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Modern portfolio theory

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In finance, a portfolio is an appropriate mix or collection of investments held by an institution or an individual. Holding a portfolio is a part of an investment and risk-limiting strategy called diversification. By owning several assets, certain types of risk (in particular specific risk) can be reduced. The assets in the portfolio could include Bank accounts; stocks, bonds, options, warrants, gold certificates, real estate, futures contracts, production facilities, or any other item that is expected to retain its value. In building up an investment portfolio a financial institution will typically conduct its own investment analysis, whilst a private individual may make use of the services of a financial advisor or a financial institution which offers portfolio management services. Management Portfolio management involves deciding what assets to include in the portfolio, given the goals of the portfolio owner and changing economic conditions. Selection involves deciding what assets to purchase, how many to purchase, when to purchase them, and what assets to divest. These decisions always involve some sort of performance measurement, most typically expected return on the portfolio, and the risk associated with this return (i.e. the standard deviation of the return). Typically the expected return from portfolios of different asset bundles are compared. The unique goals and circumstances of the investor must also be considered. Some investors are more risk averse than others. Mutual funds have developed particular techniques to optimize their portfolio holdings. See fund management for details. [edit]Portfolio formation Many strategies have been developed to form a portfolio. equally-weighted portfolio capitalization-weighted portfolio price-weighted portfolio optimal portfolio (for which the Sharpe ratio is highest) [edit]Models
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Page 1: Modern portfolio theory

In finance, a portfolio is an appropriate mix or collection of investments held by an institution or an

individual.

Holding a portfolio is a part of an investment and risk-limiting strategy called diversification. By owning

several assets, certain types of risk (in particular specific risk) can be reduced. The assets in the

portfolio could include Bank accounts; stocks, bonds, options, warrants, gold certificates, real

estate, futures contracts, production facilities, or any other item that is expected to retain its value.

In building up an investment portfolio a financial institution will typically conduct its own investment

analysis, whilst a private individual may make use of the services of a financial advisor or a financial

institution which offers portfolio management services.

Management

Portfolio management involves deciding what assets to include in the portfolio, given the goals of

the portfolio owner and changing economic conditions. Selection involves deciding what assets to

purchase, how many to purchase, when to purchase them, and what assets to divest. These

decisions always involve some sort of performance measurement, most typically expected return on

the portfolio, and the risk associated with this return (i.e. the standard deviation of the return).

Typically the expected return from portfolios of different asset bundles are compared.

The unique goals and circumstances of the investor must also be considered. Some investors are

more risk averse than others.

Mutual funds have developed particular techniques to optimize their portfolio holdings. See fund

management for details.

[edit]Portfolio formation

Many strategies have been developed to form a portfolio.

equally-weighted portfolio

capitalization-weighted portfolio

price-weighted portfolio

optimal portfolio (for which the Sharpe ratio is highest)

[edit]Models

Some of the financial models used in the process of Valuation, stock selection, and management of

portfolios include:

Maximizing return, given an acceptable level of risk

Modern portfolio theory—a model proposed by Harry Markowitz among others

The single-index model of portfolio variance

Capital asset pricing model

Page 2: Modern portfolio theory

Arbitrage pricing theory

The Jensen Index

The Treynor Index

The Sharpe Diagonal (or Index) model

Value at risk model

[edit]Returns

There are many different methods for calculating portfolio returns. A traditional method has been

using quarterly or monthly money-weighted returns. A money-weighted return calculated over a period

such as a month or a quarter assumes that the rate of return over that period is constant. As portfolio

returns actually fluctuate daily, money-weighted returns may only provide an approximation to a

portfolio’s actual return. These errors happen because of cashflows during the measurement period.

The size of the errors depends on three variables: the size of the cashflows, the timing of the

cashflows within the measurement period, and the volatility of the portfolio[1].

A more accurate method for calculating portfolio returns is to use the true time-weighted method. This

entails revaluing the portfolio on every date where a cashflow takes place (perhaps even every day),

and then compounding together the daily returns.

[edit]Attribution

Performance Attribution explains the active performance (i.e. the benchmark-relative performance) of

a portfolio. For example, a particular portfolio might be benchmarked against the S&P 500 index. If the

benchmark return over some period was 5%, and the portfolio return was 8%, this would leave an

active return of 3% to be explained. This 3% active return represents the component of the portfolio's

return that was generated by the investment manager (rather than by the benchmark).

