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Portfolio Management

Introduction A portfolio is a group of investments. A well-managed portfolio is diversified to ensure a continuous return on investment over time. Portfolio Management Policies There are three major portfolio management policies:

1. Aggressive policy: Often called capital appreciation, this is for investors who want their portfolios to
grow over time. Typically, these investors are younger and have enough earned income per year to handle current expenses.

2. Defensive policy: Often called capital preservation, this approach minimizes the risk of loss inherent in
an aggressive policy, but it also has little upside potential.

3. Balanced policy: Often called total return, this is similar to an aggressive policy, but it considers
dividend and interest income as important components alongside capital gains. Of the 250 questions on the Series 7 exam, 21 will focus on the critical function: "Monitors the customer's portfolio and makes recommendations consistent with changes in economic and financial conditions as well as the customer's needs and objectives."

Diversification Diversification Diversification - by asset class, industry, geography and/or risk profile - benefits an investor because it means that there is always something in the portfolio that is making money, no matter what the current economic circumstances. Bear in mind that an investment that might appear risky on its own could make perfect sense - and actually reduce risk - within a portfolio. Consider an uncovered call writer. You have already seen how he could end up losing everything if the underlying stock skyrocketed unexpectedly. But suppose the writer owned the stocks of all that company's key vendors and customers - all the firms in the marketplace whose fortunes were tied to that company. In that context - the context of a portfolio - that very bearish play could become a fairly cost-effective hedge that reduces the investor's overall risk. Looking at the big picture, it does not matter how well one of your stock recommendations does for your client; what is important is how well that client's portfolio performs while you are managing it. The article A Guide to Portfolio Construction delves deeper into portfolio construction by demonstrating a stepby-step approach to determining, achieving and maintaining optimal asset allocation. Capital Asset Pricing Theory This leads into the subject of the capital asset pricing model (CAPM), sometimes called the capital asset pricing theory (or CAPT), which derives the anticipated rates of return on assets based on the assets' risk levels. These rates of return fall along a curve known as the security market line (SML). Risk-free Rate of Return As you know, an investment's reward ought to be equal to its risk. However, the risk/reward relationship is not quite so straightforward. For example, there is a reward for investing in a T-bill - let's say it is a 3% return; a T-bill is a short-term

Compute the variance of RM (σ²M).RFR) Let's go through that step-by-step. Now let's start with some "dummy" data and calculate the σ²M the same way we calculated variance in Section 1. 2. Start by assuming a 3% RFR and a 15% RM. government will go out of business in the next 180 days? Of course not. Here. 8. let's say the market as a whole yields 15%. The market as a whole is comprised of a myriad of investment options. 6. 2. Every investment out there that is not risk-free will have an expected return over 3%.M).μ)2 0 4 1 9 9 1 1 . In other words. it is usually designated RM. the equation that shows the relationship between the risk and the expected return of a particular investment that you might want to recommend to a client. and thus the expected return. Establish the risk-free rate (RFR). you would have a portfolio filled with investments across the risk spectrum. was done above. If you were to buy every security in the world. but the market risk described in Section 2 still exists. Here is the SML formula: E(Ri) = RFR + βi (RM . Multiply step 5's βi by the result of step 6. some riskier than others. 3. Divide the Covi. For the purposes of this discussion. let's set the RFR at 3%. The benefit that comes from holding an essentially bulletproof investment is called the risk-free rate of return (RFR). 7. again. you now have enough assumptions to compute the security market line (SML). 6. 7. 5. does that mean there is a 3% chance the U.instrument. X 15 13 14 12 12 14 16 X-μ 0 -2 -1 -1 -3 -1 1 (X . which was done previously. 4. Compute the covariance of the market with the return on a particular investment (Covi. Uncle Sam probably is not going anywhere. Add step 7's result to step 1's RFR to compute the estimated return on the investment. the X quantities are annual rates of return. and so on: Observation 1.M from step 4 by the σ²M from step 3. For present purposes. 4. Establish the market return rate which. Here's how to build the model: 1. Basically. the following year it yielded 13 cents. No. 5. Subtract step 1's RFR from step 2's RM. 3.S. and thus across the yield spectrum. RFR is the risk in the background. the higher a return it will have to offer to attract investors. That is the baseline from which you will measure the risk. inherent in a particular security. This quantity is known as the investment's beta (βi). the broadest market portfolio yielded 15 cents for every dollar invested. The riskier the investment. so if risk really equals return. the first year. Security Market Line Following with our previous example.

