1. Portfolio management and efficient market hypothesis

2. Traditional investments covers:
Security analysis
Involves estimating the merits of individual investments
Portfolio management
Deals with the construction and maintenance of a collection of investments

3. Security Analysis A three-step process
The analyst considers prospects for the economy, given the state of the business cycle
The analyst determines which industries are likely to fare well in the forecasted economic conditions
The analyst chooses particular companies within the favored industries
EIC analysis (a top-down approach)

4. Literature supports the efficient markets paradigm
On a well-developed securities exchange, asset prices accurately reflect the tradeoff between relative risk and potential returns of a security
Efforts to identify undervalued securities are fruitless
Free lunches are difficult to find

5. Market efficiency and portfolio management
A properly constructed portfolio achieves a given level of expected return with the least possible risk
Portfolio managers have a duty to create the best possible collection of investments for each customer’s unique needs and circumstances

6. Portfolio management primarily involves reducing risk rather than increasing return
Consider two $10,000 investments:
Earns 10% per year for each of ten years (low risk)
Earns 9%, -11%, 10%, 8%, 12%, 46%, 8%, 20%, -12%, and 10% in the ten years, respectively (high risk)

7. The Six Steps of Portfolio Management
Learn the basic principles of finance
Set portfolio objectives
Formulate an investment strategy
Have a game plan for portfolio revision
Evaluate performance
Protect the portfolio when appropriate

8. Portfolio Management
Passive management has the following characteristics:
Follow a predetermined investment strategy that is invariant to market conditions or
Do nothing
Let the chips fall where they may

9. Active management:
Requires the periodic changing of the portfolio components as the manager’s outlook for the market changes

10. Performance evaluation
Did the portfolio manager do what he or she was hired to do?
Someone needs to verify that the firm followed directions
Interpreting the numbers
How much did the portfolio earn?
How much risk did the portfolio bear?
Must consider return in conjunction with risk

11. Efficient Market Hypothesis
The efficient market hypothesis (EMH) is the theory supporting the notion that market prices are in fact fair
Under the EMH, security prices fully and fairly (i.e., without bias) reflect all available information about the security
Since the 1960’s, the EMH has been perhaps the most important paradigm in finance
Whether markets are efficient has been extensively researched and remains controversial

12. Types of Efficiency
Operational efficiency measures how well things function in terms of speed of execution and accuracy
It is a function of the number of orders that are lost or filled incorrectly
It is a function of the elapsed time between the receipt of an order and its execution

13. Informational efficiency is a measure of how quickly and accurately the market reacts to new information
This is the type of efficiency with which the EMH is concerned
The market is informationally very efficient
Security prices adjust rapidly and fairly accurately to new information
However, as we’ve already seen, the market is still not completely efficient

14. Forms of Market Efficiency
Eugene Fama’s original formulation of the Efficient Market Hypothesis established three forms of market efficiency, based on the level of information reflected in security prices:
Weak form = prices reflect all past market level (price and volume) information
Semi-strong form = prices also reflect all publicly available fundamental company and economic information
Strong form = prices also reflect all privately held information that would affect the value of the company and its securities

15. Weak form
The weak form of the EMH states that it is impossible to predict future stock prices by analyzing prices from the past
The current price is a fair one that considers any information contained in the past price data
Charting techniques are of no use in predicting stock prices

16. Semi-Strong Form
The semi-strong form of the EMH states that security prices fully reflect all publicly available information
e.g., past stock prices, economic reports, brokerage firm recommendations, investment advisory letters, etc.

17. Strong Form
The strong form of the EMH states that security prices fully reflect all relevant public and private information
This would mean even corporate insiders cannot make abnormal profits by using inside information about their company
Inside information is information not available to the general public

18. End