There are different models for performance attribution, corresponding to different investment

processes. For example, one simple model explains the active return in "bottom-up" terms, as the

result of stock selection only. On the other hand, sector attribution explains the active return in terms

of both sector bets (for example, an overweight position in Materials, and an underweight position in

Financials), and also stock selection within each sector (for example, choosing to hold more of the

portfolio in one bank than another).

An altogether different paradigm for performance attribution is based on using factor models, such as

the Fama-French three-factor model.

Page 3: Modern portfolio theory

Portfolio manager

A ' team of analysts and researchers, and are ultimately responsible for establishing an

investment strategy, selecting appropriate investments and allocating each investment properly for

a fund- or asset-management vehicle.

Portfolio managers are presented with investment ideas from internal buy-side analysts and sell-side

analysts from investment banks. It is their job to sift through the relevant information and use their

judgment to buy and sell securities. Throughout each day, they read reports, talk to company

managers and monitor industry and economic trends looking for the right company and time to invest

the portfolio's capital.

Portfolio managers make decisions about investment mix and policy, matching investments to

objectives, asset allocation for individuals and institutions, and balancing risk against. performance.

Portfolio management is about strengths, weaknesses, opportunities and threats in the choice of debt

vs. equity, domestic vs. international, growth vs. safety, and other tradeoffs encountered in the

attempt to maximize return at a given appetite for risk.

In the case of mutual and exchange-traded funds (ETFs), there are two forms of portfolio

management: passive and active. Passive management simply tracks a market index, commonly

referred to as indexing or index investing. Active management involves a single manager, co-

managers, or a team of managers who attempt to beat the market return by actively managing a

fund's portfolio through investment decisions based on research and decisions on individual

holdings. Closed-end funds are generally actively managed.

That's what warren buffet says about investing in the market..."The basic ideas of investing are to look

at stocks as business, use the market's fluctuations to your advantage, and seek a margin of

safety"....

Portfolio ManagementThe act or practice of making investment decisions in order to make the largest possible return. Portfolio management takes two basic forms: active and passive. Active management involves using technical, fundamental, or some other analysis to make trades on a fairly regular basis. For example, one may sell stock A in order to buy stock B. Then, a few days or weeks later, one may sell stock B to buy bond C. Passive management, on the other hand, involves buying an index, an exchange-traded fund, or some other investment vehicle with securities the investor does not directly choose. For example, one may buy an exchange-traded fund that holds all the stocks on the S&P 500. See also: Asset management, Investment adviser.

Page 4: Modern portfolio theory

Portfolio Management is used to select a portfolio of new product development projects to achieve th following goals:

Maximize the profitability or value of the portfolio Provide balance Support the strategy of the enterprise

Portfolio Management is the responsibility of the senior management team of an organization or business unit. This team, which might be called the Product Committee, meets regularly to manage the product pipeline and make decisions about the product portfolio. Often, this is the same group that conducts the stage-gate reviews in the organization.

A logical starting point is to create a product strategy - markets, customers, products, strategy approach, competitive emphasis, etc. The second step is to understand the budget or resources available to balance the portfolio against. Third, each project must be assessed for profitability (rewards), investment requirements (resources), risks, and other appropriate factors.

The weighting of the goals in making decisions about products varies from company. But organizations must balance these goals: risk vs. profitability, new products vs. improvements, strategy fit vs. reward, market vs. product line, long-term vs. short-term. Several types of techniques have been used to support the portfolio management process:

Heuristic models Scoring techniques Visual or mapping techniques

The earliest Portfolio Management techniques optimized projects' profitability or financial returns using heuristic or mathematical models. However, this approach paid little attention to balance or aligning the portfolio to the organization's strategy. Scoring techniques weight and score criteria to take into account investment requirements, profitability, risk and strategic alignment. The shortcoming with this approach can be an over emphasis on financial measures and an inability to optimize the mix of projects. Mapping techniques use graphical presentation to visualize a portfolio's balance. These are typically presented in the form of a two-dimensional graph that shows the trade-off's or balance between two factors such as risks vs. profitability, marketplace fit vs. product line coverage, financial return vs. probability of success, etc.

