The first step in active portfolio management is to assess performance after a few quarters or a year.
You can revise the portfolio based on the information from your assessment.
It can be difficult to calculate the portfolio return.
Many of the concepts presented in this chapter are used in the procedures used to assess portfolio performance.
We will show you how to assess portfolio performance using a hypothetical securities portfolio.
We will look at three measures that you can use to compare a portfolio's return with a risk-adjusted, market-adjusted rate of return.
The investment portfolio was presented in Table 13.5.
His children are married.
He makes $60,000 per year.
His primary investment objective is long-term growth.
He looks at quality and growth potential when selecting stocks.
On January 1, he had a portfolio of 10 good quality stocks.
He was fortunate in his selection process.
He has $74,000 in unrealized price appreciation in his portfolio.
He decided to change his portfolio.
He sold 1,000 shares of Dallas National Corporation on May 7.
The holding period return for that issue was discussed earlier.
He bought an additional 1,000 shares of Florida Southcoast Banks using the proceeds from the Dallas National sale.
One of the fastest growing counties in the country is Florida Southcoast.
Every investor should list his or her holdings on a regular basis.
The number of shares, acquisition date, cost, and current value are shown in the table.
The data helps in formulating strategy decisions.
The amount invested is determined by the cost data.
The leverage of a margin account is not used by the portfolio.
His invested capital is $324,000.
He helped investors beat inflation by not adding new capital to the portfolio.
He used the pro's investment in the S&P 500 to buy another bank, Florida Southcoast Banks.
Income and capital gains are the two main sources of return from a portfolio of common stocks.
Current income was realized from the S&P500 index.
Federal and state income tax returns would have dividends and interest reported by investors.
Companies are required to give income reports to stockholders and bondholders.
He sold the Dallas National stock after he received two dividends of $0.45 per share.
He received dividends on the additional income-seeking investors that he acquired Florida Southcoast Banks shares.
The values for each issue are listed except for the additional shares of Florida Southcoast Banks.
The amounts listed for Florida Southcoast Banks reflect the fact that 1,000 additional shares of the stock were acquired on May 10, 2017, at a cost of $32,040.
The current holdings are worth $356,000 at the end of the year, including the additional Florida Southcoast Banks shares that were purchased at the beginning of the year.
There were additional shares acquired on May 10.
The additional shares were purchased at a cost of $32,040.
The cost and market value of the previously owned shares are listed.
The $324,000 market value of the portfolio on January 1, 2017 is included in the total.
It is necessary to include the realized gain in this total to calculate the unrealized gain on the portfolio.
The portfolio increased in value by almost $30,000 during the year.
In addition, he realized a capital gain by selling his Dallas National holding.
The Dallas National holding increased in value from January to May.
The portfolio had a gain of $3,040 and a loss of $28,960 in savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay Hathaway did not add or withdraw capital over the year.
The capital gain is the difference between the year-end market value and the value on January 1.
This is $32,000.
Only $3,040 is considered realized for tax purposes.
The holding period return is used to measure the total return on the portfolio.
The HPR formula for portfolios is shown below.
The formula includes both realized and unrealized yearly gains of the portfolio.
Portfolio additions and deletions are weighted by the number of months they are in the portfolio.
The table shows the change in the portfolio's value as of December 31, 2017: it lists all the stocks that are in the portfolio.
For comparison purposes, the beginning and year-end values are included.
The calculation of the HPR for the year is presented in Table 13.8.
The elements of a portfolio's return are included.
The gain of $3,040 is the increment in value of the Dallas National holding until it is sold.
The portfolio had a $28,960 gain in savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay savesay There were no withdrawals or additions of funds.
The portfolio had a total return of 13.25% in 2017, using Equation 13.3 for HPR.
The HPR figure can be compared with market measures.
His portfolio will be compared to the stock market as a whole.
The stock market as a whole can be represented by the S&P 500 stock index.
The return on the S&P 500 Index during the year was 10%.
The broad indicator of stock market return shows that the Hathaway portfolio performed 23% better than it did.
It doesn't take into account whether Hathaway's portfolio is more or less risky than the broad stock market indexes.
Further analysis is required.
Portfolio performance can be assessed using a number of risk-adjusted, market-adjusted rate-of-return measures.
We will discuss the most popular measures and demonstrate their application to the portfolio.
The total portfolio return minus the risk-free rate is called the risk premium.
The risk premium per unit of total risk is measured by the portfolio standard deviation of return.
When compared to other portfolios or to the market, Sharpe's measure is meaningful.
The measure of 0.36 for Hathaway's portfolio is greater than the measure of 0.29 for the market portfolio.
The risk premium is higher than the market.
The portfolio's per formance would be considered inferior to the market performance if the measure for the portfolio was below 0.29.
Jack L. Treynor came up with a measure to measure portfolio performance.
