Loading ...INTRODUCTION AND SUMMARY
The purpose of this paper is to present a portfolio management model which would be applicable to the portfolio management problem faced by institutional investors. The model developed extends previous efforts of the author toward removing a number of limitations of existing models which restrict their usefulness to institutional investors.
The major limitations of existing models which restrict their applicability to practical investment problems are: first, the single period nature of most portfolio selection models; second, neglect of the securities transactions ‘ costs involved in modifying an existing portfolio which is no longer optimal in terms of revised expectations about security performance; third, neglect of a number of additional considerations, such as differential tax effects and the possibilities for portfolio leverage, which may have considerable significance in realistic portfolio decision situations.
The model developed in this paper is inter-temporal as it considers the portfolio management process as a multi-stage decision problem rather than a series of single-stage unrelated decision problems. As such it allows for the planned switching of funds among securities at various decision points within a multiple period investment horizon. Explicit consideration is given to the investor’s expectations about the transactions costs involved in moving from an existing non-optimal portfolio to one which is efficient in terms of the investor’s revised expectations regarding security performance. The model generates an efficient set of portfolios which trade off between return over the investment time horizon (after transactions’ costs) and the risk associated with the level of return. Additionally, operational risk measures are defined for use in ex ante decision making and ex post evaluation which depend upon the information channels by which data were collected and estimates formed.
Before proceeding with the development of the model, an overall framework for the investment management process is developed and its relationship to the model presented is discussed.
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