Page 5: Modern portfolio theory

The chart shown above provides a graphical view of the project portfolio risk-reward balance. It is used to assure balance in the portfolio of projects - neither too risky or conservative and appropriate levels of reward for the risk involved. The horizontal axis is Net Present Value, the vertical axis is Probability of Success. The size of the bubble is proportional to the total revenue generated over the lifetime sales of the product.

While this visual presentation is useful, it can't prioritize projects. Therefore, some mix of these techniques is appropriate to support the Portfolio Management Process. This mix is often dependent upon the priority of the goals.

Our recommended approach is to start with the overall business plan that should define the planned level of R&:D investment, resources (e.g., headcount, etc.), and related sales expected from new products. With multiple business units, product lines or types of development, we recommend a strategic allocation process based on the business plan. This strategic allocation should apportion the planned R&D investment into business units, product lines, markets, geographic areas, etc. It may also breakdown the R&D investment into types of development, e.g., technology development, platform development, new products, and upgrades/enhancements/line extensions, etc.

Once this is done, then a portfolio listing can be developed including the relevant portfolio data. We favor use of the development productivity index (DPI) or scores from the scoring method. The development productivity index is calculated as follows: (Net Present Value x Probability of Success) / Development Cost Remaining. It factors the NPV by the probability of both technical and commercial success. By dividing this result by the development cost remaining, it places more weight on projects nearer completion and with lower uncommitted costs. The scoring method uses a set of criertia (potentially different for each stage of the project) as a basis for scoring or evaluating each project. An example of this scoring method is shown with the worksheet below.

Page 6: Modern portfolio theory

Weighting factors can be set for each criteria. The evaluators on a Product Committee score projects (1 to 10, where 10 is best). The worksheet computes the average scores and applies the weighting factors to compute the overall score. The maximum weighted score for a project is 100.

This portfolio list can then be ranked by either the development priority index or the score. An example of the portfolio list is shown below and the second illustration shows the category summary for the scoring method.

Page 7: Modern portfolio theory

Once the organization has its prioritized list of projects, it then needs to determine where the cutoff is based on the business plan and the planned level of investment of the resources avaialable. This subset of the high priority projects then needs to be further analyzed and checked. The first step is to check that the prioritized list reflects the planned breakdown of projects based on the strategic allocation of the business plan. Pie charts such as the one below can be used for this purpose.

Page 8: Modern portfolio theory

Other factors can also be checked using bubble charts. For example, the risk-reward balance is commonly checked using the bubble chart shown earlier. A final check is to analyze product and technology roadmaps for project relationships. For example, if a lower priority platform project was omitted from the protfolio priority list, the subsequent higher priority projects that depend on that platform or platform technology would be impossible to execute unless that platform project were included in the portfolio priority list. An example of a roadmap is shown below.

This overall portfolio management process is shown in the following diagram.

Page 9: Modern portfolio theory

Finally, this balanced portfolio that has been developed is checked against the business plan as shown below to see if the plan goals have been achieved - projects within the planned R&D investment and resource levels and sales that have met the goals.

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With the significant investments required to develop new products and the risks involved, Portfolio Management is becoming an increasingly important tool to make strategic decisions about product development and the investment of company resources. In many companies, current year revenues are increasingly based on new products developed in the last one to three years. Therefore, these portfolio decisions are the basis of a company's profitability and even its continued existence over the next several years.

Portfolio Management may refer to:

Investment management , handled by a portfolio manager

IT portfolio management

Project management

Project portfolio management

Page 11: Modern portfolio theory

Investment management is the professional management of various securities (shares, bonds and

other securities) and assets (e.g., real estate) in order to meet specified investment goals for the

benefit of the investors. Investors may be institutions (insurance companies, pension funds,

corporations etc.) or private investors (both directly via investment contracts and more commonly

via collective investment schemes e.g. mutual funds or exchange-traded funds).

The term asset management is often used to refer to the investment management of collective

investments, (not necessarily) while the more generic fund management may refer to all forms of

institutional investment as well as investment management for private investors. Investment

managers who specialize in advisory or discretionary management on behalf of (normally wealthy)

private investors may often refer to their services as wealth management or portfolio management

often within the context of so-called "private banking".

The provision of 'investment management services' includes elements of financial statement analysis,

asset selection, stock selection, plan implementation and ongoing monitoring of investments.

