Chapter 11

Charles P. Jones and Gerald R. Jensen,

Investments: Analysis and Management,
13th Edition, John Wiley & Sons

11-1
 Pervasive and dominant
 The single most important risk affecting the
price movement of common stocks
◦ Particularly true for a diversified portfolio of
stocks
 Can account for 90% or more of the variability in
a well-diversified portfolio’s return
 Investors buying foreign stocks face the
same situation

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Two step decision process:
 Asset Allocation
◦ % of wealth allocated to various asset classes such
as stocks, bonds, real estate, and cash
◦ This decision is the main factor in determining the
risk and return of the portfolio
 Security Selection
◦ Determining the individual securities in each
asset class

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 Natural outcome of belief in efficient markets
◦ No active strategy should be able to beat the
market on a risk-adjusted basis over time
 Aim, to do as well as the market
◦ Emphasis is on minimizing transaction costs
and time spent in managing the portfolio
◦ No attempt to time market or find undervalued
stocks
◦ Assume benefits from active trading are less
than the costs

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Forms of passive investing:
Buy & hold: investor purchases securities and
holds them to meet some future objective
Indexing:investor purchases fund designed to
match performance of a broad portfolio
 ETFs and ETNs can also be used for this purpose
Enhanced indexing: purchases fund that
represents an index with a slight variation
 WisdomTree fundamentally-weighted funds
 Buy-and-hold strategy
◦ Avoids the transactions costs and errors that
accompany active management
 Relatively tax efficient strategy

◦ Initial portfolio selection needs to be made

◦ Investors still must take some actions
 Reinvesting portfolio income
 Adjusting to changes in risk tolerance

11-6
 Index funds
◦ Mutual funds designed to duplicate the
performance of some market index
◦ No attempt is made to forecast market
movements and trade on forecast
◦ No attempt to select under- or over-valued
securities
◦ Low costs to operate, low turnover, tax efficient

11-7
Passive Strategies, Index Funds
 Historical returns show index funds generally
outperform actively managed funds
 Index funds are available in many forms
 Available as ETFs and/or mutual funds
 Funds track broad indexes e.g. S&P 500 and
NASDAQ 100.
 Funds track foreign indexes e.g. EAFE and Nikkei
 Funds track strategies such as small cap, value,
large cap, growth, etc.

11-8
 Assumes the investor possesses some
advantage relative to market participants
◦ Superior information, analytical skills, ability
to do what other investors cannot
◦ Most investors favor this approach despite
efficient markets support
 Both the potential rewards and risks are
large

11-9
 Traditional strategy is to select individual stocks
◦ Majority of investment advice geared to stock
selection
 Investors focus on EPS forecasts
 Growth stocks and value stocks
◦ Value stocks “cheap” relative to fundamentals
◦ Growth stocks have strong prospects
 Value investing takes long-term, sometimes
contrarian approach

11-10
 Security analysts forecast stock value
 Sell-side analysts: reports used to “sell” idea
 Buy-side analysts: employed by money
management firms to generate reports
◦ Research typically only available to employers
 Estimates provided by analysts
◦ Expected performance, earnings estimates, price
targets
◦ Recommendations: Buy, Hold, or Sell

11-11
 Recommendation changes often affect stock
prices
 Analysts focus on forecasting earnings
◦ Typically overly optimistic about long-term EPS
◦ Analysts rarely recommend selling
 Analysts generally good at analyzing industries
 Good independent info sources available
◦ Value Line Investment Survey, S&P’s Outlook,
Morningstar

11-12
Number of Analyst Recommendations by Type for the S&P 500 Stocks

Sell/Underperform

Hold

Buy/
Outperform

1,000 3,000 6,000

11-12
 Involves shifting sector weights in the portfolio
◦ Over-weight sectors expected to perform well,
under-weight those expected to perform poorly
 Four broad sectors:
◦ Interest-sensitive, consumer durables, capital
goods, and defensive stocks
 Subject to greater risk than investing in overall
market
 Can be pursued with sector mutual funds, ETFs

11-14
 Market timers attempt to earn excess
returns by varying % held in equities
◦ Shift to cash when stocks expected to do
poorly
 Success depends on the amount of
brokerage commissions and taxes paid
 Research suggests market timing is risky
◦ Investors may not be in market at critical
times and may miss out on returns

11-15
Rational Markets and Active Strategies
 If market is efficient, prices reflect fair value
◦ Active strategies are unlikely to be successful
over time after all costs
 Market efficiency proponents argue that little
time should be spent on security analysis
◦ Spend time on reducing taxes/costs and
maintaining chosen portfolio risk
 Investor’s beliefs affect strategy implemented

11-16
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11-17