Complete Guide to Portfolio Construction and Management

LUKASZ SNOPEK has been working for many years as a wealth manager and investment consultant in the private banking sector. His qualifications include a Master of Law and a Master’s degree in Business Administration (HEC), the Swiss Federal Diploma for Experts in Finance and Investments and the International Wealth Manager Certificate (CIWM). Lukasz Snopek is also a corrector for the Swiss Financial Analysts Association and teaches portfolio construction and management at the Institut Supérieur de Formation Bancaire (ISFB) in Geneva.

• Foreword xiiiAbout the Author xvAcknowledgements xviiIntroduction xixPart I Investors and Risk 11 Basic Principles 31.1 Investors 31.2 Inflation 31.3 Choices for Investors in Terms of Investments 52 Measures of Risk 72.1 Volatility or Standard Deviation 72.2 Beta as a Measure of Risk 112.3 Value-at-Risk (VaR) 132.4 Investor Behaviour Towards Risk 14Part II Asset Classes and Their Degree of Risk 173 Asset Classes and Associated Risks 193.1 Money Market Investments 193.1.1 Definition 193.1.2 Risks associated with money market investments 203.2 Bonds 223.2.1 Definition 223.2.2 Risks associated with bonds 263.3 Stocks 333.3.1 Definition 333.3.2 Risks associated with stocks 363.4 Real Estate 453.4.1 Definition 453.4.2 Risks associated with real estate 463.5 Commodities and Metals 483.5.1 Definition 483.5.2 Risks associated with commodities and metals 513.6 Private Equity 543.6.1 Definition 543.6.2 Risks associated with private equity 543.7 Other Asset Classes 564 Particular Forms of Investment within Asset Classes 594.1 Hedge Funds 594.1.1 Definition 594.1.2 Risks associated with hedge funds 604.2 Structured Products 634.2.1 Definition 634.2.2 Risks associated with structured products 644.3 Options 654.3.1 Definition 654.3.2 Risks associated with options 665 Classification of Asset Classes According to their Degree of Risk 715.1 Selected Criteria for Classification of Asset Classes 715.2 Classification of the Different Asset Classes 75Part III the Market 776 Market Efficiency 796.1 Weak Form Market Efficiency 796.2 Semi-strong Form Market Efficiency 806.3 Strong Form Market Efficiency 806.4 Conclusion on Market Efficiency 817 Fundamental Analysis 837.1 Discounted Cash Flow 837.2 Relative Measures 857.2.1 Price to Earnings Ratio (P/E) 857.2.2 Price to Book 857.3 Strategic Analysis 867.3.1 The business model 867.3.2 External analysis 887.3.3 Internal analysis 957.3.4 The SWOT table (Strengths, Weaknesses, Opportunities and Threats) 977.4 Criticism of Fundamental Analysis 988 Technical Analysis 1018.1 The Three Fundamental Principles of Technical Analysis 1018.1.1 Prices reflect all available information 1018.1.2 Prices move in trends 1028.1.3 History repeats 1048.1.4 Criticism of technical analysis 1058.2 Conclusion on Technical Analysis 1069 Investment Approach Based on “Psychological Principles” 109Part IV Valuation of Financial Assets 11110 Valuation of Money Market Investments 11311 Valuation of Bonds 11512 Valuation of Stocks 11713 Valuation of Options 11914 Valuation of Real Estate 12115 Valuation of Commodities and Metals 12316 Conclusion on Valuation 125Part V Three Practical Approaches to Security Selection: Buffett, Graham and Lynch 12717 Warren Buffett’s Value Investing Approach 12918 Benjamin Graham’s Approach 13318.1 The Defensive Investor 13318.2 The Enterprising Investor 13418.3 Security Analysis 13518.3.1 Bond selection 13518.3.2 Stock selection 13518.4 The Margin of Safety Concept 13619 Peter Lynch’s Approach 13719.1 Stock Categories 13819.1.1 Slow growers 13819.1.2 The stalwarts 13819.1.3 The fast growers 13919.1.4 Cyclicals 13919.1.5 Turnarounds 14019.1.6 The asset plays 14019.2 The Perfect Company According to Lynch 14019.3 Earnings and Earnings Growth 14319.4 Selection Criteria 14419.4.1 The sales percentage 14419.4.2 The P/E ratio 14519.4.3 Liquid assets 14519.4.4 Debt 14519.4.5 Dividends 14619.4.6 Hidden assets 14619.4.7 Cash flow 14619.4.8 Inventories 14619.4.9 Growth rate 14619.4.10 Gross profits 14619.5 Conclusion on Peter Lynch’s Approach 147Part VI Behavioural Finance 14920 Investors in Behavioural Finance 15121 Heuristics and Cognitive Biases 15321.1 Information Selection 15321.1.1 Availability heuristic 15321.1.2 Herding 