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Chapter 2 Securities Markets and Transactions 15
Chapter 13
Managing Your Own Portfolio
Outline
Learning Goals
I. Constructing a Portfolio Using an Asset Allocation Scheme
A. Investor Characteristics and Objectives
B. Portfolio Objectives and Policies
C. Developing an Asset Allocation Scheme
1. Approaches to Asset Allocation
a. Fixed Weightings
b. Flexible Weightings
c. Tactical Asset Allocation
2. Asset Allocation Alternatives
3. Applying Asset Allocation
Concepts in Review
II. Evaluating the Performance of Individual Investments
A. Obtaining Data
1. Return Data
2. Economic and Market Activity
B. Indexes of Investment Performance
C. Measuring the Performance of Investments
1. Stocks and Bonds
a. Stocks
b. Bonds
2. Mutual Funds
3. Options and Futures
D. Comparing Performance to Investment Goals
1. Balancing Risk and Return
2. Isolating Problem Investments
Concepts in Review
©2017 Pearson Education, Inc.
16 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
III. Assessing Portfolio Performance
A. Measuring Portfolio Return
1. Measuring the Amount Invested
2. Measuring Income
3. Measuring Capital Gains
4. Measuring the Portfolio’s Holding Period Return
B. Comparison of Return with Overall Market Measures
1. Sharpe’s Measure
2. Treynor’s Measure
3. Jensen’s Measure (Jensen’s Alpha)
C. Portfolio Revision
Concepts in Review
IV. Timing Transactions
A. Formula Plans
1. Dollar-Cost Averaging
2. Constant-Dollar Plan
3. Constant-Ratio Plan
4. Variable-Ratio Plan
B. Using Limit and Stop-Loss Orders
1. Limit Orders
2. Stop-Loss Orders
C. Warehousing Liquidity
D. Timing Investment Sales
1. Tax Consequences
2. Achieving Investment Goals
Concepts in Review
Summary
Key Terms
Discussion Questions
Problems
Case Problems
13.1 Assessing the Stalchecks’s Portfolio Performance
13.2 Evaluating Formula Plans: Charles Spurge’s Approach
Excel@Investing
Key Concepts
1. The role of investor characteristics and objectives and portfolio objectives in planning and
building
a portfolio
2. Procedure for building a portfolio using an asset allocation scheme that considers investor
characteristics and objectives as inputs to the establishment of portfolio objectives and policies
3. Obtaining needed data, indexes of investment performance, and techniques for measuring
the performance of investments
©2017 Pearson Education, Inc.
Chapter 2 Securities Markets and Transactions 17
4. The methods used to compare investment performance to investment goals
5. The techniques used to measure the amount invested, current income, capital gains, and
total portfolio return relative to the amount of money actually invested in the portfolio
6. Statistical measures and uses of portfolio return—Sharpe’s, Treynor’s, and Jensen’s measures—
and the importance of portfolio revision
7. The role of common types of formula plans in timing purchase and sale decisions
8. The use of limit and stop-loss orders in investment timing, the warehousing of liquidity, and the
key factors in timing investment sales in order to achieve maximum benefits
Overview
This chapter describes how investment portfolios are constructed and monitored, including procedures for
evaluating investment performance and timing portfolio transactions.
1. The first section of the chapter provides basic guidelines for building a portfolio using an
asset allocation scheme. In addition to portfolio objectives, an individual’s level and stability of income,
family factors, net worth, experience and age, and disposition toward risk are key factors to consider
during portfolio construction. The instructor should mention that tax and liquidity considerations should
also be taken into account when constructing a portfolio. The logic as well as general procedures involved
in developing an asset allocation scheme consistent with the investor’s needs are demonstrated. All these
discussions focus on the chapter’s key idea: The individual investor should assemble a portfolio that will
yield maximum expected returns commensurate with the level of risk he or she is willing to assume.
2. The evaluation of an individual investment’s performance is discussed. Such performance may be
measured by comparing an investment’s return against a standard. Two such standards might involve
comparing actual with anticipated returns or comparing an actual return against the return of another
vehicle of a similar type. The text stresses the need for a broad range of data to assess performance
accurately.
