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Passive vs. Active Strategy
Passive
One of the most profound ideas affecting the investment decision
process, and indeed all of finance, is the idea that the securities
markets, particularly the equity markets, are efficient. In an efficient
market, the prices of securities do not depart for any length of time
from the justified economic values that investors calculate for them.
Economic values for securities are determined by investor expectations
about earnings, risks, and so on, as investors grapple with the
uncertain future. If the market price of a security does depart from its
estimated economic value, investors act to bring the two values
together. Thus, as new information arrives in an efficient marketplace,
causing a revision in the estimated economic value of a security, its
price adjusts to this information quickly and, on balance, correctly. In
other words, securities are efficiently priced on a continuous basis.
An efficient market does not have to be perfectly efficient to have a
profound impact on investors. All that is required is that the market be
economically efficient. That is, after acting on information to trade
securities and subtracting all costs (transaction costs and taxes, to
name two), the investor would have been as well off with a simply
buy-and-hold strategy. If the market is economically efficient,
securities could depart somewhat from their economic (justified) values,
but it would not pay investors to take advantage of these small
discrepancies.
A natural outcome of a belief in efficient markets is to employ some
type of passive strategy in owning and managing common stocks. If the
market is totally efficient, no active strategy should be able to beat
the market on a risk-adjusted basis. The Efficient Market Hypothesis has
implications for fundamental analysis and technical analysis, both of
which are active strategies for selecting common stocks.
Passive strategies do not seek to outperform the market but simply to
do as well as the market. The emphasis is on minimizing transaction
costs and time spent in managing the portfolio because any expected
benefits from active trading or analysis are likely to be less than the
costs. Passive investors act as if the market is efficient and accept
the consensus estimates of return and risk, accepting current market
price as the best estimate of a security’s value.
Paralleling our discussion of passive approaches to bond management,
an investor can simply follow a buy-and-hold strategy for whatever
portfolio of stocks is owned. Alternatively, a very effective w ay to
employ a passive strategy with common stocks is to invest in an indexed
portfolio. We will consider each of these strategies in turn.
A buy-and-hold strategy means exactly that - an investor buys stocks
and basically holds them until some future time in order to meet some
objective. The emphasis is on avoiding transaction costs, additional
search costs, and so forth., The investor believes that such a strategy
will, over some period of time, produce results as good as alternatives
that require active management whereby some securities are deemed not
satisfactory, sold, and replaced with other securities. These
alternatives incur transaction costs and involve inevitable mistakes.
Notice that a buy-and-hold strategy is applicable to the investor’s
portfolio, whatever its composition. It may be large or small, and it
may emphasize various types of stocks. Also note that an important
initial selection must be made to implement the strategy. The investor
must decide to buy stocks A, B and C and not X, Y and Z.
Note that the investor will, in fact, have to perform certain
functions while the buy-and-hold strategy is in existence. For example,
any income generated by the portfolio may be reinvested in other
securities. Alternatively, a few stocks may do so well that they
dominate the total market value of the portfolio and reduce its
diversification. If the portfolio changes in such a way that it is no
longer compatible with the investor’s risk tolerance, adjustments may be
required. The point is simply that even under such a strategy investors
must still take certain actions.
An interesting variant of this strategy is to buy-and-hold the 10
highest dividend-yielding stocks among the DJIA at the beginning of the
year, hold for a year, and replace any stocks if necessary at the
beginning of the next year with the newest highest-yielding stocks in
the DJIA. This strategy does not require stock selection since it is
based only on using the easily calculated dividend yield for 30
identified stocks, and making substitutions when necessary.
An increasing amount of mutual fund and pension fund assets can be
described as passive equity investments. Using
index funds, these asset pools are designed to duplicate as
precisely as possible the performance of some market index.
A stock-index fund may consist of all the stocks in a well-known
market average such as the Standard & Poor’s 500 Composite Stock Index.
No attempt is made to forecast market movements and act accordingly, or
to select under-or overvalued securities. Expenses are kept to a
minimum, including research costs (security analysis), portfolio
managers’ fees, and brokerage commissions. Index funds can be run
efficiently by a small staff.
