CHAPTER EIGHTEEN
MANAGING
THE EQUITY PORTFOLIO
Practical Investment Management
Robert A. Strong
Outline
 Structuring a Stock Portfolio
 The Portfolio Objective
 Asset Allocation
 Active vs. Passive Management
 Portfolio Rebalancing






What’s Wrong with Buy and Hold?
The Costs of Revision
Constant Proportion Rebalancing
Constant Beta Rebalancing
Indexing
Dollar Cost Averaging
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Outline
 Overwriting
 Writing Options to Generate Income
 Improving on the Market
 Portfolio Protection




Writing Covered Calls for Downside Protection
Protective Puts
Using Index Options
Using Index Futures Contracts
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Structuring a Stock Portfolio : The Objective
 Semantics are important in any statement
of investment objectives.
 The four main portfolio objectives are
stability of principal, income, growth of
income, and capital appreciation.
 In a world with taxes, one dollar in capital
gains is worth more than one dollar in
income.
 The overriding investment objective is
utility maximization.
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Relative Riskiness of Portfolio Objectives
20
18
capital appreciation
small
company
stocks
expected return
16
14
large company stocks
12
growth
of income
10
intermediateterm
8 government
bonds
6
long-term
corporate bonds
4 T-bills
inflation
2
stability
0 of principal
0
6
long-term
government bonds
12
income
18
24
30
36
standard deviation (%)
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Structuring a Stock Portfolio : The Objective
Insert Figure 18-1 here.
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Structuring a Stock Portfolio : Asset Allocation
 An asset class refers to a broad category
of investments.
 U.S. equities, foreign equities, bonds, and
cash are four widely used asset classes.
 The relative distribution of funds across
asset classes is called asset allocation.
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Structuring a Stock Portfolio : Asset Allocation
Portfolio
attitude
toward risk
need for
return
individual choice
stocks
bonds
real
estate
ASSET
CLASSES
cash foreign
equities
asset class mix
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realized
return
and risk
with the
passage
of time
investment results
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Structuring a Stock Portfolio :
Active vs. Passive Management
 A strategy of passive management is one
in which, once established, the portfolio is
largely left alone.
 An active management policy, in contrast,
is one in which the composition of the
portfolio is dynamic.
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What’s Wrong with Buy and Hold ?

With a passive buy and hold strategy
(a naive strategy), investors simply
select their investments and hang on
to them.
 Portfolio managers often fail to outperform
a passive buy and hold strategy.
 When tested statistically, trading systems
also do not have a good long-term batting
average.
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The Costs of Revision

There are costs to revising a portfolio.
 Trading fees : Historically, stock
commissions are a function of the number
of shares and the dollar amount involved.
 Even relatively simple portfolio revisions
take up management time.
 Selling securities can involve tax
implications.
 Window dressing refers to largely cosmetic
portfolio changes made near the end of a
reporting period.
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Portfolio Rebalancing
 Rebalancing a portfolio is the process of
periodically adjusting the portfolio so that
certain original conditions of the portfolio
are maintained.
 In a constant proportion portfolio,
adjustments are made so as to maintain
the relative weighting of the portfolio
components as their price change.
 A constant beta rebalancing scheme seeks
to maintain beta at a prespecified level.
This method is not commonly used now.
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Portfolio Rebalancing
Insert Table 18-1 here.
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Portfolio Rebalancing
Insert Table 18-2 here.
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Portfolio Rebalancing
Insert Table 18-3 here.
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Portfolio Rebalancing
Insert Table 18-4 here.
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Portfolio Rebalancing
 Indexing : Some funds seek to mirror the
performance of a market index such as the
S&P 500 or the Dow Jones Industrial
Average.
 Dollar cost averaging : The idea is to invest
a fixed amount on a regular interval into the
same security, regardless of current market
conditions.
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Portfolio Rebalancing
Insert Table 18-5 here.
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Portfolio Rebalancing
 The context of dollar cost averaging is one
of the few times in finance when the
harmonic mean is useful. The harmonic
mean considers reciprocals of values
rather than the values themselves.
harmonic mean 
1
1 N 1

N i 1 Pi
where Pi = price paid at time i
N = number of observations
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Overwriting
 Option overwriting refers to the creation
and sale of stock options in conjunction
with a stock portfolio.
 The most common purpose is to generate
additional portfolio income.
 The second motivation for writing options
is to permit the purchase or sale of stock at
a better-than-market price.
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Writing Options to Generate Income
 When investors write call options against
stock they already own, the call is said to
be covered.
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Writing Options to Generate Income
Insert Table 18-6 here.
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Writing Options to Generate Income
Insert Figure 18-4 here.
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Overwriting : Improving on the Market
 Improving on the market involves writing
deep-in-the-money put or call options that
have “substantial” intrinsic value.
 Selling stock:
Current XYZ stock price = $116
Write $100 call premium @ $18
If option is exercised,
total income = $100 + $18 = $118
> income without overwriting = $116
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Overwriting : Improving on the Market
 Buying stock:
Current Intel stock price = $67.20
Write $75 put premium @ $9
If option is exercised,
total cost = $75 - $9 = $66
< cost without overwriting = $67.20
 Deep-in-the-money options can be used to
improve a buying or selling price at the
cost of a slight increase in risk.
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Portfolio Protection
 Portfolio protection basically involves adding
adding components to a portfolio such that
a floor value is established below which the
value of the portfolio will not fall.
 Writing covered calls provide downside
protection up to the amount of the premium.
 If an investor owns shares of a particular
stock (long stock position) and buys a put on
that same stock (long put position), the put is
called a protective put.
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Portfolio Protection
Insert Figure 18-5 here.
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Portfolio Protection
Insert Table 18-7 here.
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Portfolio Protection
 Using index options : An index put can
protect a diversified stock portfolio against
a market downturn. If market prices
decline, a gain on the puts can largely
offset the losses on the stock portfolio.
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Portfolio Protection
Insert Table 18-8 here.
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Portfolio Protection
 Using index futures contracts : A short
futures position can help offset a long
stock position. If the market falls, a gain in
the futures market can largely offset the
loss on the stock portfolio, and vice versa
if the market rises.
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Portfolio Protection
Insert Table 18-9 here.
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Review

Structuring a Stock Portfolio




The Portfolio Objective
Asset Allocation
Active vs. Passive Management
Portfolio Rebalancing






What’s Wrong with Buy and Hold?
The Costs of Revision
Constant Proportion Rebalancing
Constant Beta Rebalancing
Indexing
Dollar Cost Averaging
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Review

Overwriting



Writing Options to Generate Income
Improving on the Market
Portfolio Protection




Writing Covered Calls for Downside Protection
Protective Puts
Using Index Options
Using Index Futures Contracts
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Appendix: Index Overwriting

Index options
Put and call options
 have virtually the same characteristics as an
option on common stock
 DIFFERENCE is the underlying security is an
index representing the current level of some set
of stock prices
 OEX
 DJX

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Appendix: Index Overwriting

Advantage is they drastically reduce the
unsystematic risk usually associated with
small portfolios
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Appendix: Index Overwriting

Table 18A-1
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Appendix: Index Overwriting

Risk of index calls is that the index will rise
above the strike price
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Appendix: Index Overwriting
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Appendix: Index Overwriting
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