13.9 The role of portfolio management

Question 1

What is a portfolio?

Answer 1

A mix of investment or projects in a company.

Question 2

What are the key elements of a good portfolio?

Answer 2

• return
• risk reduction
• liquidity and marketability
• tax shelter
• appreciation in capital value

Question 3

What is meant by “asset allocation” in portfolio management?

Answer 3

An investment strategy that aims to reduce uncertainties and balance risk and reward within a portfolio by using a mix of assets with low correlation (e.g. bonds vs shares)

Question 4

What is meant by “diversification” in portfolio management?

Answer 4

Spreading risk across multiple investments within an asset class.

Question 5

What is meant by “rebalancing” in portfolio management?

Answer 5

Continuous process of monitoring portfolio performance and adjusting for market conditions.

Question 6

What is meant by “correlation” in portfolio management?

Answer 6

A statistical tool for measuring the degree to which two securities move in relation to one another.

Question 7

What three correlation scenarios are possible between two stocks?

Answer 7

1 Positive - when one increases so does the other
2 Negative - when one increases the other decreases
3 Zero - there is no relationship between the two

Question 8

What is the “efficient frontier” in portfolio management?

Answer 8

A modern portfolio tool that shows investors the best possible return they can expect for a defined level of risk.

Question 9

What are the limitations of portfolio theory?

Answer 9

• it is a single-period framework
• probabilities are only estimates
• makes assumptions around investor behavior
• assumes constant correlation between assets, when in reality correlation might change
• ignores investment timeframes (i.e. short vs long term)
• ignores factors such as tax and administration costs
• investors often prefer to use their own judgement rather than complex portfolio tools