Active
Investors who do not accept the EMH, or have serious doubts, pursue
active investment strategies, believing that they can identify
undervalued securities and that lags exist in the market’s adjustment of
these securities’ prices to new (better) information. These investors
generate more search costs (both in time and money) and more transaction
costs, but they believe that the marginal benefit outweighs the marginal
costs incurred.
Most investment techniques involve an active approach to investing.
In the area of common stocks the use of valuation models to value and
select stocks indicates that investors are analyzing and valuing stocks
in an attempt to improve their performance relative to some benchmark
such as a market index. They assume or expect the benefits to be greater
than the costs.
Pursuit of an active strategy assumes that investors possess some
advantage relative to other market participants. Such advantages could
include superior analytical or judgment skills, superior information, or
the ability or willingness to do what other investors, particularly
institutions, are unable to do. For example, many large institutional
investors cannot take positions in very small companies, leaving this
field for individual investors. Furthermore, individuals are not
required to own diversified portfolios and are typically not prohibited
from short sales or margin trading as are some institutions.
Most investors still favor an active approach to common stock
selection and management, despite the accumulating evidence from
efficient market studies and the published performance results of
institutional investors. The reason for this is obvious - the potential
rewards are very large, and many investors feel confident that they can
achieve such awards even if other investors cannot.
The most traditional and popular form of active stock strategies is
the selection of individual stocks identified as offering superior
return-risk characteristics. Such stocks typically are selected using
fundamental security analysis, but technical analysis is also used, and
sometimes a combination of the two. Many investors have always believed,
and continue to believe despite evidence to the contrary from the EMH,
that they possess the requisite skill, patience, and ability to identify
undervalued stocks.
We know that a key feature of the investments environment is the
uncertainty that always surrounds investing decisions. Most stock
pickers recognize the pervasiveness of this uncertainty and protect
themselves accordingly by diversifying., Therefore, the standard
assumption of rational, intelligent investors who select stocks to buy
and sell is that such selections will be part of a diversified
portfolio.
How important is stock selection in the overall investment process?
Most active investors, individuals or institutions, are, to various
degrees, stock selectors. The majority of investment advice and
investment advisory services is geared to the selection of stocks
thought to be attractive candidates at the time.
Stocks are, of course, selected by both individual investors and
institutional investors. Rather than do their own security analysis,
individual investors may choose to rely on the recommendations of the
professionals. An important part of the institutional side of stock
selection and recommendation is the role of the security analyst (also
called investment analyst, or, simply, analyst) in the investment
process. There are perhaps 2500 analysts on Wall Street.
The security analyst typically works for an institution concerned
with stocks and other financial assets, but the analysts' product is
often available to the individual investor in the form of brokerage
reports and newsletters, reports from Standard & Poor's and other
recommendation services, and so forth. Therefore, when considering stock
selection it is important to analyze the role of the analyst.
The central focus of the analysts' job is to attempt to forecast
stock returns. This task typically involves a direct forecast of a
specific company's return. Alternatively, it can involve the inputs to a
valuation model. Investors interested in stock selection use valuation
models, and for inputs they can utilize their own estimates or, in some
cases, use those provided by analysts.
What sources of information do analysts use in evaluating common
stocks for possible selection or selling?' The major sources of
information are presentations from the top management of the companies
being considered, annual reports, and Form 10-K reports that must be
filed by the companies with the SEC. According to surveys of analysts,
they consistently emphasize the long term over the short term. Variables
of major importance in their analysis include expected changes in
earnings per share, expected return on equity (ROE), and industry
outlook.
One of the most important responsibilities of an analyst is to
forecast earnings per share for particular companies because of the
widely perceived linkage between expected earnings and stock returns.
Earnings are critical in determining stock prices, and what matters is
expected earnings (what is referred to on Wall Street as earnings
estimates). Therefore, the primary emphasis in fundamental security
analysis is on expected earnings, and analysts spend much of their time
forecasting earnings.
Empirical studies indicate that current expectations of earnings, as
represented by the average of the analysts' forecasts, are incorporated
into current stock prices. Perhaps more importantly, revisions in the
average forecast for year-ahead earnings have predictive ability
concerning future stock returns.
