Asset allocation and security selection in theory & in practice: A literature survey from a practitioner’s perspective
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Issue Date
2015
Editor
Authors
Fahmy, Hany
License
Subject
Asset allocation
Security selection
Security selection
Abstract
Whether for the sake of trying to make a fortune or for the sake of knowledge, both practitioners and academicians have
had interests in studying the behavior of financial time series data since the existence of financial markets.
Academicians contributed equilibrium models that aim to describe the process of price formation in capital markets.
Over time, two schools of thoughts were established: the efficient markets school and the behavioral finance school.
Proponents of the former believed in the Efficient Markets Hypothesis (EMH), whereas the latter brought evidence
from behavioral finance and neurosciences showing that investors, especially retail traders, exhibit irrational behavior,
which can explain the observed violations of the EMH in financial markets. Practitioners were not interested in
developing models of price formation; rather they were interested in developing techniques to analyze and predict the
price movements of financial assets. Same as academicians, practitioners can also be grouped into two schools of
thought: the fundamental analysis school and the technical analysis school. Although both schools of thought share the
same objective, which is to give advice on what and when to buy and sell assets for the sake of making profit, they
differ in their ways of analysis.
The significant role played by academicians and practitioners in the finance industry and the interconnection between
both schools and the approaches followed within each of them are best perceived in the way financial assets are
allocated and portfolios are constructed. In an attempt to cross that bridge between the theory of price formation in
financial markets and its practical implementations, this paper aims to survey the literature on both the theoretical and
the practical frontiers of asset allocation and portfolio construction, and the best way of carrying on this task is through
a thorough description of the portfolio management process (PMP). To this end, the paper breaks the PMP into three
main steps, namely, portfolio planning, portfolio construction, and portfolio evaluation, in that order, and then discusses
each step while surveying the literature pertaining to it. In addition to the description of the PMP, the paper also answers
questions of particular interest to young practitioners, who are taking their first steps towards a career in the finance
industry, such as: How portfolio theory, which is at the core of finance theory, is applied in practice? How a financial
portfolio of assets is constructed in practice? How the individual assets forming a portfolio are selected and allocated?
And is the process of constructing portfolios unique? Although the answers to these questions might appear to be simple
and straightforward, they are, in fact, quite complicated. The complication lies not only in making the theory, which is
based on certain restrictive and unrealistic assumptions, work in practice, but also in the simultaneous use of a variety of
tools and financial concepts in forming a sound investment strategy.
Keywords:
Asset Allocation, Security Selection, Portfolio Construction, Portfolio Management Process, Investment
Policy Statement, Asset Valuation, Fundamental Analysis, Technical Analysis, Behavioral Finance, Efficient Markets
Hypothesis, CAPM, Mean Variance Optimization.
Description
Copyrights for articles are retained by the authors, with first publication rights granted to the journal. This article is available online at http://dx.doi.org/10.11114/afa.v1i2725.