On the implementation of portfolio theory: Attitudes, understanding, and application

ON THE IMPLEMENTATION OF PORTFOLIO THEORY: ATTITUDES, UNDERSTANDING, AND APPLICATION Thomas M. Tole Prior (10)

in 1952,

almost

inception

portfolio

exclusively

earnings For

to the

concepts

quality

portfolio

the

portfolio

of

this

portfolio

that

a portfolio

turn

and expected

folio's sensitivity

the

based and

of competition.

and refining

in a myriad

to measure

the

industry

and apply asset

be constructed

from

risk

are

from

its

a portfolio's

risk,

to examine on the

capital

of

of

were

and analysis

having

management

measure returns

is

is

understand

(1)

quantitative

Markowitz

such as sales

been developing

study

In order

managers theory:

decisions

considerations

resulting

theory

securities

folio

by Harry

the

early

of theoretical

and

articles.

managers.

theory,

investment

have

theory,

The objective of

theory

of management,

academicians

journal

25 years

portfolio

managers'

of portfolio

empirical

of

upon fundamental

growth,

25 years,

and Sammy 0. McCord'

the

only such

mean return returns

the

influence

investment

decisions

influence

to determine

following

pricing

tenets

of

which

suggests

securities

for

which

expected

necessary

inputs

standard

(a measure to the

(3,

8, 12);

deviation of

returns

1 Thomas M. Tole and Samny 0. McCord are Assistant Finance at Auburn University, Auburn, Alabama.

total

if

port-

model,

as the

of

of portfolio

was surveyed the

that

re(2)

a

of a portrisk)

and the

of a market Professors

of

120 portfolio

(systematic

theory, the

which

number

of

suggests

of

sification

risk) that

securities

to ten

7,

12,

portfolio

16);

exhausted

stocks

(2,

and (3)

risk

diversification

can be reduced

in a portfolio,

is generally

eight

(5,

but

when the

that

the

by increasing

benefit

portfolio

of diver-

contains

in excess

6).

THE QUESTIONNAIRE Questionnaires the

investment

mutual the

fund

groups

nies

consisting

of America

trust

(4).

Approximately questionnaires

is

that,

due to

insufficient

was not

possible. concerning

the

the main survey

taught

and what

the

response objective.

was to

(ll), of

I).

Table

which portfolio

ment management

course.

Only

directly

role

of portfolio

size,

six

the

manager's

topics theory

Association

managers

surveyed

of the

the

practitioners should

in making

study

nonrespondents

a large

body

stated

of

theory.

was designed

of twenty-eight theory

compa-

use of portfolio

questionnaire

questionnaire

nonlife

advisory

the

(17),

the

50 largest

A limitation

provide

360

(15),

Counsel

with

of

Companies

size

portfolio

187 responses

On the

were

by asset

a follow-up

the

study

in the

Investment

(see

bias,

ascertain

the

of

portfolio

sectors

and investment

32 percent

the

emphasis

to the

ranked

funds,

However,

To eliminate ceal

size

major

Investment

by asset

59 members

usable

information

Included

companies

returned

in five

in Wiesenberger's

by asset

of the

584 firms

departments

insurance

companies

to

industry.

described

bank

life

insurance

mailed

management

65 largest

50 largest

were

to con-

objective believe

be given

of

should

in an invest-

questions investment

pertained decisions.

be

121

Table

I

RESPONSE RATE FOR DIFFERENT INVESTMENT MANAGEMENT SECTORS

Sample Size

Responses

Percentage

65

32

49.2

360

94

26.1

50

25

50.0

Nonlife Insurance Companies

50

16

32.0

Investment Companies

59

- 20

33.9

584

187

32.0

Investment Sector

Management

Bank Trust

Departments

Mutual Life

Funds Insurance

Totals

Companies

Advisory

122 . The remaining

questions

in a different

study

related

to the

stated

objective

and were

used

(9). EXTENT OF APPLICATION

In order theory

to determine

in their

day-to-day

asked.

The first

"Do you

actually

Depending

theory

suggested

about

pation

risk is

essential above.

which

is actually

measuring

theory

first

managers

a stock

theory

that

by the

Investment

are

i.e.,

using

the

with

decisions?"

mutual

to 35.5

were

managers

investment

sector,

is actively

question,

they

consider

before

applied,

it

would

be a popular

on the

fact

input

to the

capital

that

a quantitative

to

second

asked

being

In addition,

the

used

were

based

2The results

portfolio

in your

actively

portfolio

two questions

confronted

28 percent

using

fund,

trust

percent

of

the

re-

concepts

of

portfolio

II).2

Table

To verify

they

are

decisions,

management

approximately that

managers

theory

investment

stated (see

directly

use portfolio

etc.,

spondents

portfolio

investment

question

on the

department,

if

list

the

in practice question four

most

that

The logic

an analytical

risk

risk

measure

factors

purchase.

was anticipated

model,

direct.

important

recommending

pricing

extent

was less

response.