In doing their job of estimating expected returns, analysts
supposedly present their recommendations in the form of "Buy," "Hold,"
and "Sell." However, investors who receive brokerage reports typically
will see recommendations for specific companies as either "buy," or
"hold," or "speculative hold." Analysts are under some pressure to avoid
the word "sell" from the companies they follow.
An active strategy that is similar to stock selection is group or
sector rotation. This strategy involves shifting sector weights in the
portfolio in order to take advantage of those sectors that are expected
to do relatively better, and avoid or de-emphasize those sectors that
are expected to do relatively worse. Investors employing this strategy
are betting that particular sectors will repeat their price performance
relative to the current phase of the business and credit cycle.
An investor could think of larger groups as the relevant sectors,
shifting between cyclicals, growth stocks, and value stocks. It is quite
standard in sector analysis to divide common stocks into four broad
sectors: interest-sensitive stocks, consumer durable stocks, capital
goods stocks, and defensive stocks. Each of these sectors is expected to
perform differently during the various phases of the business and credit
cycles. For example, interest-sensitive stocks would be expected to be
adversely impacted during periods of high interest rates, and such
periods tend to occur at the latter stages of the business cycle. As
interest rates decline, the earnings of the companies in this
sector-banks, finance companies, savings and loans, utilities, and
residential construction firms-should improve.
Defensive stocks deserve some explanation. Included here are
companies in such businesses as food production, soft drinks, beer,
pharmaceuticals, and so forth that often are not hurt as badly during
the down side of the business cycle as are other companies because
people will still purchase bread, milk, soft drinks, and the like. As
the economy worsens and more problems are foreseen, investors may move
into these stocks for investment protection. These stocks often do well
during the late phases of a business cycle.
Investors may view industries as the sectors and act accordingly. For
example, if interest rates are expected to drop significantly, increased
emphasis could be placed on the interest-sensitive industries such as
housing, banking, and the savings and loans. The defense industry is a
good example of an industry in recent years that has experienced wide
swings in performance over multiyear periods. The defense buildup that
occurred under the Reagan administration was followed by a de-emphasize
of defense following the dramatic end of the cold war and the
dissolution of the Soviet Union in the early 1990s.
It is clear that effective strategies involving sector rotation
depend heavily on an accurate assessment of current economic conditions.
A knowledge and understanding of the phases of the business cycle are
important, as is an understanding of political environments,
international linkages among economies, and credit conditions both
domestic and international.
Market timers attempt to earn excess returns by varying the
percentage of portfolio assets in equity securities. One has only to
observe a chart of stock prices over time to appreciate the profit
potential of being in the stock market at the right times and being out
of the stock market at the bad times.
When equities are expected to do well, timers shift from cash
equivalents such as money market funds to common stocks. When equities
are expected to do poorly, the opposite occurs. Alternatively, timers
could increase the Betas of their portfolios when the market is expected
to rise and carry most stocks up, or decrease the Betas of their
portfolio when the market is expected to go down. One important factor
affecting the success of a market timing strategy is the amount of
brokerage commissions and taxes paid with such a strategy as opposed to
those paid with a buy-and-hold strategy.
Like many issues in the investing arena, the subject of market timing
is controversial. Evidence indicates it is difficult for investors to
regularly time the market efficiently enough to provide excess returns
on a risk-adjusted basis.
On a pure timing basis, only a small percent of the stock timing
strategies tracked over the most recent five-and eight-year periods
outperformed a buy-and-hold approach.
Much of the empirical evidence on market timing comes from studies of
mutual funds. A basic issue is whether fund managers increase the beta
of their portfolios when they anticipate a rising market and reduce the
beta when they anticipate a declining market. Several studies found no
evidence that funds were able to time market changes and change their
risk level in response.