4. and you will get 21. to 21. 8.riave) -8 -10 -6 -2 -3 5 5 7 5 7 Step 4 and 5 (rM . 10.rMave) * (ri .8. from the market rate of return.riave) 0 20 6 6 9 -5 5 14 15 28 1.rMave) 0 -2 -1 -3 -3 -1 1 2 3 4 98 9. You can also tell by looking at the mean why the market rate of return in this example is said to be 15%. Multiply that 12% by 1.8.8. r1ave . 3%. 4. 3.1 . 10. 15%. by the market variance.8. 9. add the RFR.4.6%. simply divide the covariance.6%. Finally. 5. That is the rate of return you would expect from that investment given its correlation with the market.6% and you will get a final result of 24. 5. Capital Market Line (CML) Figure 12. • • • • To find the βi for this investment. and you will get 12%. 2. The next step is even simpler: subtract the RFR. 7. 9. 9.Ri) Again. Now let's compute the covariance of the market and the particular investment: Year RM Ri Step 2 (rM .8 Step 3 (ri . just based on numbers that we simply plugged in.8. Sum (Σ) Number (N) Mean (μ) 17 18 19 150 10 15 2 3 4 54 10 σ² = 4 9 16 5. 6.4 The variance of the market is 5. 3%. notated E(Ri). you can come up with a covariance of 9. r2ave Number (N) 15 13 14 12 12 14 16 17 18 19 15 10 35 33 37 41 40 48 48 50 48 50 43 Cov (RM. Your result will be 1.1 below shows why it is called the security market line: Figure 12.

The RFR is sometimes called alpha (α). • • • The takeaway message from the CML is that. Incidentally. that is. then.Know the Risk. which is defined as the measure of a stock's performance beyond what its beta would predict. Given a beta. Investing in any portfolio above the line is too risky compared to investing in other arrays of securities with the same expected yield. The way to properly position an individual client's portfolio along the CML is through asset allocation. Asset Allocation The real question. fresh graph paper and neat handwriting. investing in anything below the line means leaving money on the table. a market rate. while those who have reached the spending phase will want to be over to the left. a risk-free rate. the rational investor will always choose the portfolios that will give her the greatest possible return. the line along which every rational portfolio lies. or by countries around the globe. how an investment that varies constantly in direct proportion to the market (and thus has a covariance equal to the variance of the market) should yield the market rate. is where does each of your clients belong on the graph above? Those in the accumulation phase should probably be closer to the right. you should be able to draw a graph allowing you to eyeball a corresponding expected rate of return for an investment. and how one particular investment that moves with greater volatility than the market (and thus has a higher covariance) ought to yield a higher return. The Capital Market Line The SML figure is sometimes called the capital market line (CML) when it is used to illustrate a portfolio instead of a single investment. risk-free investment should yield the RFR.1 illustrates: • • • how a static. the slope of the SML line is equal to beta. the process of deciding how to distribute an investor's capital for investment purposes.Figure 12. Read more about the advantages and disadvantages of Beta in the article Beta . . by region within a country. These distributions can be done according to the following categories: • geography. for any given variance. The CML is a proxy for the efficient frontier.

