ABSTRACT
Investment theory is based on the assumption that assets are fairly valued. This is encouraging for the financial economist and frustrating for his active manager. Active managers need theoretical support. In choosing an investment strategy, investors select assets that are likely to meet their respective return targets while managing the likelihood or severity of returns below those targets. Therefore, evaluating the appropriate trade-off between risk and return requires a framework which is used to build a portfolio of investments that maximize the amount of expected return for the collective given level of risk.
This can be expressed, for example, in the form of benchmarks or return targets. Ideally, these goals are embedded in the investor’s overall landscape. An investor’s asset allocation may be just one of several avenues that can be adjusted to achieve these goals. These targets help determine the average return required on an investor’s assets. Risk Tolerance is an assessment of an investor’s willingness to accept a return below a target return. Simply put, this can be described as an aversion to volatility, but it might be more appropriate to focus more explicitly on the likelihood and severity of poor returns. This chapter begins the process of building a strategic context for risk-return portfolio management. In this context, we develop several theories and concepts that may be useful in evaluating and implementing active strategies. Readers are invited to transcend the details. You don’t have to worry about transaction costs, inventory limits, liquidity, short sales, or sources of alpha. At this point, active management should be considered from a strategic perspective. The implementation will focus on the details and show how the conclusions can be adjusted to take these key issues into account.