Investment management is a large and important global industry in its own right responsible for

caretaking of trillions of yuan, dollars, euro, pounds and yen. Coming under the remit of financial

services many of the world's largest companies are at least in part investment managers and employ

millions of staff and create billions in revenue.

Fund manager (or investment adviser in the United States) refers to both a firm that provides

investment management services and an individual who directs fund management decisions.

Industry scope

The business of investment management has several facets, including the employment of

professional fund managers, research (of individual assets and asset classes), dealing, settlement,

marketing, internal auditing, and the preparation of reports for clients. The largest financial fund

managers are firms that exhibit all the complexity their size demands. Apart from the people who bring

in the money (marketers) and the people who direct investment (the fund managers), there are

compliance staff (to ensure accord with legislative and regulatory constraints), internal auditors of

various kinds (to examine internal systems and controls), financial controllers (to account for the

institutions' own money and costs), computer experts, and "back office" employees (to track and

record transactions and fund valuations for up to thousands of clients per institution).

[edit]Key problems of running such businesses

Key problems include:

revenue is directly linked to market valuations, so a major fall in asset prices causes a precipitous

decline in revenues relative to costs;

Page 12: Modern portfolio theory

above-average fund performance is difficult to sustain, and clients may not be patient during times

of poor performance;

successful fund managers are expensive and may be headhunted by competitors;

above-average fund performance appears to be dependent on the unique skills of the fund

manager; however, clients are loath to stake their investments on the ability of a few individuals-

they would rather see firm-wide success, attributable to a single philosophy and internal

discipline;

analysts who generate above-average returns often become sufficiently wealthy that they avoid

corporate employment in favor of managing their personal portfolios.

[edit]Representing the owners of shares

Institutions often control huge shareholdings. In most cases they are acting as fiduciary agents rather

than principals (direct owners). The owners of shares theoretically have great power to alter the

companies they own via the voting rights the shares carry and the consequent ability to pressure

managements, and if necessary out-vote them at annual and other meetings.

In practice, the ultimate owners of shares often do not exercise the power they collectively hold

(because the owners are many, each with small holdings); financial institutions (as agents) sometimes

do. There is a general belief that shareholders - in this case, the institutions acting as agents—could

and should exercise more active influence over the companies in which they hold shares (e.g., to hold

managers to account, to ensure Boards effective functioning). Such action would add a pressure

group to those (the regulators and the Board) overseeing management.

However there is the problem of how the institution should exercise this power. One way is for the

institution to decide, the other is for the institution to poll its beneficiaries. Assuming that the institution

polls, should it then: (i) Vote the entire holding as directed by the majority of votes cast? (ii) Split the

vote (where this is allowed) according to the proportions of the vote? (iii) Or respect the abstainers

and only vote the respondents' holdings?

The price signals generated by large active managers holding or not holding the stock may contribute

to management change. For example, this is the case when a large active manager sells his position

in a company, leading to (possibly) a decline in the stock price, but more importantly a loss of

confidence by the markets in the management of the company, thus precipitating changes in the

management team.

Some institutions have been more vocal and active in pursuing such matters; for instance, some firms

believe that there are investment advantages to accumulating substantial minority shareholdings (i.e.

10% or more) and putting pressure on management to implement significant changes in the business.

In some cases, institutions with minority holdings work together to force management change.

Perhaps more frequent is the sustained pressure that large institutions bring to bear on management

teams through persuasive discourse and PR. On the other hand, some of the largest investment

managers—such as BlackRock and Vanguard—advocate simply owning every company, reducing

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the incentive to influence management teams. A reason for this last strategy is that the investment

manager prefers a closer, more open and honest relationship with a company's management team

than would exist if they exercised control; allowing them to make a better investment decision.

The national context in which shareholder representation considerations are set is variable and

important. The USA is a litigious society and shareholders use the law as a lever to pressure

management teams. In Japan it is traditional for shareholders to be low in the 'pecking order,' which

often allows management and labor to ignore the rights of the ultimate owners. Whereas US firms

generally cater to shareholders, Japanese businesses generally exhibit a stakeholder mentality, in

which they seek consensus amongst all interested parties (against a background of strong unions and

labour legislation).