Considerable research now suggests that the biggest risk of market
timing is the investors will not be in the market at critical times,
thereby significantly reducing their overall returns. Investors who miss
only a few key months may suffer significantly. For example, over a
recent 40-year period, investors who missed the 34 best months for
stocks would have seen an initial $1,000 investment grow to only $4,492
instead of $86,650. Even Treasury bills would have been a better
alternative in this situation. If you are still considering market
timing as a strategy suitable for the average individual investor, think
again, particularly after considering the following information. For the
period 1986-1995, inclusive, returns on the S&P 500 Composite Index
were:
Fully invested - annualized rate of return = 14.8 percent
Take out the 10 best days = 10.2 percent
Take out the 20 best days = 7.3 percent
Take out the 30 best days = 4.8 percent
Take out the 40 best days = 2.5 percent
Building an Investment Portfolio
Asset Allocation
We now consider how investors go about selecting stocks to be held in
portfolios. Individual investors often consider the investment decision
as consisting of two steps:
Asset allocation
Security selection
The asset allocation decision refers to the allocation of portfolio
assets to broad asset markets; in other words, how much of the
portfolio’s funds is to be invested in stocks, how much in bonds, money
market assets, and so forth. Each weight can range from zero percent to
100 percent. Examining the asset allocation decision globally leads us
to ask the following questions:
What percentage of portfolio funds is to be invested in each of
the countries for which financial markets are available to
investors?
Within each country, what percentage of portfolio funds is to be
invested in stocks, bonds, bills, and other assets?
Within each of the major asset classes, what percentage of
portfolio funds is to go to various types of bonds, exchange-listed
stocks versus over-the-counter stocks, and so forth?
Many knowledgeable market observers agree that the asset allocation
decision may be the most important decision made by an investor.
According to some studies, for example, the asset allocation decision
accounts for more than 90 percent of the variance in quarterly returns
for a typical large pension fund.
The rationale behind this approach is that different asset classes
offer various potential returns and various levels of risk, and the
correlation coefficients may be quite low.
Correlation determines the extent to which a variable moves in the
same direction as other variable, such as inflation. It is statistically
determined and labeled as the correlation coefficient. Correlation can
help in making decisions concerning diversification among mutual fund
categories.
The asset allocation decision involves deciding the percentage of
investable funds to be placed in stocks, bonds, and cash equivalents. It
is the most important investment decision made by investors because it
is the basic determinant of the return and risk taken. This is a result
of holding a well-diversified portfolio, which we know is the primary
lesson of portfolio management.
The returns of a well-diversified portfolio within a given asset
class are highly correlated with the returns of the asset class itself.
Within an asset class diversified portfolios will tend to produce
similar returns over time. However, different asset classes are likely
to produce results that are quite dissimilar. Therefore, differences in
asset allocation will be the key factor over time causing differences in
portfolio performance.
Factors to consider in making the asset allocation decision include
the investor’s return requirements (current income versus future
income), the investor’s risk tolerance, and the time horizon. This is
done in conjunction with the investment manager’s expectations about the
capital markets and about individual assets.
According to some analyses, asset allocation is closely related to
the age of an investor. This involves the so-called life-cycle theory
of asset allocation. This makes intuitive sense because the needs
and financial positions of workers in their 50s should differ, on
average, from those who are starting out in their 20s. According to the
life-cycle theory, for example, as individuals approach retirement they
become more risk averse.
Stated at its simplest, portfolio construction involves the selection
of securities to be included in the portfolio and the determination of
portfolio funds (the weights) to be placed in each security. The
Markowitz model provides the basis for a scientific portfolio
construction that results in efficient portfolios. An efficient
portfolio is one with the highest level of expected return for a given
level of risk, or the lowest risk for a given level of expected return.
Asset Classes
Portfolio construction begins with the basic building blocks of asset
classes, which are the following major categories of investments:
- Cash (or cash
equivalents such as money market funds)
- Stocks
- Bonds
- Real Estate (including Real Estate Investment Trusts)
- Foreign Securities
Each investor must determine which of these major categories of
investments is suitable for him/her. The next step, as discussed in the
preceding section on asset allocation, is to determine which percentage
of total investable assets should be allocated to each category deemed
appropriate. Only then, should individual securities be considered
within each asset class.
Diversification
The insurance principle illustrates the concept of attempting to
diversify the risk involved in a portfolio of assets (or liabilities).