asset

to the

If

quantitatively

for

measure

this

antici-

is an

as was suggested

makes the

of this question are similar to the results in a Shearson, Hammell and Co., Inc., survey taken in 1972. study, approximately 34 percent of the 60 portfolio managers stated they actively used portfolio theory in their day-to-day decisions (1).

task

of obtained

In that surveyed

123

Table

II

PERCENTAGE OF INVESTMENT MANAGEMENT SECTORS CLAIMING TO USE PORTFOLIO THEORY IN DAY-TO-DAY INVESTMENTDECISIONS

Investment Management Sector Mutual

Funds

Bank Trust Life

Percentage 28.6

Departments

Insurance

Nonlife Investment

35.5

Companies

Insurance Advisory

Companies Companies

29.1 28.3 32.0

124 . comparing

the

risk

of

solely

upon

subjective

prior

to the

advent

Contrary the

to

responses

and only

to any other question cepts

descriptions

fundamental,

suggests

have

been using

portfolio

theory

the

shows that 1.6

Thus,

managers

are

in their

97.2

practice

percent

percent

were

practice.

the not

evidence

Instead,

and technical

of

really

of

technical,

assessment

theory.

same fundamental for

relying

as had been the

to a quantitative

of portfolio that

of portfolio upon

III

basically

aspect

than

theory. Table

alluded

much simpler

of risk,

of portfolio

percent

relying

stocks

expectations,

were

1.2

alternative

risk

or

from

this

including they

factors

con-

are

which

still

they

so many years. UNDERSTANDING

An examination agers

are

not

and why they stock

using still

analysis.

themselves because

with

portfolio

leads

theory

almost

totally

Is it

because

these

the

essential

are convinced

that

theory,

fully

applied

in a realistic

In order

to determine

if

concepts

of

theory,

asked.

The first

diversification."

the

portfolio question

are

managers

indeed

methods to

theory? with form,

man-

decisions

have failed

familiar

present

investment

of

acquaint

Or is the

cannot

it

theory

but

be success-

environment?

portfolio

An understanding

investment

of portfolio

in its

requested

ask why portfolio

upon traditional

tenets

makers

one to in their

rely

decision

tial

these

III

of Table

managers

three

nonrigorous

respondents of diversification

understand

the

questions to define theory

essenwere

"adequate should

125

Table

III

LIST OF FACTORS TO CONSIDER BEFORE RECOMMENDING A STOCK, RANKED BY PERCENTAGE OF RESPONSES

Factors Quality Growth

Percent

13.8

of Management Rate of

Financial Industry

Earnings,

Sales,

Strength

etc.

13.7 13.7

Outlook

Company's

of Responses

8.9

Industry

Position

4.5 4.1

P/E Ratio Product

and Competition

3.6

Outlook

for

3.3

Financial Retained Timing, . Quantitative Others Total

Stock

Market

Structure

2.0 1.9

Earnings Charts,

Technical Risk

Measure

Analysis

1.6 1.2 27.7 100.0

126 have elicited

a reference

securities

in a portfolio

managers

who answered

this

of

theory.

understanding question

investments

avoided

investment

managers

The third

returns portfolio coefficient)

of

of the

investment

least

a vague

who answered

this

of diversification.

or "no more

than

10 percent

over

20 percent

understanding

capital

asset

in portfolio

they

pricing

the

but essence

not

of

the

either

know the

of

is useful

The intent

to observe

40 percent

did

concepts model

management."

opinions

about

the

of

whether

or

capital

asset

ignored

this

meaning

of

the

capi-

model.3 question

in this of

alluding

either

as a measure

of

returns

at

Significantly,

understood

An understanding

a response

with

number

at all.

Surprisingly,

pricing

8 percent

majority

industries"

"the

that

as the

definitions

to obtain

or indicated

asset

capital

if

was not

model.

question

The vast

concerning

be useful

not

pricing

question

will

question

responded

question

asked

this

question

of

theory

or someday

Only

traditional

this

in risk

increased.

in any one industry."

answering

portfolio

risk.

with section

The second

tal

the

responded

such as a "cross of

to a reduction

to the

as a measure

30ne respondent asset pricing

asked

portfolio

risk

to the

standard

investor returns of

replied model)

section

for

a definition

theory

should

deviation

of

have elicited

of portfolio

uncertainty

or to the

sensitivity

of a market

portfolio

(the

systematic

risk.

that he "could not in the dictionary."

Instead, even

beta

68 percent' find

of

it

(the

of

127 the

portfolio

managers

a totally

in the

nonquantitative

The high

rate

diversification,

the

tant,

in view

for

the

remaining

response

rate

retically acquainted

capital

and the

with

of

large

suggest the

for

the

basic

the

respond

or offered

concerning

pricing

model,

4 percent

average

survey.

number

of

of

adequate

and risk

is

responses

which

rate high

were

managers

portfolio

impor:.

nonresponse

The relatively

many portfolio

tenets

not

questions

in the

that

did

4

asset

questions

derived

either

definition.

nonresponse

especially

study

non-

not

simply

theoare

not

theory.