[edit]Size of the global fund management industry

Conventional assets under management of the global fund management industry fell 19% in 2008, to

$61.6 trillion. Pension assets accounted for $24.0 trillion of the total, with $18.9 trillion invested in

mutual funds and $18.7 trillion in insurance funds. Together with alternative assets (sovereign wealth

funds, hedge funds, private equity funds and exchange traded funds) and funds of wealthy individuals,

assets of the global fund management industry totalled around $90 trillion at the end of 2008, a fall of

17% on the previous year. The decline in 2008 followed five successive years of growth during which

assets under management more than doubled. Falls on equity markets, poor investment performance,

reduced inflow of new funds, and investor redemptions, all contributed to the fall in assets in 2008.

The decline reported in US dollars was also exacerbated by the strengthening of the US dollar during

the particular year.

The US remained by far the biggest source of funds, accounting for over a half of conventional assets

under management in 2008 or over $30 trillion. The UK was the second largest centre in the world

and by far the largest in Europe with around 9% of the global total.[1]

[edit]Philosophy, process and people

The 3-P's (Philosophy, Process and People) are often used to describe the reasons why the manager

is able to produce above average results.

Philosophy refers to the over-arching beliefs of the investment organization. For example: (i)

Does the manager buy growth or value shares (and why)? (ii) Do they believe in market timing

(and on what evidence)? (iii) Do they rely on external research or do they employ a team of

researchers? It is helpful if any and all of such fundamental beliefs are supported by proof-

statements.

Process refers to the way in which the overall philosophy is implemented. For example: (i) Which

universe of assets is explored before particular assets are chosen as suitable investments? (ii)

How does the manager decide what to buy and when? (iii) How does the manager decide what to

Page 14: Modern portfolio theory

sell and when? (iv) Who takes the decisions and are they taken by committee? (v) What controls

are in place to ensure that a rogue fund (one very different from others and from what is intended)

cannot arise?

People refers to the staff, especially the fund managers. The questions are, Who are they? How

are they selected? How old are they? Who reports to whom? How deep is the team (and do all

the members understand the philosophy and process they are supposed to be using)? And most

important of all, How long has the team been working together? This last question is vital because

whatever performance record was presented at the outset of the relationship with the client may

or may not relate to (have been produced by) a team that is still in place. If the team has changed

greatly (high staff turnover or changes to the team), then arguably the performance record is

completely unrelated to the existing team (of fund managers).

[edit]Investment managers and portfolio structures

At the heart of the investment management industry are the managers who invest and divest client

investments.

A certified company investment advisor should conduct an assessment of each client's individual

needs and risk profile. The advisor then recommends appropriate investments.

[edit]Asset allocation

The different asset class definitions are widely debated, but four common divisions

are stocks, bonds, real-estate and commodities. The exercise of allocating funds among these assets

(and among individual securities within each asset class) is what investment management firms are

paid for. Asset classes exhibit different market dynamics, and different interaction effects; thus, the

allocation of money among asset classes will have a significant effect on the performance of the fund.

Some research suggests that allocation among asset classes has more predictive power than the

choice of individual holdings in determining portfolio return. Arguably, the skill of a successful

investment manager resides in constructing the asset allocation, and separately the individual

holdings, so as to outperform certain benchmarks (e.g., the peer group of competing funds, bond and

stock indices)...

[edit]Long-term returns

It is important to look at the evidence on the long-term returns to different assets, and to holding

period returns (the returns that accrue on average over different lengths of investment). For example,

over very long holding periods (eg. 10+ years) in most countries, equities have generated higher

returns than bonds, and bonds have generated higher returns than cash. According to financial

theory, this is because equities are riskier (more volatile) than bonds which are themselves more risky

than cash.

[edit]Diversification

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Against the background of the asset allocation, fund managers consider the degree

of diversification that makes sense for a given client (given its risk preferences) and construct a list of

planned holdings accordingly. The list will indicate what percentage of the fund should be invested in

each particular stock or bond. The theory of portfolio diversification was originated by Markowitz (and

many others) and effective diversification requires management of the correlation between the asset

returns and the liability returns, issues internal to the portfolio (individual holdings volatility), and cross-

correlations between the returns.

[edit]Investment styles

There are a range of different styles of fund management that the institution can implement. For

example, growth, value, market neutral, small capitalisation, indexed, etc. Each of these approaches

has its distinctive features, adherents and, in any particular financial environment, distinctive risk

characteristics. For example, there is evidence that growth styles (buying rapidly growing earnings)

are especially effective when the companies able to generate such growth are scarce; conversely,

when such growth is plentiful, then there is evidence that value styles tend to outperform the indices

particularly successfully.