The following articles discuss the various strategies to minimize risk while maximizing return: • • Achieving Optimal Asset Allocation. Market Sentiment The driving forces in the stock market are fear and greed. questions falling into the category of securities analysis are likely to be de-emphasized in the Series 7 exam. to sit for the Series 86/87 a budding analyst first has to pass the Series 7. o Sometimes stocks move drastically in price on light trading . another in retail. for example. Exam Tips and Tricks The Series 7 exam is likely to ask a few questions about the analysis of some or all of the following securities: equities. • Market Momentum o Market momentum is the change in an index over a period of time multiplied by the volume of component shares traded in that period. or during the month of August when most people on Wall Street take at least a week's vacation. However.0 indicates more active puts than calls and. mutual funds and municipal bonds. which is the number of put options divided by the number of call options. Let's focus on equities first. another in government. More formally. That is because the FINRA established in 2004 the Series 86/87 exam specifically for research analysts. you will need to develop an investment policy for each client that will specify how assets will be allocated in the portfolio. the ratio of all stocks traded on an exchange that have gained in value to all those that have lost value. • Advance-Decline Index o One measure of market sentiment is the advance-decline index. o • Over front of regulators. another in bonds. that is.they are known collectively as market sentiment.bullish or bearish .the day before a holiday. In polite company . a certain percentage in stocks. that is. whether the investment is speculative. o A ratio higher than 1. so you can still expect some analysis questions on your upcoming exam. some percentage in technology. risk profile. this index shows the direction in which the market is headed. As a registered representative. You will also need to revisit that policy every year. they are known as the consensus . or industry. Securities Analysis Currently. defensive or growth-oriented. that is.of the participants in the market. Five Things to Know About Asset Allocation. if not more often. . thus. bearish sentiment.• • • asset class. Put/Call Ratio o Another measure is the put/call ratio. for instance .

but not spectacular either. this figure is not a dollar figure. Market Index An example of an index would be the Standard & Poor's 500 Stock Composite. • Trading Volume o The number of shares traded in a day on an exchange. Every time a blue-chip stock splits.many analysts find this a more useful tool than the Dow. the components of the Dow today are not what they were when the average was founded: General Electric is the only original member still in the club. but you frequently will hear an index mistakenly called an "average" and vice versa. o If you are curious to learn more about how the DJIA is calculated.) . the stocks that most consistently return value to shareholders.that is. That is why market indexes and market averages exist. if the S&P was trading at 1178. For those who are unfamiliar with the topic of price momentum. the denominator goes down to compensate. It is a comparison to a date in the early 1940s when the index was established and assigned an arbitrary value of "10".o These changes have a way of correcting themselves once people are back at their desks. If the S&P was trading at 1178. the S&P stocks are worth 117. but sometimes that is just too big a sample to work with. • The DJIA o The Dow generally trades within the 10. market momentum helps analysts avoid reaching misleading conclusions and giving bad advice. the article Momentum and the Relative Strength Index will shed light. An average is just what it sounds like: the sum of all the prices of all the shares in the basket divided by the number of shares in the basket. and there have been a lot since the Dow 30 was established in 1928. An index is a formula for measuring changes in a basket of stocks against a base date and value. (As impressive as that sounds. • The S&P 500 o The S&P 500 tends to trade in the 1000s. o In other words. Market Average An example of an average would be the famous Dow Jones Industrial Average. and Intel and Microsoft have superseded Union Carbide and Sears Roebuck.000s. Today the divided-by number is not 30.2. and the astute reader knows that few stocks ever trade in dollars of that magnitude. By factoring in the number of shares traded as well as the price per share. o o o What makes the Dow a five-digit number is that its denominator is adjusted for stock splits. To further muddy the waters. Because it is a broader measure 500 components rather than 30 .8 times what they were worth 60-odd years ago. Strictly speaking. these terms are not interchangeable. Market Indexes and Averages All of the measures we've discussed thus far look at the market in general. Despite all these caveats. even if you added 30 of them together. the article Calculating the Dow Jones Industrial Average is for you. Both of these terms refer to ways of measuring how the value of a basket of selected stocks changes over time. it works out to approximately 8.not bad. the Dow is still an average. it is closer to 0.3% annual compounded growth . consisting of 30 "blue chip" stocks .

