Using Portfolio Theory Effectively

A STUDY OF MISTAKES, THEORIES & APPLICATION

PLAMEN TODOROW

KELLEY SCHOOL OF BUSINESS

Market EfficiencyInvesting Mistakes

Theories

Applications

Market EfficiencyInvesting Mistakes

Theories

Applications

Market Efficiency

Firm Foundation

Theory

Market Psychology

Trading Techniques

Crashes / Valuation

Market EfficiencyInvesting Mistakes

Theories

Applications

Market Efficiency

Firm Foundation

Theory

Market Psychology

Trading Techniques

Crashes / Valuation

Intrinsic Value• In equity, intrinsic value is usually utilized by

fundamental analysis

• Intrinsic value is the actual value of a company based on tangible and intangible assets

• Intrinsic value measured:• Earnings assumptions• Growth assumptions• Confidence margin

Market EfficiencyInvesting Mistakes

Theories

Applications

Market EfficiencyInvesting Mistakes

Theories

Applications

Market Efficiency

Firm Foundation

Theory

Market Psychology

Trading Techniques

Crashes / Valuation

Market EfficiencyInvesting Mistakes

Theories

Applications

Market Efficiency

Firm Foundation

Theory

Market Psychology

Trading Techniques

Crashes / Valuation

Types of Stocks

• Growth vs. Value– Which strategy is better?

Market EfficiencyInvesting Mistakes

Theories

Applications

• Future: Grow faster than market

• Dividends: Few or noneGrowth Stocks

• Discount/Undervaluation

• Dividends: No limitValue Stocks

Stock Analysis• Techniques:

– Fundamental Analysis– Technical Analysis– Momentum Investing

Market EfficiencyInvesting Mistakes

Theories

Applications

Why Equity Trading Strategies Don’t Work

• They become outdated with new trends

• If a successful strategy exists, influx of new investors will mitigate and eventually wipe out additional gains

• Case in point: January effect Santa Claus effect

• Excessive brokerage costs, risk, and tax implications

Market EfficiencyInvesting Mistakes

Theories

Applications

Market EfficiencyInvesting Mistakes

Theories

Applications

Market Efficiency

Firm Foundation

Theory

Market Psychology

Trading Techniques

Crashes / Valuation

Common Portfolio Mistakes

Starting a portfolio

with stocks

Timing the

Market

Excessive Trading

Portfolio Imbalance

Not Dollar-Cost

Averaging

Unnecessary Risk Levels

Portfolio Imbalance

Market EfficiencyInvesting Mistakes

Theories

Applications

Capital-Asset Pricing Model (CAPM)

Market EfficiencyInvesting Mistakes

Theories

Applications

Risk and Return• To understand portfolio theory, realize the

relationship between risk and return

• CAPM asserts that to get a higher average long-run rate of return beta in portfolio should be higher

Market EfficiencyInvesting Mistakes

Theories

Applications

Stock Market Simulators

• www.Investopedia.com

• www.UpDown.com

• www.caps.fool.com

Market EfficiencyInvesting Mistakes

Theories

Applications

ETF AdvantagesYou know what you own

Diversification + tax advantages

ETF’s tend to have low turnover

Not exposed to fallacies of individual stock investing

Market EfficiencyInvesting Mistakes

Theories

Applications

Efficient Asset Mixes for Different Levels of Risk

Portfolio Risk Level

0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.5

Cash 100% 35% 25% 4% 0% 0% 0% 0%

Bonds 0% 55% 42% 50%

35% 19% 0% 0%

Large-Cap Stocks

0% 6% 17% 29%

33% 38% 43% 33%

International Stocks

0% 4% 14% 17%

20% 22% 29% 20%

Small- and Mid-Cap Stocks

0% 0% 2% 0% 12% 21% 28% 47%

Utilizing An Optimal Portfolio

18

Proper portfolio allocation requires investing in mix of low and high beta investment vehicles

High Beta

Low Beta INCREASED WEALTH

POTENTIAL

Low Beta Vehicles

High Beta Vehicles

Optimal Mix

Market EfficiencyInvesting Mistakes

Theories

Applications

Period Investment Price of Fund Shares

Shares Purchased

1 $150 $75 2

2 $150 $25 6

3 $150 $50 3

Total Cost $450

Average price $50

Total shares owned

11

Average cost: $41

Percentage of Total Expected Return Lost to Fees

Percentage of Total Expected Return Lost

Fund Type +0.10% Incremental

Fee

+0.25% Incremental

Fee

+0.50% Incremental

Fee

Money Market/ Cash

6.0% 15.0% 30.0%

Bonds 3.3% 8.3% 16.7%

Large-Cap Stocks

1.4% 3.6% 7.2%

Small/Mid-Cap Stocks

1.3% 3.2% 6.4%

International Stocks

1.5% 3.6% 7.3%

Be An Intelligent Investor

• Isaac Newton, a fool?

• Patience, discipline, andeagerness to learn aremost important tools

• People who invest makemoney for themselves;people who speculatemake money for theirbrokers

Questions?

“The business schools reward difficult complex behavior more than simple

behavior, but simple behavior is more effective.” –Warren Buffet

S&P 500 Price Dividend Ratio

http://static.seekingalpha.com/uploads/2008/10/13/saupload_sp500_20price_20dividend_20ratio_20long_20term_20chart.png