Question

(a) Explain how representatives may lead to biases in stock valuation.

(b) Discuss three strategies active managers can use to add value to their portfolios.

(c) Define bond portfolio indexing strategy and explain its purpose.

(d) Describe the interest rate anticipation in the active bond portfolio management strategies.

Answer 1

a) Representative bias leads to a rapid judgment based on the available information. Investors may overweight the newly obtained information related to the stocks. The representation bias will mislead the investors to believe they have correctly processed the information they received before they make a decision.

Representative bias can be horizontal and vertical. Horizontal bias is the tendency to classify and forecast the things in the future according to its similarities. Vertical bias is the tendency to judge a stock according to its history records.

b) Managers can add value to their portfolio with the following strategies:

1. timing their investments in light of estimated risk premiums and market forecasts
2. sector rotation : shifting of the funds from one sector to another, or between industries, or investment styles
3. stock picking of individual issues and buying it at less price and selling at higher price

c) The main objective of portfolio indexing strategy is to provide a return and risk characteristic which is equal to the targeted index. Investment is done in a specific bond of specific index. This strategy has the advantage of flexibility.

d) The interest rate anticipation strategy is an active bond portfolio management strategy. It involves moving between long-term government bonds and very short-term treasury bills. The movement is based on the forecast of interest rates over a certain time period. This will help to provide the maximum increase in the price of a portfolio.