Robert F. Vandell

Portfolio objective: Win big, lose little!

W hat is an idealistic description of a highpotential stock? It has high upside potential and low downside risk. What is an idealistic description of a highpotential portfolio? It too has high upside potential and low downside risk. The purpose of this paper will be to describe how investment managers can turn these idealistic specifications of po ten t ia l i n t o realizable achievements. Our first point requires a change in attitude toward risk on the part of the portfolio manager. We believe that, for those managers with proven forecasting skill, risks should be actively and purposefully managed just as returns are. We believe that present passive risk-control systems are the antithesis of management. Indeed, they tend to add undesirable charac. teristics to portfolio performance. Passive risk control reduces average portfolio return performance over a market cycle and increases downside risk. Neither of these results pleases a client. Figure 1 contrasts three sample management styles by comparing their portfolio characteristic lines. The thin solid line (AB) represents the results that we can expect on average from indexing. Most period plots would fall about on this line. The dashed line (CD) represents the return expected from a portfolio manager whose goal is to achieve a positive alpha but with a relatively high level of risk control. The individual period plots might be somewhat scattered, but if pursued with moderate success (skill) this strategy would clearly be better than the existing strategy for the client over the course of the cycle. Our strategy differs from both. The goal is to achieve a portfolio characteristic line like the heavy line (EFG). We are trying to manage the portfolio so Figure 1 37

Personal Taxes and Equity Security Pricing

* Do personal taxes affect pricing in the security markets? To a practitioner, the answer to this question is obvious: Yes. Yet, capital asset pricing theory is based on a number of perfect market assumptions one of which is that personal taxes do not exist. Equity prices are strictly a function of a securitys beta and the expected market risk premium. Beta, the only company-specific estimate, is unlikely to capture any tax factors.