3. Investment performance also may be measured by computing and comparing holding period
returns (HPR) before and after tax. The instructor might work out HPRs for different investments
such as stocks, bonds, mutual funds, or real estate. It should be emphasized that the comparison of
HPRs must be accompanied by the consideration of the associated risk. Riskier investments should
provide higher returns than low-risk investments to compensate for the greater risk involved.
©2017 Pearson Education, Inc.
18 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
4. Next, the assessment of portfolio performance is considered. The instructor should discuss
procedures for computing the invested amount, income, and capital gains of a portfolio. Applying
risk-adjusted, market-adjusted rate of return measures—Sharpe’s, Treynor’s, and Jensen’s measures—
allows the investor to compare the base portfolio return figure to a risk-adjusted, market-adjusted rate
of return. Depending upon its performance, an investor may want to revise or rebalance a portfolio in
order to better attain his or her investment goals.
5. The final section of the chapter discusses the timing of portfolio transactions. The instructor may
want to indicate that, even though “buying low and selling high” is theoretically a good strategy,
it is often difficult for an investor to determine when the price is too high or too low. A price may
dip lower or rise higher in one day, and the investor has no way of anticipating such a change
until it happens.
6. Techniques investors use to time buy and sell decisions are formula plans, including dollar cost
averaging, constant-dollar plans, constant- or variable-ratio plans, and limit and stop-loss orders.
Also emphasized are the role of liquidity in the portfolio and the importance of tax considerations
when timing investment sales.
Answers to Concepts in Review
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Chapter 2 Securities Markets and Transactions 19
1. An investor’s personal characteristics are important inputs to an investment policy. In particular,
there are several factors to consider. These include but are not necessarily limited to the level and
2. Portfolio objectives can fall into five major categories: current income, capital preservation,
capital growth, tax considerations, and risk. An investor’s portfolio strategy will be guided by his or
her particular portfolio objectives, which are in turn based on his or her needs and attitudes toward
risk. Normally, a person with current needs and a motive for capital preservation would choose
3. An asset allocation scheme is an investment strategy that involves dividing one’s portfolio into
various asset classes to increase diversification and reduce non-systematic risk. It is different from
diversification in its focus on asset classes (e.g., how much to invest in stocks vs. bonds) as opposed
4. There are three basic approaches to asset allocation:
a. Fixed weightings involve allocating a fixed percentage of the portfolio to each of the (typically
b. Flexible weightings involve periodic adjustments of the weights for each asset category based
either on market analysis or technical analysis (i.e., market timing). The use of flexible weights is
©2017 Pearson Education, Inc.
20 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
c. Tactical asset allocation is a sophisticated approach that uses stock index futures and bond
futures to change a portfolio’s asset allocation. When stocks seem less attractive than bonds,
5. An asset allocation plan should consider the investor’s investment, savings and spending
patterns, the economic outlook, tax situations, return expectations, risk tolerance, and so forth.
Age will also have an effect; younger investors should be willing to accept greater risk than those
To decide the appropriate asset mix, investors must evaluate each asset category relative to
current return, growth potential, safety, liquidity, transaction costs (brokerage fees), and potential
tax savings. Frequently, mutual funds are employed to diversify within each asset category; a
family of funds can be used to permit switching among categories by phone or online. As an
7. Current market information, such as share price, dividend yield, and similar return data,
are critical to performance evaluation. Regularly checking this data, as well as following a
company’s earnings, dividend payments, and general news, provides a way to monitor stock
performance and decide whether the investment should be held. Changes in economic and market
activity can affect the level of current income and the market value of each investment vehicle
the Federal Reserve Banks, investment services and publications such as Forbes, the Economist
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Chapter 2 Securities Markets and Transactions 21
8. In evaluating the performance of his or her portfolio, an investor should compare it to some
measure of general market returns. For stocks, one could use the Dow Jones Industrial Average.
