StockTrak Project Summary
I chose to passively manage my portfolio for a number of reasons. The first reason was in order to minimize trading costs and therefore increase overall real return of my portfolio. The second reason was that finding mispriced securities is a hard task to undertake, and therefore would increase the volatility of your returns. Since I don’t have previous trading experience, I would be taking a risk by trying to outperform the market. For that reason, I decided to passively hold the indexed portfolio. My third reason for choosing a passive management style was that the current state of the market is very volatile. Even experts from top banks have had a hard ...view middle of the document...
My portfolio was not actually as diversified as I had hoped through the stratified sampling method. My portfolio industry breakdown can be seen in the following chart:
As you can see in Figure 1.2, my stratified sample did not come out to be as diversified in terms of sector as I had expected initially. This was probably due to chance when I used the random function to select a subsample of securities. My portfolio was, however, diversified when it comes to size and style. An equal number of small cap and large cap securities were chosen with high and low price to book ratios. The goal was to have a portfolio diversified in style, size, and sector. My portfolio came out to be mainly diversified in size and style, but still managed to model the S&P 500 index pretty closely. The significance of this kind of diversification is that your portfolio is exposed to less macroeconomic risk through diversification of style, size, and sector.
The biggest advantage in my opinion of selecting a subsample of securities from the S&P 500 versus each constituent is that you minimize trading costs by only purchasing 100 different securities, while still modeling the overall returns of each constituent in the S&P 500 index. For example, through our stratified sampling method, we came up with 100 securities that were well diversified to model the returns of the S&P 500. By only having 100 securities, we only had to pay trading costs for 100 securities. If we had chosen all 500 securities, we would have had to pay 5 times the amount of trading costs. Also, the difference in the returns would be minimal with considering we chose a well diversified subsample of 100 securities.
A disadvantage is always trying to keep your portfolio weights in each industry at your target weight. When prices of certain securities rise or drop dramatically, you have to adjust your portfolio in order to reach your target weights again. This can be a a hassle in the day to day management of a passive portfolio. It can also increase trading costs, resulting in a lower return on investment. Even though you have to constantly adjust your portfolio to achieve desired weights, this is not by any means an active strategy. Active managers try to identify mispriced securities to gain a profit by “beating” the market. They do not adjust for target weights.
Despite using a stratified sampling method to choose a subsample of securities, there is still active risk present that can lead to a portfolio that lacks diversification in terms of sector. This is the case with my portfolio. Even though the securities were chosen in a fairly random manner given size and style requirements, my portfolio was heavily invested in Consumer Discretionary by chance. This results in a potentially large risk. If the consumer discretionary industry were to take a hit, my portfolio would suffer dramatic losses. On the other hand, if the consumer discretionary...