If the portfolio has been built in a way that diversifies away all diversifiable risk, then the focus will be on nondiversifiable risk.
The measure is shown in Equation 13.5.
The measure shows the risk premium per unit of nondiversifiable risk.
When compared to other port folios or to the market, Treynor's measure is useful.
The fact that Hathaway's portfolio has a higher measure than the market's is indicative of its superior performance.
The risk premium is higher than the market.
The portfolio's performance would be viewed as inferior to that of the market if the measure for the portfolio had been below 3.05%.
The portfolio perfor mance measure developed by Michael C. Jensen seems to be in line with the measures of Treynor and Sharpe.
The amount by which the portfolio's actual return deviates from its required return is called excess return.
The excess return can be positive, zero, or negative.
Jensen's measure focuses on the nondiversifiable, or relevant, risk by using CAPM.
It is assumed that the portfolio has been diversified.
Jensen's measure is shown in Equation 13.6.
Jensen's measure shows the difference between the portfolio's actual return and required return.
Positive values show superior performance.
The portfolio earned a return in excess of its required return.
A zero indicates that the portfolio earned its required return.
The portfolio failed to earn its required return.
The 1.85% value for Jensen's measure indicates that the portfolio earned an excess return.
Hathaway's portfolio has performed better than the market on a risk-adjusted basis.
PArT fivE i POrTfOliO MAnAGE MEnT note that Jensen's measure adjusts for the market return through the use of CAPM.
There is no need for a market comparison.
The better the portfolio has performed, the higher the value of Jensen's measure.
The portfolios with positive Jensen measures have performed better than the market on a risk-adjusted basis.
Jensen's measure tends to be preferred over the others for assessing portfolio performance due to its simplicity and reliance on nondiversifiable risk.
We have been talking about one transaction in the portfolio.
The right risk-return characteristics for your goals and ally are reflected by investors who systematically study the issues in their portfolios.
As the economy changes, industries and stocks become less attractive as investments, prompting investors to make adjustments to their portfolios.
A child's rebalancing of the portfolio is a necessity given the dynamics of the investment world and the loss of a spouse.
It's important to finish college to change your investment objectives.
As an investor nears retirement, the portfolio's emphasis usually changes from a strategy that stresses growth and capital appreciation.
Changing a portfolio's emphasis is usually substantial.
A specific issue in the portfolio can change in risk-return characteristics.
Diversification is a constant need.
Diversification effect may be lessened as investments vary in value.
You can allocate by 10% or more.
Explain how the following measures are used to assess portfolio performance.
This is the dream of all investors.
There are several methods you can use to time purchases and sales.
Next, we discuss formula plans.
Limit and stop-loss orders can be used by investors.
They can follow procedures for warehousing and consider other aspects of timing when selling their investments.
Formula plans aren't set up to give high returns.
They are employed by investors who don't want to bear a high level of risk.
The four popular formula plans are dollar-cost averaging, constant-dollar plan, con stant-ratio plan, and variable-ratio plan.
The periodic dollar investment is held constant in this passive buy-and-hold strategy.
You have to invest on a regular basis to make the plan work.
Growth in the value of the security to which the funds are allocated is the goal of a dollar-cost averaging program.
Over time, the price of the investment security is likely to change.
You would chase more shares if the price fell.
You would purchase fewer shares if the price went up.
The table shows the amount of money invested in the mutual fund.
You have placed $6,000 in the mutual fund shares.
NAVs ranged from a low of $24.16 to a high of $30.19.
The value of your holdings in the fund was $6,900 at the end of the year.
Other formula plans are more active than dollar-cost averaging.
There are securities that have high promise of capital gains.
Low-risk investments include bonds or money market accounts.
The speculative portion of the dollar amount is constant.
Trigger points are where funds are removed from or added to a portion.
The constant-dollar plan skims off profits from the speculative portion of the portfolio if it rises a certain percentage or amount in value and adds these funds to the conservative portion of the portfolio.
If the speculative portion of the portfolio goes down by a certain percentage, you add funds to it from the conservative portion.
The constant-dollar plan is shown in Table 13.10
A $20,000 portfolio consists of $10,000 invested in a high-beta, no-load mutual fund and $10,000 deposited in a money market account.
Every time the speculative portion of the portfolio is worth more or less than its initial value, you have decided to change the portfolio's composition.
If you sell enough shares of the fund to bring its value down to $10,000, you'll add the proceeds from the sale to the conservative portion of the portfolio.
If the spec ulative portion falls in value to $8,000 or less, you can use funds from the conservative portion to purchase enough shares to raise the speculative portion to $10,000.
There are two portfolio-rebalancing actions in the time sequence.
$10,000 was allocated to each part of the portfolio.
The speculative portion of the mutual fund was worth $12,000 when the net asset value was $12.
