Portfolio Execution

By the time this phase of portfolio management is reached, several key issues have been sorted out. Investment objectives and constraints have been specified, asset mix has been chosen, portfolio strategy has been developed, and specific securities to be included in the portfolio have been identified. The next step is to implement the portfolio plan by buying and/or selling specified securities in given amounts. This is the phase of portfolio execution which is often glossed over in portfolio management literature. However, it is an important practical step that has a significant bewaring on investment results. Further, it is neither simple nor costless as is sometimes naively felt.

For effectively handling the portfolio execution phase, you should understand what the trading game is like, what is the nature of key players (transactors) in this game, who are the likely winners and lowers in this game, and what guidelines should be borne in mind while trading.

Trading Game:

Security transactions tend to differ from normal business transactions in two fundamental ways:

1. A businessman entering into a transaction does so with a reasonable understanding of the motives of the party on the other side of the transaction. For example, when you are buying a piece of used machinery, you are well aware of the motives of the seller. In contrast, in a typical securities transaction, the motive and even the identity of the other party is not known.
2. While both parties generally gain from a business transaction, a security transaction tends to be a zero sum game. A security offers the same future cash flow stream to the buyer as well as the seller. So, apart from considerations of taxes and differential risk bearing abilities, the value of security is the same to the buyer as well as the seller. Hence, constructive motives which guide business transactions are not present in most security transactions. This means that if a security benefits one party, it hurts the other. Put differently, if one wins the other loses.

Motives for trade:

Why do people trade? One motivation is cognitive. People trade because they think they have superior information or better methods of analyzing information. However, most traders tend to confuse noise or randomness for information. Traders see patterns in stock prices that are random, and they rely on intuitive judgment even when systematic analysis would have demonstrated that their judgment is incorrect.

Another motivation is emotional. Trading can be a source of pride. Specifically people trade because trading brings with it the joy of pride. When someone decides to buy a stock he assumes responsibility for the decision. A stock that goes up brings not only profits, but also pride. Of course, if the trading decision turns out to be wrong it can inflict losses and cause embarrassment.

Key players:

Securities market appears to be thronged by four types of players or transactors: value based transactors (VBT), liquidity based transactors (LBT), and pseudo information based transactors (PIBT). Generally the dealer or the market maker intermediates between these transactors.

Who Wins, Who losses:

Who wins and who loses in the trading game which is essentially a zero sum game. It appears that Information based transactor (IBT)’s odds of wining are the highest, assuming that his information is substantiated by the market. He is followed by the VBT, LBT, and PIBT in that order. Put differently, the above question may be answered as follows:

1. The IBT seems to have a distinct edge over others.
2. The VBT tends to lose against the IBT but gains against the LBT and PIBT.
3. The LBT may have some advantage over the PIBT.