Equity Valuation and Portfolio Management

THE ULTIMATE OBJECTIVE

The ultimate objective of investment management, of course, is to establish an investment structure that will, in the aggregate and over time, provide a return that compensates for the risk incurred, where the risk incurred is consistent with the investor's risk tolerance. The objective may be the equity market's return at the market's risk level or the market return plus incremental returns commensurate with incremental risks incurred.

This may be accomplished by focusing on the core universe and a passive representation or by mixing universes (core and static subsets, for example) and approaches (e.g., passive with traditional active or engineered). Whatever the selection universe and investment approach chosen, success is more likely when investors start off knowing their risk-tolerance levels and their potential managers' skill levels. The goal is to take no more risk than is compensated by expected return, but to take as much risk as risk-aversion level and manager skill allow.

Success is also more likely when equity architecture is taken into account. Without explicit ties between portfolios and the underlying market or market subsets (and thus between market subsets and the overall market), managers may be tempted to stray from their fold (core, value, or growth investing) in search of return. If value stocks are being punished, for example, an undisciplined value manager may be tempted to poach return from growth stock territory. An investor utilizing ...