You added the pro ceeds to the money market account after you sold 166.67 shares.
The speculative portion of the mutual fund's NAV dropped below $8,000 after the NAV declined to $9.50 per share.
The speculative portion was raised to $10,000 by the purchase of sufficient shares.
If the speculative investment of the constant dollar plan increases in value, the conservative component of the portfolio will increase in dollar value as profits are transferred into it.
Rebalancing occurs when the actual ratio of the two is different from the desired ratio.
Transactions are made to bring the actual ratio back to the desired ratio.
If you want to use the constant ratio plan, you have to choose between speculative and conservative investments.
The ratiotrigger point is where transactions occur.
The constant-ratio plan illustrated in Table 13.11 is yours to see how this works.
The initial value is $20,000.
50% of the portfolio will be allocated to a speculative, high-beta mutual fund and 50% to a money market account.
When the speculative portion to the conser vative portion is greater than or equal to 1.20, you will adjust the portfolio.
Table 13.11 shows a sequence of changes in net asset value.
$10,000 is allocated to each part of the portfolio.
The sale of 83.33 shares is triggered when the fund NAV reaches $12.
The portfolio is back to its original ratio.
The speculative portion of the fund is lowered to $8,250 when the NAV falls to $9.
The speculative portion to the conservative portion is 0.75, which is below the 0.80 threshold.
The desired ratio can be brought back up to 50:50 with the purchase of 152.78 shares.
The long-run expectation is that the speculative ties will rise in value.
The conservative portion of the portfolio can be increased.
The philosophy is similar to the constant-dollar plan, except that it uses a ratio as atrigger point.
Timing the market attempts to turn stock market movements to the investor's advantage.
Depending on the value of the speculative securities, the speculative portion to the total portfolio value varies.
The speculative portion of the portfolio is reduced when the ratio increases.
The amount committed to the speculative portion of the portfolio is increased if the speculative portion's value drops in proportion to the total portfolio value.
There are a lot of decisions to be made when implementing the variable-ratio plan.
You have to determine the initial allocation between speculative and conserva tive portions of the portfolio.
Trigger points are where you must start buying or selling activity.
The points are based on the ratio between the value of the specula tive portion and the total portfolio.
You have to adjust that ratio at each point.
The variable-ratio plan is shown in Table 13.
Initially, you divide the portfolio between speculative and conservative.
A high-beta mutual fund is part of the specula tive portion.
The money market account is conservative.
When the speculative portion reaches 60 percent of the total portfolio, you will reduce its proportion to 45%.
If the speculative portion of the portfolio drops to 40%, you will raise it to 45%.
This strategy attempts to time the movements of the mutual fund's value.
You increase the proportion invested in the no-risk money market account when the fund moves up in value.
You increase the proportion of capital committed to the speculative portion when the fund is worth less.
Table 13.12 shows a sequence of transactions.
You can sell 250 shares of the fund when the fund's net asset value climbs to fifteen dollars.
The portion of the portfolio that is specu lative is 45% if you place the proceeds in the money market account.
The speculative portion of the portfolio dropped to 35% as the fund NAV declined.
You purchase 418.75 shares and move the specula tive portion to 45%.
The total portfolio value would have been only $22,000 if the initial investment of $20,000 had been allocated equally and the money market account had not been rebalanced.
The market order, limit order, and stop-loss order were discussed earlier in the text.
The limit and stop-loss orders can be used to rebalance a portfolio.
If properly used, these types of security orders can increase return.
Limit orders can be used by investors when buying or selling securities.
If you decide to add a stock to the portfolio, you should use a limit order to make sure you buy at or below the desired price.
The main risk in using limit is that the order may not be executed.
If you placed a GTC order to buy 100 shares of State Oil of California at $27 per share and the stock never traded at $27 per share or less, the order would never be executed.
You have to consider the need for immediate execution against the possibility of a better price with a limit order.
Limit orders can increase your return if you can sell it at a higher price or buy it at a lower cost.
A stock's price will fluctuate over a normal trading range.
For example, suppose the common shares of Jama Motor traded 10 times in a row: $36.00, $35.88, $35.75, $35.94, $35.50, $35.63, $35.82, $36.00, $36.13, and $36.00.
A market order to sell could have been executed between 35.50 and 36.13.
A limit order to sell at 36.00 would have been executed.
It is possible that $0.50 per share was gained by using a limit order.
There are stop-loss orders that can be used.
If you purchase 500 shares of Easy Work at $26.00 and set a goal to sell them at $32 or less, you can see how this works.
You would enter a GTC stop order to sell with a price limit of $32 and another stop order at a price of $23.
The broker will sell the stock at the best price if the issue trades at $23.00 or less.
The broker will sell the stock if the issue trades at $32.00 or higher.
In the first situation, you are trying to reduce your losses, and in the second, you are trying to protect a profit.