ATTITUDES It

is

apparent

has been limited with

the

that feel

terminant exhibit

tenets

attitudes

suggests

the

reason

investment

gence

much more

important portfolio

"chance of are typical

are generally

is that

portfolio

of portfolio

investment

fundamental

4 For example, forecasted price"

theory

generally techniques, to successful

feel

familiar

passive.

Table

managers

typically

theory

management.

not

theory

ask why portfolio

theory.

an understanding

of

portfolio

One must

the

programs,

an understanding

of

of

managers

are

application

are

toward

successful

the

managers

portfolio

is

that

that

many investment

one possible that

of

above

and that

essential

managers'

do not

from

is

a strong

de-

It

appears

from

that

solid

research

experience, portfolio

IV

this

and intellimanagement

than

theory. loss," "loss of money," and "not of nonquantitative responses.

reaching

Totals

ranking was assigned three points; rank was calculated by dividing each

Experience

*A first-place The weighted each sector.

Other

Related

Portfolio

11.5 100.0

12.5 100.0 second-place, attribute's

two points; total points

and third-place, one point. by the total points for

100.0

12.0

100.0

42.3

25.4 24.0

19.1

24.4

100.0

0.0

3.6 2.0 7.1

4.6

of

Theory

Understanding

3.8

18.0 19.6 24.0

19.7

23.6

Intelligence

8.0

23.0

I

23.1 24.0

30.1

Techniques

15.5 19.4

Investment

Research

Fundamental

Solid

n+fyE%

Insurance

12.8

Funds

Rankings*

.

20.3

Mutual

Percentage

14.0

Programs

r 12.6

Reasons

IV

DETERMINANTS OF SUCCESSFUL INVESTMENT MANAGEMENT

Table

129 The last Table

question

supports

that

theoretical

V shows

the

this

belief

of

journals,

portfolio

i.e.,

managers.

the

American

Economic Review, the Harvard Business

Review, and the Journal

Finance,

reading

are

In answering

not

considered

this

question,

The periodicals

managers'

believe of

that

this

Goudzwaard

category

mentioned

were

support portfolio

investment

management,

question

in 1969

the

Wall

theory nor

was asked

Joumat,

Street

that

is

used.

preferences

contention

they

a strong

has their

of

port-

do not

determinant

attitude

by Keith

5

managers.

was heavily

The reading

the

understanding

identical

by portfolio

"other"

and Ba.rrons.

therefore

successful

since

the

most typically

Business Week, Fortune, folio

essential

of

Smith

changed

and Maurice

(14). CONCLUSION

This

study

are

not

day

investment

with

actively

the

managers

using

do not

of

management

vestment

that:

concepts

of

feel

that

50ne exception considered theoretical

theory

an understanding

in their

managers

theory, of

managers

are

day-tonot

acquainted

and (3) many portfolio theory

is

important

to

management.

which are

many portfolio

portfolio

of portfolio

applying

managers

(1)

many portfolio

(2)

tenets

investment

Instead

evidence

decisions,

essential

successful

folio

offers

the are still

is the but

techniques

of

stock

an outgrowth

of

portfolio

relying

on traditional,

Fimncid

Analysts

with

an applications

selection

and port-

theory,

many in-

fundamental

JoumZ

which orientation.

is Often

V

11.8 8.7

14.9 4.6 34.8 100.0

10.4 5.8 41.1 100.0 second-place, attribute's

Totals

*A first-place The weighted each sector.

Other

Journal

Institutional

of

Review

Investor

ranking was assigned three points; rank was calculated by dividing each

Finance

Business

two points; total points

4.0

3.4

2.8

Harvard

e

100.0

27.8

27.0 100.0

3.7

20.9

5.8

11.6

29.1

1.1

5.8

12.9

6.0

16.4

31.1

0.8

Insurance Companies Life Nonlife

and third-place, one point. by the total points for

100.0

40.9

7.3

12.6

13.7

Journal

Forbes

Analysts

Financial

22.0

Investment Advisory Companies

25.7

Bank Trust Departments

21.9

Economic

American

4.3

Funds

Rankings

5.5

Review

Mutual

Percentage

4.0

Journals

I

PERCENTAGE RANKINGS OF MOST READ JOURNALS, BY INVESTMENT MANAGEMENT SECTOR*

Table

t; 0

131 analysis

to select

to enhance are often damental their

their looking investment

investment

stocks. day-to-day to

better techniques,

decisions.

Rather

than

investment

looking

portfolio

theory

portfolio

managers

better

understanding

of

and to additional

experience

research,

decisions,

to

to

to

funimprove

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2.

Evans;

John L., and Stephen H. Archer. "Diversification and the Reduction of Dispersion: An Empirical Analysis." JownaZ of Finance, Vol. 23, December 1968, pp. 761-767.

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