However, it is actually not considered the most appropriate gauge of stock price movement. Including
only 30 stocks, it is not broad based. A better index is the Standard and Poor’s 500 Stock Composite
9. A bond market indicator is information and/or an index that reflects the general behavior of the
bond markets. Where stock indexes are presented relative to an original base, bond indexes are
stated relative to the bond’s par, or face value, or as the yield-to-maturity. The Dow Jones Corporate
10. The dividend yield measures the current yearly dividend return earned from a stock investment. It is
calculated by dividing the stock’s yearly cash dividend by its price. The holding period return (HPR),
11. Mutual funds pay investment income dividends and capital gains dividends. Income dividends are
derived from the interest and dividends received by the fund, while capital gains dividends are a
12. An investment holding is a candidate for sale when:
©2017 Pearson Education, Inc.
22 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
13. A problem investment is one that has not lived up to expectations. Either the investment has
experienced a loss or has provided an actual return less than the investor expected.
When analyzing an investment, the investor should first ask: “Has the investment performed
14. Active portfolio management is the process of building a portfolio using traditional and modern
portfolio approaches and then managing and controlling it to meet investment objectives. Active
management may improve the returns earned on the portfolio. This contradicts the efficient market
15. Portfolio performance is measured by calculating the holding period return (HPR) for the portfolio.
This involves (1) measuring the amount invested, (2) measuring income, (3) measuring capital gain,
The HPR formula includes both realized returns (income plus realized capital gains) and the
unrealized capital gains of the portfolio. Further, portfolio additions and deletions must be
16. Once the HPR for the portfolio is calculated, the return figure should be utilized in a risk-adjusted,
market-adjusted rate of return analysis. This type of comparative study can be very useful because it
17. a. Sharpe’s measure compares a portfolio’s risk premium to its standard deviation of return
to assess the risk premium per unit of total risk. The formula is:
Sharpe’s measure (SM)
Total portfolio return Risk-free rate
Portfolio standard deviation
-
-=p F
p
r R
s
Once calculated, Sharpe’s measure can be compared to the Sharpe’s measures of other portfolios
or the market. If the portfolio’s SM is higher, it is performing better than the other portfolio or the
market.
b. Treynor’s measure also measures the risk premium per risk unit but uses beta rather than the
standard deviation to do so. It focuses on non-diversifiable risk only and is calculated as follows:
Treynor’s measure (TM)
Total portfolio return Risk-free rate
Portfolio beta
-
-=p F
p
r R
b
©2017 Pearson Education, Inc.
c. Jensen’s measure, also called alpha, uses portfolio beta and the capital asset pricing model
(CAPM) to calculate the excess return—the difference between the actual return and the required
Jensen’s measure (JM) (Total portfolio return – Risk-free rate) – [Portfolio beta
(Market return – Risk-free rate)]
18. Jensen’s measure is similar to Treynor’s measure; both focus only on non-diversifiable risk by
19. When an investor decides to change the composition of a portfolio by selling some securities and
As economic conditions and individual priorities change, an investor must revise the
has dramatically increased in value can come to dominate a portfolio while one that has lost
20. Formula plans are mechanical methods of portfolio management that try to take advantage of
price changes in securities that result from cyclical price movements. Formula plans, part of a
21. a. The dollar-cost averaging plan involves investing a fixed dollar amount in a security at
fixed time intervals. This is a passive buy-and-hold strategy in which a periodic dollar investment
b. A constant-dollar plan uses a two-part portfolio. The speculative portion is invested in securities
having high promise of capital gain. The conservative portion consists of low-risk investments
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24 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
c. The constant-ratio plan establishes a desired fixed ratio of the speculative to the conservative
portion of the portfolio. An individual rebalances the portfolio whenever the actual ratio differs
d. The variable-ratio plan is a more aggressive strategy. The target ratio between the speculative
portion and the conservative portion of the portfolio is varied by the investor and depends on the
22. A limit order can be used to specify the investor’s minimum sell price or the maximum price the
investor will pay to buy the security. The stop-loss order is a type of suspended order that requests the
23. The first reason investors should maintain some funds in a low-risk, highly liquid investment is
Second, highly liquid investments can provide funds for use in pursuing future opportunities. A
sudden change in economic conditions might make it conducive for an investor to invest more
24. The two considerations in timing investment sales are tax consequences and compatibility with
investment goals. When there is a capital loss, the investor receives the benefit of a tax deduction. In
particular, capital losses provide tax benefits by offsetting capital gains and thereby lowering the
Suggested Answers to Discussion Questions
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