In fact, diversification is the key to the management of portfolio risk
because it allows investors to minimize risk without adversely affecting
return.
Random or naïve diversification refers to the act of randomly
diversifying without regard to relevant investment characteristics such
as expected return and industry classification. An investor simply
selects a relatively large n umber of securities randomly – the
proverbial "throwing a dart at The Wall Street Journal page
showing stock quotes."
For randomly selected portfolios average portfolio risk can be
reduced to approximately 19 percent. As we add securities to the
portfolio, the total risk associated with the portfolio of stocks
declines rapidly. The first few stocks cause a large decrease in
portfolio risk. Based on these actual data, 51 percent of portfolio
standard deviation is eliminated as we go from 1 to 10 securities.
Unfortunately, the benefits of random diversification do not continue
as we add more securities. As subsequent stocks are added, the marginal
risk reduction is small. Nevertheless, adding one more stock to the
portfolio will continue to reduce the risk, although the amount of the
reduction becomes smaller and smaller.
Throughout the entire range of portfolio sizes, the risk is reduced
when international investing is compared to U.S. stocks, and the
difference is dramatic - about one-third less.
Risk Reduction in the Stock Portion
of a Portfolio
Law of Large Numbers
Assume that all risk sources in a portfolio of securities are
independent. As we add securities to this portfolio, the exposure to any
particular source of risk becomes small. According to the Law of
Large Numbers, the larger the sample size, the more likely it is
that the sample mean will be close to the population expected value.
Risk reduction in the case of independent risk sources can be thought of
as the insurance principle, named for the idea that an insurance
company reduces its risk by writing many policies against many
independent sources of risk.
We are assuming here that rates of return on individual securities
are statistically independent such that any one security’s rate of
return is unaffected by another’s rate of return.
Unfortunately, the assumption of statistically independent returns on
stocks is unrealistic in the real world. We find that most stocks are
positively correlated with each other; that is, the movement sin their
returns are related. Most stocks have a significant level of co-movement
with the overall market of stocks, as measured by such indexes as the
S&P 500 Composite Index. Risk cannot be eliminated because common
sources of risk affect all firms.
Modern Portfolio Theory
In the 1950’s, Harry Markowitz, considered the father of modern
portfolio theory, originated the basic portfolio model that underlies
modern portfolio theory. Before Markowitz, investors dealt loosely with
the concepts of return and risk. Investors have known intuitively for
many years that it is smart to diversify, that is, not to "put all of
your eggs in one basket." Markowitz, however, was the first to develop
the concept of portfolio diversification in a formal way. He showed
quantitatively why, and how, portfolio diversification works to reduce
the risk of a portfolio to an investor.
Markowitz sought to organize the existing thoughts and practices into
a more formal framework and to answer a basic question: Is the risk of a
portfolio equal to the sum of the risks of the individual securities
comprising it? Markowitz was the first to develop a specific measure of
portfolio risk and to derive the expected return and risk for a
portfolio based on covariance relationships.
Markowitz developed an equation that calculates the risk of a
portfolio as measured by the variance or standard deviation. His
equation accounts for two factors:
Weighted individual security risks (i.e., the variance of each
individual security, weighted by the percentage of investable funds
placed in each individual security).
Weighted co-movements between securities’ returns (i.e., the
covariance between the securities’ returns, again weighted by the
percentage of investable funds placed in each security).
Covariance is a measure of the co-movements between security returns
used in the calculation of portfolio risk. Markowitz found we can
analyze how security returns move together by considering the
correlation coefficient, a measure of association learned in statistics.
As used in portfolio theory, the correlation
coefficient is a statistical measure of the relative
co-movements between security returns. It measures the extent to which
the returns on any two securities are related; however, it denotes only
association, not causation. It is a relative measure of association that
is bounded by +1.0 and -1.0, with 1.0 being a perfect correlation and
-1.0 being a perfect negative correlation.
With perfect positive correlation, the returns have a perfect direct
linear relationship. Knowing what the return on one security will do
allows an investor to
forecast perfectly what the other will do.
