Planning ensures that your goals are met.
Risk Management protects your assets.
Portfolios are built with Modern Portfolio Theory.
I. MPT - Tactical Portfolio Optimization a. Corellation
The problem of constructing a portfolio is thought about daily by all those investing money. The objective is to build a portfolio with a high probability of positive returns and a low probability of losses (negative risk). Modern Portfolio Theory (MPT) recognized in 1990 with a Nobel Prize in Economics accomplishes this objective.
Modern Portfolio Theory (MPT) is recognized by every major Financial and Educational institution as the solution to portfolio management. Irrefutable evidence has been gathered over the years and a Nobel Prize awarded to assure all wealthy institutions and individuals to practice MPT in the management of their wealth.
MPT reveals that a portfolio can be built with many investments. While each individual investment may be risky - when combined, the portfolio will have a lower probability of losses (negative risk). Investments that are less than perfectly correlated move dissimilarly to each other. Including investments, with low correlations, in a portfolio reduces losses (downside volatility). MPT construction effectively hedges the inherent risk of individual investments in an otherwise volatile and risky portfolio. The Efficient Frontier plots the curve of all portfolios along a return vs. risk graph.
b. Portfolio's Return
Over 90% of a portfolio's return (variance) is attributable to asset allocation. Attribution analysis identifies the value-added contributed by asset class, style, investment selection, and trading activity. Individual investment selection and market timing contribute little return to almost all portfolios (over time). Asset allocation is the only significant factor investors should consider. Strategic Asset Allocation builds a total return strategy (capital appreciation and income) - opportunistically targeting investments (specific asset classes across geographic regions) based on their business cycle and valuation.
c. Characteristics of Investments
Analysts identify two primary characteristics: Growth (price momentum) and Value (a balance sheet ratios). Investments must be liquid (so that they can be sold). Crucial is the persistence of Jensen's Alpha (the excess return above benchmark). Alpha is value-added performance. Beta is the sensitivity of individual investments to the movements of the market. Gamma is the speed that an investment moves. Avoiding negative Gamma exposure (accelerating downside risk) is possibly the most important factor in the performance of a portfolio.
d. Investment Risk
Investment risk is price volatility - capturing market conditions, relevant comparisons and currency risk. Expected return is based on an investment's historical probability distribution. Return volatility is the variability of the investment's return (measured by standard deviation). The Sharpe ratio measures the risk-adjusted return. Downside Risk Optimization, DRO recognizes non-normal return distributions - adjusting reward for the excess return per unit of risk. R-squared measures the percentage of a portfolio's movement compared to the movement of a similar benchmark. VaR, Value at Risk, measures (with 95% confidence) the risk of losing two standard deviations of value over a given time period. MAR defines the Minimum Acceptable Return. Hedging is investing in a negatively correlated asset - against an investment already owned. Hedging an investment can remove its risk from a portfolio.
e. Active Asset Allocation
Active or Dynamic Asset Allocation we call Tactical Portfolio Optimization - a methodical process to optimize the returns to an investor's portfolio. Working within a Client's risk (aggressive, balanced or conservative) profile - specific investments are selected/rejected and bought/sold in the investor's portfolio. The objective of Tactical Portfolio Optimization is to pick up extra return on perceived market inefficiencies (contrarian /oversold /overbought positions) - while optimizing each investment's position in its sector's business cycle and valuation. Monte Carlo simulation (a mathematical /statistical technique) estimates the probability of meeting investor's goals in the future. The Treynor ratio measures the benefits of adding a particular investment to an investor's portfolio. A manager's portfolio style is revealed by which investments are added to and removed from a portfolio.