15321.1.3 Ambiguity aversion 15421.1.4 Wishful thinking 15421.2 Information Processing 15421.2.1 Representation bias 15421.2.2 Confirmation bias 15421.2.3 Narrative fallacy 15521.2.4 Gambler’s fallacy 15521.2.5 Anchoring 15521.2.6 Framing 15521.2.7 Probability matching 15521.2.8 Wearing blinkers 15621.2.9 Overconfidence bias 15621.2.10 Illusion of control 15721.3 The Use of Assets 15721.3.1 Mental accounting 15721.3.2 Disposition effect 15821.3.3 House money effect 15821.3.4 Endowment effect 15821.3.5 Home bias 15821.3.6 No go’s 15821.3.7 Sunk costs 15821.3.8 Lack of control 15921.3.9 Pride and regret 15922 Investment Approach Based on Behavioural Finance 16122.1 Momentum Strategy 16123 Criticism of Behavioural Finance 165Part VII Forecasting Market Movements 16724 Investment Approach Based on Probabilities 16925 Random Walk Theory 17126 Market Timing 17327 Macroeconomic Investment Approach 17727.1 State Interventions 17927.1.1 Tax and fiscal policy 18027.1.2 Monetary policy 18127.1.3 The appropriate policy 18127.2 The Major Macroeconomic Forces 18227.2.1 Inflation 18227.2.2 Economic growth 18527.2.3 Recession 19227.2.4 Productivity and technological change 19527.2.5 Regulations and taxes 19727.3 Sectorial Analysis 19727.4 Peter Navarro’s Approach 19827.4.1 Trends and stock picking 19927.4.2 Sector rotation 20027.5 Criticism of the Macroeconomic Approach 202Part VIII Modelling Market Movements 20328 Suggested Investment Approach 20729 The Forces 20929.1 The Macroeconomic Force 20929.2 The Fundamental Force 20929.3 The Technical Force 20929.4 The Behavioural Force 21029.5 The Luck Force 21030 The Forces’ Strength 21131 The Beauty of the Approach 213Part IX Portfolio Construction and Management 21532 Modern Portfolio Theory According to Markowitz 21732.1 David Swensen’s Approach 21933 The Capital Asset Pricing Model (CAPM) 22134 The Minimum Variance Portfolio 22335 Value-at-Risk (VaR) 22736 Discretionary Mandates 22937 The Dollar-cost Averaging Approach 23138 Our Portfolio Construction Method 23338.1 Basic Principles of Portfolio Construction 23338.1.1 10 rules for protecting your capital 23438.1.2 The 12 rules of risk management 23538.2 The Portfolio Construction Process 23838.2.1 The investor’s life objectives 23838.2.2 The investor’s life cycle and investment time horizon 23838.2.3 Choosing a reference currency 23838.2.4 Evaluating the risk profile 23838.2.5 Estimating a return target 23938.2.6 The investor’s tax rate 24038.2.7 Determining the proportion of risky assets 24038.2.8 Evaluating the expected degree of liquidity (share of illiquid assets) 24038.2.9 Portfolio construction and management 24038.3 A Practical Example of Portfolio Construction 249Part X Attractiveness of the Different Asset Classes 25339 Asset Classes 25539.1 Money Market Investments 25539.2 Bonds 25539.3 Stocks 25639.4 Real Estate 25739.5 Commodities and Precious and Industrial Metals 25840 The Four Forces of the Investment Model 25940.1 The Macroeconomic Force 25940.1.1 The Macroeconomic Force and money market investments 25940.1.2 The Macroeconomic Force and bonds 25940.1.3 The Macroeconomic Force and stocks 26040.1.4 The Macroeconomic Force and real estate 26140.1.5 The Macroeconomic Force and commodities, precious and industrial metals 26240.2 The Fundamental Force 26240.2.1 The Fundamental Force and money market investments 26240.2.2 The Fundamental Force and bonds 26340.2.3 The Fundamental Force and stocks 26340.2.4 The Fundamental Force and real estate 26940.2.5 The Fundamental Force and commodities, precious and industrial metals 26940.3 The Technical Force 26940.3.1 The Technical Force and money market investments 26940.3.2 The Technical Force and bonds 27040.3.3 The Technical Force and stocks 27040.3.4 The Technical Force and real estate 27040.3.5 The Technical Force and commodities, precious and industrial metals 27140.4 The Behavioural Force 27140.4.1 The Behavioural Force and money market investments 27140.4.2 The Behavioural Force and bonds 27140.4.3 The Behavioural Force and stocks 27140.4.4 The Behavioural Force and real estate 27240.4.5 The Behavioural Force and commodities, precious and industrial metals 27241 Table Summarising the Different Forces 27342 A Final Example: Analysis of the Subprime Crisis 277Conclusion 281Bibliography 283Index 285