Equity Valuation and Portfolio Management

CHAPTER 18

Equity Portfolio Selection in Practice

Dessislava A. Pachamanova, Ph.D.

Associate Professor of Operations Research Babson College

Frank J. Fabozzi, Ph.D., CFA, CPA

Professor of Finance EDHEC Business School

An integrated investment process generally involves the following activities:¹

1. An investor's objectives, preferences, and constraints are identified and specified to develop explicit investment policies.
2. Strategies are developed and implemented through the choice of optimal combinations of financial and real assets in the marketplace.
3. Market conditions, relative asset values, and the investor's circumstances are monitored.
4. Portfolio adjustments are made as appropriate to reflect significant changes in any or all of the relevant variables.

In this chapter, we focus on the second activity of the investment process, developing and implementing a portfolio strategy. The development of the portfolio strategy itself is typically done in two stages: First, funds are allocated among asset classes. Then, they are managed within the asset classes. The mean-variance framework is used at both stages, but in this chapter, we discuss the second stage. Specifically, we introduce quantitative formulations of portfolio allocation problems used in equity portfolio management. Quantitative equity portfolio selection often involves extending the classical mean-variance framework as originally formulated by Harry Markowitz 60 years ago² or more advanced tail-risk portfolio allocation ...