Asset Allocation and Security Selection in Theory & in Practice: A Literature Survey from a Practitioner’s Perspective

Abstract

Whether for the sake of trying to make a fortune or for the sake of knowledge, both practitioners and academicians have had interests in studying the behavior of financial time series data since the existence of financial markets. Academicians contributed equilibrium models that aim to describe the process of price formation in capital markets. Over time, two schools of thoughts were established: the efficient markets school and the behavioral finance school. Proponents of the former believed in the Efficient Markets Hypothesis (EMH), whereas the latter brought evidence from behavioral finance and neurosciences showing that investors, especially retail traders, exhibit irrational behavior, which can explain the observed violations of the EMH in financial markets. Practitioners were not interested in developing models of price formation; rather they were interested in developing techniques to analyze and predict the price movements of financial assets. Same as academicians, practitioners can also be grouped into two schools of thought: the fundamental analysis school and the technical analysis school. Although both schools of thought share the same objective, which is to give advice on what and when to buy and sell assets for the sake of making profit, they differ in their ways of analysis.

The significant role played by academicians and practitioners in the finance industry and the interconnection between both schools and the approaches followed within each of them are best perceived in the way financial assets are allocated and portfolios are constructed. In an attempt to cross that bridge between the theory of price formation in financial markets and its practical implementations, this paper aims to survey the literature on both the theoretical and the practical frontiers of asset allocation and portfolio construction, and the best way of carrying on this task is through a thorough description of the portfolio management process (PMP). To this end, the paper breaks the PMP into three main steps, namely, portfolio planning, portfolio construction, and portfolio evaluation, in that order, and then discusses each step while surveying the literature pertaining to it. In addition to the description of the PMP, the paper also answers questions of particular interest to young practitioners, who are taking their first steps towards a career in the finance industry, such as: How portfolio theory, which is at the core of finance theory, is applied in practice? How a financial portfolio of assets is constructed in practice? How the individual assets forming a portfolio are selected and allocated? And is the process of constructing portfolios unique? Although the answers to these questions might appear to be simple and straightforward, they are, in fact, quite complicated. The complication lies not only in making the theory, which is based on certain restrictive and unrealistic assumptions, work in practice, but also in the simultaneous use of a variety of tools and financial concepts in forming a sound investment strategy.