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.

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

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:

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:

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.

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.

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.

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:

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 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.