Abstract

We will look at the entire cycle of the investment process relating to all aspects of, formulating an investment hypothesis; constructing a portfolio based on that; executing the trades to implement it; on-going risk management; periodically measuring the performance of the portfolio; and rebalancing the portfolio either due to an increase in the risk parameters or due to a deviation from the intended asset allocation.

We touch upon the fundamentals of multi-factor models and how they are used across the different stages of the investment cycle. We also provide several illustrative analogies that are meant to intuitively explain the pleasures and the pitfalls that can arise while managing a portfolio.

If we consider the entire investment management procedure as being akin to connecting the dots of a circle, then the Circle of Investment can be represented as a dotted circle with many dots falling approximately on the circumference and with no clue about the exact location of the centre or the length of the radius.

We represent the investment process as a dotted circle since there is a lot of ambiguity in the various steps involved. The circle also indicates the repetitive nature of many steps that are continuously carried out while investing.

While there are numerous methods that can be applied to each step of the process, we mention the ones that are most used in practice and highlight the elements that a practitioner needs to watch out for. In the beginning, we consider the idea of market efficiency and equilibrium and the lack of both, though we find that there is a tendency to move towards efficiency and the establishment of states of pseudo-equilibrium. This leads to the realization that any hypothesis comes with limitations and that investments are constantly under the shadow of this uncertainty.

This work introduces two new points pertaining to this dotted circle and improves the ability; to understand how far-off this dotted circle is, from a more well-defined circle and; to create a well-formed circle. One point lies close to the centre of the circle and helps clarify both the size and shape of the circle. The other point lies on the periphery of the circle and helps with forming a more round shape.

The two innovations we introduce regarding the investment life-cycle are:

1). The first, relating to the limitations that apply to any finding in the social sciences, would be the additional point we introduce that lies near the centre of the circle. We title this as, “The Uncertainty Principle of the Social Sciences”.

2). The second, relating to establishing confidence levels in a systematic manner for each view we associate with a security or group of securities as required by the Black Litterman framework, would be the new point we present near the circumference of the circle.

We restrict ourselves primarily to the equity asset class, while clarifying earlier on that the main differences between asset classes are simply due to the contractual terms and the number of parties involved in the transfer of wealth. In addition to equities, we look at the execution costs that apply to foreign exchange, fixed income and commodities. This is important since some equity portfolios could be across different markets and hence have currency exposure; or the portfolio could hold high grade fixed income instruments, in lieu of holding cash; or there might be the occasional active bet on commodities to increase the return or as a diversification measure.

This work is licensed under a Creative Commons Attribution 4.0 License.