the Treynors
measure, the better

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Measuring Portfolio Return:

Jensens Measure
Uses the Capital Asset Pricing Model (CAPM) to
calculate the portfolios excess return (actual return
compared to required return)
Positive returns are preferred; negative returns
indicate required return was not earned

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Assessing Portfolio Performance

Portfolio Revision: the process of selling certain issues in a
portfolio and purchasing new ones to replace them
Periodic reallocation and rebalancing are necessary
Reasons to revise portfolio:

Changes in economic conditions

Major life event
Proportion of one asset class increases or decreases substantially
Expect to reach specific goal within two years
Percentage allocation of asset class varies from original
allocation by 10% or more.

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Timing Transactions
Dollar-Cost Averaging
Fixed dollar amount is invested at fixed intervals
Discipline to invest on regular basis is vital
Purchase more shares when prices are low and
fewer shares when prices are high

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Timing Transactions (contd)

Constant-Dollar Plan
Speculative portion seeks capital gains
Conservative portion seeks low risk
When speculative portion increases to a
predetermined dollar amount, profits are
transferred to conservative portion
If speculative portion decreases, funds are
added from conservative portion

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Timing Transactions (contd)

Constant-Ratio Plan
Similar to constant-dollar plan, only the ratio
between the speculative and conservative
portions is fixed

Variable-Ratio Plan
Similar to constant-ratio plan, only the ratio
between the speculative and conservative
portions is allowed to fluctuate to predetermined
levels
Moderately aggressive strategy which tries to
buy low and sell high

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Using Limit and Stop-Loss Orders

Limit Orders
May be used to purchase additional securities
only at desired purchase price or below

Stop-Loss Orders
Used to limit downside loss or protect a profit by
selling security when price falls below
predetermined price

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Other Portfolio Considerations

Warehousing Liquidity

Keep portion of portfolio in low-risk, highly liquid

investments to protect against loss or to wait for future
investment opportunities

Tax Consequences

Use long-term capital gains when possible

Use capital losses to offset capital gains

Achieving Investment Goals

When an investment becomes more or less risky, or it

does not meet its return objective, sell it
Dont hold out for top price; take your profits and reinvest
in more suitable investment

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Chapter 13 Review
Learning Goals
1. Explain how to use an asset allocation scheme
to construct a portfolio consistent with investor
objectives.
2. Discuss the data and indexes needed to
measure and compare investment performance.
3. Understand the techniques used to measure
income, capital gains, and total portfolio return.

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Chapter 13 Review (contd)

Learning Goals (contd)
4. Use the Sharpe, Treynor, and Jensen measures
to compare a portfolios return with a riskadjusted, market-adjusted rate of return, and
discuss portfolio revision.
5. Describe the role and logic of dollar-cost
averaging, constant-dollar plans, constant-ratio
plans, and variable-ratio plans.
6. Explain the role of limit and stop-loss orders in
investment timing, warehousing liquidity, and
timing investment sales.
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Chapter 13
Additional
Chapter Art

Table 13.3 Calculation of Pretax HPR on

a Bond

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Table 13.4 Calculation of Pretax HPR on

a Mutual Fund

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Table 13.5 Bob Hathaways Portfolio

(January 1, 2011)

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Table 13.6 Dividend Income on Hathaways Portfolio

(Calendar year 2011)

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Table 13.7 Unrealized Gains in Value of Hathaways

Portfolio
(January 1, 2011, to December 31, 2011)

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Table 13.8 Holding Period Return Calculation on

Hathaways Portfolio
(January 1, 2011, to December 31, 2011, holding period)

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Table 13.9 Dollar-Cost Averaging

($500 per month, Wolverine Mutual Fund shares)

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Table 13.10 Constant-Dollar Plan

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Table 13.11 Constant-Ratio Plan

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Table 13.12 Variable-Ratio Plan

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