expenses. and like any investment strategy or philosophy. both have their advocates and adversaries. and many volumes of textbooks have been written on both of these methods. Mutual Fund Analysis The Series 7 exam will also cover analysis of mutual funds. mostly airlines. Fundamental analysts report which shares are undervalued by the investor community and which are overvalued.Get to know the most important market considered proprietary. • In the world of stock analysis. although the precise components . U. • Technical analysis. assets and liabilities are all important characteristics to fundamental analysts.S. Which strategy works best is always debated. Here are the most widely cited U.S. tracks the broader market of large-cap stocks More than 3. that trade on the Nasdaq.S. small-cap stocks Philadelphia Stock Exchange's index of 19 companies involved in designing. tracks the most consistently profitable U.000 U. goes on the assumption that a share of ownership of a company has an intrinsic value that is a function of the underlying value of the company as a whole. fundamental and technical analysis are on completely opposite sides of the spectrum. Earnings. We'll discuss each in turn. Fundamental analysis. DJIA) Standard & Poor's 500 Stock Composite (S&P 500) Nasdaq Composite 30 blue-chip stocks. which involves detecting patterns in security prices. and international. most shares relate to the technology sector Approximately 5.and even the number of components .000 stocks. whereas technical analysts could not care less about these numbers. companies 500 largest U. then trust the market to make corrections. or technicians. mostly generators and distributors of electricity Comprised of all stocks trading on the NYSE Dow Jones Wilshire 5000 Total Market (Wilshire 5000) Russell 2000 PHLX Semiconductor (SOX) Dow Transports Dow Utilities NYSE Composite Technical vs. trucking fleets and railroads 15 U. companies by market capitalization.S. Technical the price of everything else . utilities. manufacturing and selling semiconductors 20 U. averages and indexes: Dow Jones Industrial Average (Dow.S. distributing.S. There are two sets of data points used to compare mutual funds: . Fundamental Analysis There are two schools of thought about how a stock will behave relative to the market. which examines the earning potential of the company issuing a a matter of supply and demand. companies.S. goes on the assumption that the price of a stock .S. and the advantages and disadvantages of investing in them within the Index Investing tutorial. generate and interpret charts of the price and volume histories of stocks to predict movement in stock prices according to perceived trends. considered the broadest market measure 2.000 U. delivery services. stocks.

