Type A Investor: No Market Timing and No Stock-picking Skills
If the investor does not believe that he has any special skills in picking undervalued
stocks or in predicting the movement of the market, then the portfolio design problem
becomes relatively simple. The investor simply chooses a diversified portfolio (in the
manner described above) and then adjusts its beta to the desired level. If he weights the
chooses securities in proportion to market capitalization, he can expect to get a portfolio
beta close to one. To achieve a higher or lower beta, he can shift the weights towards
high or low beta stocks. He can achieve the same effect by increasing or decreasing the
allocation to the equity portfolio in the overall portfolio.
The type A investor would hold a passive, diversified portfolio with a constant beta equal
to the target beta. He may also prefer to invest his money in a mutual fund and let it do
the portfolio management for him.
Type B Investor: Only Stock-picking Skills
An investor who has and wishes to exploit his stock picking skills should start with a base
portfolio similar to that of the type A investor. He should then adjust the weights of the
stocks which are in his opinion mispriced. Specifically, he should overweight the stocks
which are overvalued and underweight those which are under valued. For example, the
base portfolio may have 2% in Stock X and 1.5% in Stock Y. The investor who finds-X
undervalued and Y overvalued may change the weights to 3% to X, he may have a
problem as he would then have to shortsell Y to the extent of 0.5% of the portfolio. This
may not be legally or practically possible. The investor then has to raise the weight of X
to 4%, eliminate Y from the portfolio and reduce the weight of some other stocks by
0 .5%.
The investor can deal with this problem in a slightly different manner. He can put, say
90%, of his equity investment in the diversified portfolio and reserve the remaining 10%
for the mispriced stocks. How large a fraction he should devote to mispriced scrips
depends on how good analyst may choose a larger fraction? What we are doing in this
decision is to balance the profit potential of investing in undervalued stocks against the
benefit of diversification. Unless we are confident about our analysis, we should give
primacy to the need for diversification.
Since the average beta of the undervalued and overvalued stocks is likely to be close to
one, the overall beta is likely to remain close to the target value, unless the target beta is
substantially different from one and the percentage of the portfolio devoted to mispriced
stocks is large. If, for some reason, this is not so, the investor would have to take further
action to maintain the beta at the target value. The portfolio of the type B investor is
concentrated but has a constant beta.