With perfect negative correlation, the securities’ returns have a
perfect inverse linear relationship to each other. Therefore, knowing
the return on one security provides full knowledge about the return on
the second security. When one security’s return is high, the other is
low.
With zero correlation, there is no relationship between the returns
on the two securities. Knowledge of the return on one security is of no
value in predicting the return of the second security.
When does diversification pay?
- Combining securities with perfect positive correlation with each
other provides no reduction in portfolio risk. The risk of the
resulting portfolio is simply a weighted average of the individual
risks of the securities. As more securities are added under the
condition of perfect positive correlation, portfolio risk remains a
weighted average. There is no risk reduction.
- Combining two securities with zero correlation (statistical
independence) with each other reduces the risk or the portfolio. If
more securities with uncorrelated returns are added to the
portfolio, significant risk reduction can be achieved. However,
portfolio risk cannot be eliminated in this case.
- Combining two securities with perfect negative correlation with
each other could eliminate risk altogether. This is the principle
behind hedging strategies.
- Finally, we must understand that in the real world, these
extreme correlations are rare. Rather, securities typically have
some positive correlation with each other. Thus, although risk can
be reduced, it usually cannot be eliminated. Other things being
equal, investors wish to find securities with the least positive
correlation possible. Ideally, they would like securities with
negative correlation or low positive correlation, but they generally
will be faced with positively correlated security returns.
Markowitz’ theory shows us that the risk for a portfolio encompasses
not only the individual security risk but also the co-variance between
the securities and that three factors determine portfolio risk:
The variance of each security.
The co-variances between securities.
The portfolio weights for each security.
The standard deviation of the portfolio will be directly affected by
the correlation between the two stocks. Portfolio risk will be reduced
as the correlation coefficient moves from +1.0 downward.
One of Markowitz’s real contributions to portfolio theory is his
insight about the relative importance of the variances and co-variances.
As the number of securities held in a portfolio increases, the
importance of each individual security’s risk (variance) decreases,
while the importance of the covariance relationships increases. In a
portfolio of 500 securities, for example, the contribution of each
security’s own risk to the total portfolio risk will be extremely small;
portfolio risk will consist almost entirely of the covariance risk
between securities.
Markowitz’s approach to portfolio selection is that an investor
should evaluate portfolios on the basis of their expected returns and
risk as measured by the standard deviation. He was the first to derive
the concept of an efficient portfolio,
defined as one that has the smallest portfolio risk for a given level of
expected return or the largest expected return for a given level of
risk. Investors can identify efficient portfolios by specifying an
expected portfolio return and minimizing the portfolio risk at this
level of return. Alternatively, they can specify a portfolio risk level
they are willing to assume and maximize the expected return on the
portfolio for this level of risk. Rational investors will seek efficient
portfolios because these portfolios are optimized on the two dimensions
of most importance to investors, expected return and risk.
Dollar Cost Averaging
The systematic addition of dividends (usually with mutual funds),
along with consistent periodic new purchases of shares, creates risk
reduction by creating a lower cost per share owned over time. This is
known as dollar cost averaging. This strategy allows one to take away
the guesswork of trying to time the market. You invest a fixed amount of
money at a regular interval, regardless of whether the market is high or
low. By doing so, you buy fewer shares when the prices are high and more
shares when the prices are low. Because dollar cost averaging involves
regular investments during periods of fluctuating prices, you should
consider your financial ability to continue investing when price levels
are low. However, this approach reduces the effects of market
fluctuation on the average price you pay for your shares. Additionally,
it helps you maintain a regular investing plan. See
more.
Dividend Reinvestment
A dividend is a payment to stockholders, usually in the form of cash,
but perhaps in the form of stock or other property, to owners of the
company. Dividends may be regular dividends, which are steady dividend
payments distributed at regular intervals. Also, dividends may be
irregular, meaning that they do not occur at regular intervals or that
they vary substantially in amount. An extra dividend is a dividend that
is in addition to the company’s regular dividend.
A dividend reinvestment plan allows an investor in mutual fund or
other shares to acquire additional shares automatically, often without
sales charge. Instead of a cash payment, the investor is issued shares
as dividends. This creates a form of dollar cost averaging.


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