Failure to invest the amount stated in an LOI allows the fund to collect the higher fee retroactively. Statistical We will discuss each in turn within the following sections. corporate bonds. If the investor fails to make the deposits. If the plan is employer-sponsored and the investor changes jobs.1. as discussed in Chapter 6 "Packaged securities and retirement/estate planning". Those expecting to invest regularly in a fund with a front-end sales load should find out if an LOI can help them qualify for a reduced charge. Other non-statistical factors used to compare mutual funds include the following: • Minimum purchase amounts: These are typically $500. Letter of intent (LOI): This is a statement expressing a client's intent to invest an amount over the breakpoint within a specified period of time. or they impose account fees on investors who do not maintain a certain threshold balance. or qualitative. growth funds can invest specifically in growth stocks. and it can pursue those objectives by adopting the appropriate policies. There is usually no reinvestment cost. the cost of entry into bond mutual funds is typically far lower than the cost of actual bonds. Conversion privileges: These give an investor the right to switch from one fund to another in the same family. Charges include front-end loads on purchasing fund shares and back-end loads on selling shares. Meanwhile. As you saw in the section on packaged securities in Chapter 6 "Packaged securities and retirement/estate planning". the first things an investor ought to look at are the funds' investment objectives and policies. a fund's objective can be either growth or income. Non-Statistical Analysis Starting with the non-statistical. Prior to retirement. he might be penalized for early withdrawal. Various sales charge methods: These can add up quickly and erode the returns on an apparently highperforming fund. For example. usually described as 12b-1 fees. criteria. Many fund companies allow purchases completed within 90 days before the LOI is signed and within 13 months after the LOI is signed to be used to reach the breakpoint. $1. Even so. Non-statistical 2. Withdrawal options: These come into play if the fund is part of a retirement or variable annuity plan. the fund will bill the investor for the difference between the breakpoint sales charge and the amount that would have been charged without the breakpoint • • • • • Right of accumulation (ROA) . or they have purchase fees which are paid to the fund family rather than to the broker and are thus not considered sales loads. speculative stocks or stocks within a particular geographic or economic sector. income funds may invest specifically in municipal bonds. an investor may have the choice of a lump sum or a periodic withdrawal schedule. based on his/her intention to make the deposits over the next 13-months that reach the breakpoint. At retirement age.000. and only "new money" counts. $5.000 or more. money markets or defensive stocks. Even noload funds have marketing and operating fees. Look Out! A LOI provides a mutual fund investor with a way of immediately qualifying for a lower sales charge. he might be able to rollover the fund into a plan sponsored by his new employer. government bonds. but sometimes these transfer charges are required by the fund family. often required by the mutual fund issuer or by the selling group member.

those amounts can be combined to reach a $50. income) and 4) by industry sector (for example. bonds and cash). real estate and technology).in the fund's prospectus or quarterly report. but she previously invested $40.which determine what percentage of assets go straight into paying expenses before being distributed to shareholders . You will find these figures . 2. total return: These are all affected by the age of the fund. Portfolio turnover: This is the purchases or sales of assets in the fund (whichever is lower) divided by the average NAV. "rookie" funds often beat the more established players.S. emerging markets stocks).75% average NAV per share according to NASD rules. back-end load charges over time. Statistical Analysis Moving on to statistical measures used to compare mutual funds. If your client is looking to invest for the long haul. the only protection against sudden. Having a diversified portfolio does not mean you will never lose money. a portfolio can be diversified in four different ways: 1) by asset class (stocks. The age of a fund might have no correlation to its success.: This gives an investor a discount on current mutual fund purchases by combining both current and previous fund transactions to reach a breakpoint. It is important to note two things here: 1.. • A fund that outpaced the market every year for the past 20 years is not necessarily going to do so again this year. For example. systemic losses is to put some assets into a money market fund.  Eligibility for conduit theory application on distributions: This is a factor because not all investment companies qualify for this treatment. there are several quantitative concerns you must bear in mind when presenting a client with options: • • • Sales charges: These charges matter. the greater the transaction costs incurred by buying and selling securities. regardless of the timing . Expense ratio: This is operating expenses divided by average NAV.or back-loaded. The back-end load is initially higher than the front-end load. 2) by geography (U. and their distributions might be decimated by taxes on the corporate level before reaching the investors. As noted earlier in this chapter. past performance is not indicative of future performance. its risk profile.000 breakpoint. which will entitle her to a lower sales load on the $10.000. Performance over time in terms of growth.  Diversified portfolio: This is a factor because owning various types of funds can help reduce the volatility of a portfolio over the long term. 3) by risk profile (growth. The higher the portfolio turnover. these cannot exceed 0. but it decreases over time. and this can adversely affect the fund's performance. • • .front. Distribution fees: Also known as 12b-1 fees. this may be advantageous for her. and how they can affect the total expenses paid by the investor: Sometimes a fund will give the investor a choice between a front-end load and a back-end load.000 purchase. if your client is investing $10. its volatility and its expenses. income.000 in a fund today. The investor ought to know if they are closer to 4% or to 8% of purchase price. foreign developed markets stocks. Comparison of front-end vs.