Chapter 21

Types of Positions and Sizing

Manager bias spreadsheets go a long way toward constructing the equity portion of an overall asset allocation plan. Fundamental analysis techniques (introduced in the previous chapter) provide a general appraisal of business characteristics, as well as the market valuation of the security concerned. Assessing whether the security fits neatly with the equity portion of one’s own portfolio and, if so, what would be an appropriate allocation size can be puzzling questions.

The strategy of owning equities in different market areas is sound, as it reduces both security and area-specific risks, which is the essence of diversification. A pair of securities can move along a similar path, go opposite ways, or be totally independent of one another. These movements are statistically represented by the correlation coefficient. Applying this observation to portfolio construction by combining negatively correlated assets to reduce overall risk is called hedging.

In the context of the overall asset allocation plan, the details of the different types of assets used by managers are not part of their 13F filings. However, most of their strategies can be drawn from other public disclosures. The common thread that binds many of the best managers is their reliance on diversification and hedging techniques to optimize portfolio risk and reward. This is the core message of modern portfolio theory (MPT) and the capital asset pricing model (CAPM). While it may seem ...

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