Formulation of Portfolio Strategy

After you have chosen a certain asset mix, you have to formulate an appropriate portfolio strategy. Two broad choices are available in this respect, and active portfolio strategy or a passive portfolio strategy.

Active Portfolio Strategy:

An active portfolio strategy is followed by most investment professionals and aggressive investors who strive to earn superior returns, after adjustment for risk. The four principal vectors of an active strategy, as shown below are:

1. Market timing
2. Sector rotation
3. Security selection
4. Use of a specialized concept

Vectors of Active Portfolio Management:

Highly Active Highly Passive

Market Timing l …………………………….l
Sector Rotation l ……………………………..l
Security Selection l…………………………….. l
Use of a specialized concept l………………………………l

Market Timing: This involves departing from the normal (or strategic or long run) asset mix to reflect one’s assessment of the prospects of various assets in the near future. Suppose your investible resources for financial assets are 100 and your normal (or strategic) stock-bond mix is 50:50. In the short and intermediate run however you may be inclined to deviate from your long term asset mix. If you expect stocks to outperform bonds, on a risk adjusted basis, in the near future, you may perhaps step up the stock component of your portfolio to say 60 or 70 percent. Such an action, of course, would raise the beta of your portfolio. On the other hand, if you expect bonds to outperform stocks, on a risk adjusted basis, in the near future, you may step up the bond component of your portfolio to 60 percent or 70 percent. This will naturally lower the beta of your portfolio.

Market timing is based on an explicit on an explicit or implicit forecast of general market movements. The advocates of market timing employ a variety of tools like business cycle analysis, moving average analysis, advance decline analysis, and econometric models. The forecast of the general market movement derived with the help of one or more of these tools is tempered by the subjective judgment of the investor. Often, of course, the investor may go largely by his market sense.

Anyone who reviews the fluctuations in the market may be tempted to play the game of market timing. Yet very few seem to succeed in this game. A careful study on market timing argues that an investment manager must forecast the market correctly 75 percent of the time just to break even after taking into account the costs of errors and the costs of transactions. The market does just as well, on average, when the investor is out of the market as it does when he is in. So he loses money, relative to a simple buy and hold strategy, by being out of the market part of the time. Echoing a similar view John Bogle, founder of the Vanguard Group of investment companies said: In 30 years in this business, I do not know anyone has done it successfully and consistently, or anybody who knows anybody who has done it successfully and consistently. Indeed, my impression is that trying to do market timing is likely to be counterproductive. John Maynard Keynes rendered a similar verdict decades ago: We have not proved able to take much advantage of a general systematic movement out of and into ordinary shares as a whole at different phases of the trade cycle. As a result of these experiences I am clear that the idea of wholesale shifts is for various reasons impracticable and indeed undesirable

Sector Rotation: The concept of sector rotation can be applied to stocks as well as bonds. It is, however more commonly with respect to the stock component of the portfolio where it essentially involves shifting the weightings for various industrial sectors a based on their assessed outlook. For example, if you believe that cement and pharmaceutical sectors would do well compared to other sectors in the forthcoming period (one year, two years, or whatever), you may overweight these sectors, relative top their position in the market portfolio. Put differently, your stock portfolio will be tilted more towards these sectors in comparison to the market portfolio.

With respect to bonds, sector rotation implies a shift in the composition of the bond portfolio in terms of quality as reflected in credit rating, coupon rate, term to maturity, and so on. For example, if you anticipate a rise rates you may shift from long term bonds to medium term or even short term bonds. Remember that a long term bond is more sensitive to interest rate variation compared to a short term bond.

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