Portfolio Management
MGMT 645: Portfolio Management
Contact
Instructor: Robert (Bob) Dittmar
email: robert.dittmar@rice.edu
Office: McNair 332
Office hours: after class, MW 10:45-12:15 or
appointment
Course materials and communication: Canvas
About me (professional)
At Rice since 2022
University of Michigan, Ross School of Business 2003-
2022
Indiana University, Kelley School of Business 1999-
2003
Professional interests
Portfolio management, pricing of equities, pricing of
fixed income securities
About me
(personal)
Grew up in Chicago
Two kids (22 and 25) in culinary school
and grad school, respectively
(humblebrag?) married to Rice
University’s provost
Two dogs that are meant to live in
Canada, not Texas
What is portfolio management?
Definition from Investopedia* [emphasis mine]:
Portfolio management is the art and science of selecting and
overseeing a group of investments that meet the long-term financial
objectives and risk tolerance of a client, a company, or an
institution.
*https://www.investopedia.com/terms/p/portfoliomanagement.asp
Selecting
assets
Which assets should we
select?
Financial objectives
• I want to make money and lots of it!!!!
• I need to have enough money to retire in 20 years
• I am already retired and need a safe, fixed stream of
income
• I’m a company CFO managing a pension plan for
10,000 employees
Risk tolerance
• What would you do if faced with a drop in the market
of 20%?
• What if you were 67?
• What if you already had $10,000,000 and were 67?
• What if you only had $100,000 and were 67?
MGMT 645
• Develop a system for allocating assets to portfolios
• Emphasis on allocation, rather than stock selection
• Build general rules for most investors
• Consider specific situations
• What if we think we have an “edge” in stock selection?
• How can we use leverage and derivatives to enhance or
protect our returns?
Modern portfolio theory (MPT)
Harry Markowitz (1927-
2023)
• Ph.D., University of
Chicago
• Seminal work: “Portfolio
Selection,” Journal of
Finance 1952
• Winner of the Nobel
Memorial Prize in
Economic Sciences 1990
MPT vs Graham & Dodd
• Graham & Dodd (1934): determine the intrinsic value
of a stock
• Forecast future cash flows
• Compare value of these cash flows to the current price
• Graham & Dodd (1960): Graham’s formula
Markowtiz’ insight
• G&D and Williams (1934): Find stocks to maximize
expected returns
• (Extreme) implication: find a superstock
• People hold diversified portfolios
• Tradeoff between risk of an investment and its
expected return
Common misperceptions about MPT*
1. It assumes all investors are rational
• MPT assumes investors assess expected returns and risks
• These expectations can result from biased beliefs
• Tells us an allocation based on our subjective expectations
2. It assumes markets are efficient
• As above, investors assess expected returns and risks
• These expected returns can be above “fair” expected
returns
* https://medium.com/the-intelligent-sports-wagerer/a-tale-of-two-investment-
philosophies-f85162477ce4
How can we use MPT?
How can we use MPT?
• Personal portfolio management
• Build wealth over time
• Tax-advantaged
• General
• Professional passive portfolio management
• Build portfolios as cheaply as possible
• Professional active portfolio management
• Use research or insights to outperform passive investments
Personal portfolio management
After earning your Jones MBA, you’ve landed a position earning
$150K with a 401(k). Your employer will match up to 5% of your
salary in this tax-deferred investment vehicle.
The 401(k) is designed to fund your income in retirement. You are
currently 28 years old, and plan to retire at 67.
• What should your savings goals be?
• How should you allocate assets to best achieve these goals?
• What do you monitor over time to meet them?
Setting up the problem
• We can start to tackle this problem using time value
of money (TVM) tools from introductory finance
• Our tax-sheltered savings are $15,000 next year
• We expect our earnings to grow by 5% per year
• We have 39 years to achieve our goals
Determining the target
• How much do we need to have saved (what is FV)?
• You assume inflation of 2% per year
• You want to maintain a lifestyle of $150,000 per year in
today’s dollars
• You want your retirement savings to last 40 years
• You assume you can earn 2% above inflation (4%) on your
money after retirement
Determining the target (continued)
• What is the income you need at age 67?
• If I want that income to grow by inflation and I expect
to earn 5%, how much do I need to give me that
income for 40 years?
Required rate of return
• Now I can solve for the target rate of return on my
401(k)
• MPT guides us in finding allocations to earn this rate
of return
Portfolio management and expected
return
• One goal of portfolio management: achieve this
8.49% expected return as efficiently as possible
• Efficient: with as little variability as possible
• Monte Carlo simulations
• Mean (log) return = 8.49%
• Standard deviation = 10%, 20%
Monte Carlo
Shortfall
Class agenda
1. Expectations, risk, correlation, and downsides
2. Allocating funds between a risky asset and a risk-free asset
3. Allocating funds between multiple risky assets and a risk-free asset
4. Benchmark expected returns
5. Covariance matrices (factor models)
6. Sources of “extra” returns (alpha)
7. Incorporating alpha into asset allocation
8. Active risk
9. Leverage and short sales