[edit]Performance measurement

Fund performance is the acid test of fund management, and in the institutional context accurate

measurement is a necessity. For that purpose, institutions measure the performance of each fund

(and usually for internal purposes components of each fund) under their management, and

performance is also measured by external firms that specialize in performance measurement. The

leading performance measurement firms (e.g. Frank Russell in the USA or BI-SAM [1] in Europe)

compile aggregate industry data, e.g., showing how funds in general performed against given indices

and peer groups over various time periods.

In a typical case (let us say an equity fund), then the calculation would be made (as far as the client is

concerned) every quarter and would show a percentage change compared with the prior quarter (e.g.,

+4.6% total return in US dollars). This figure would be compared with other similar funds managed

within the institution (for purposes of monitoring internal controls), with performance data for peer

group funds, and with relevant indices (where available) or tailor-made performance benchmarks

where appropriate. The specialist performance measurement firms calculate quartile and decile data

and close attention would be paid to the (percentile) ranking of any fund.

Generally speaking, it is probably appropriate for an investment firm to persuade its clients to assess

performance over longer periods (e.g., 3 to 5 years) to smooth out very short term fluctuations in

performance and the influence of the business cycle. This can be difficult however and, industry wide,

there is a serious preoccupation with short-term numbers and the effect on the relationship with

clients (and resultant business risks for the institutions).

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An enduring problem is whether to measure before-tax or after-tax performance. After-tax

measurement represents the benefit to the investor, but investors' tax positions may vary. Before-tax

measurement can be misleading, especially in regimens that tax realised capital gains (and not

unrealised). It is thus possible that successful active managers (measured before tax) may produce

miserable after-tax results. One possible solution is to report the after-tax position of some standard

taxpayer.

[edit]Risk-adjusted performance measurement

Performance measurement should not be reduced to the evaluation of fund returns alone, but must

also integrate other fund elements that would be of interest to investors, such as the measure of risk

taken. Several other aspects are also part of performance measurement: evaluating if managers have

succeeded in reaching their objective, i.e. if their return was sufficiently high to reward the risks taken;

how they compare to their peers; and finally whether the portfolio management results were due to

luck or the manager’s skill. The need to answer all these questions has led to the development of

more sophisticated performance measures, many of which originate in modern portfolio theory.

Modern portfolio theory established the quantitative link that exists between portfolio risk and return.

The Capital Asset Pricing Model (CAPM) developed by Sharpe (1964) highlighted the notion of

rewarding risk and produced the first performance indicators, be they risk-adjusted ratios (Sharpe

ratio, information ratio) or differential returns compared to benchmarks (alphas). The Sharpe ratio is

the simplest and best known performance measure. It measures the return of a portfolio in excess of

the risk-free rate, compared to the total risk of the portfolio. This measure is said to be absolute, as it

does not refer to any benchmark, avoiding drawbacks related to a poor choice of benchmark.

Meanwhile, it does not allow the separation of the performance of the market in which the portfolio is

invested from that of the manager. The information ratio is a more general form of the Sharpe ratio in

which the risk-free asset is replaced by a benchmark portfolio. This measure is relative, as it

evaluates portfolio performance in reference to a benchmark, making the result strongly dependent on

this benchmark choice.

Portfolio alpha is obtained by measuring the difference between the return of the portfolio and that of

a benchmark portfolio. This measure appears to be the only reliable performance measure to evaluate

active management. In fact, we have to distinguish between normal returns, provided by the fair

reward for portfolio exposure to different risks, and obtained through passive management, from

abnormal performance (or outperformance) due to the manager’s skill, whether through market timing

or stock picking. The first component is related to allocation and style investment choices, which may

not be under the sole control of the manager, and depends on the economic context, while the second

component is an evaluation of the success of the manager’s decisions. Only the latter, measured by

alpha, allows the evaluation of the manager’s true performance.

Portfolio normal return may be evaluated using factor models. The first model, proposed by Jensen

(1968), relies on the CAPM and explains portfolio normal returns with the market index as the only

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factor. It quickly becomes clear, however, that one factor is not enough to explain the returns and that

other factors have to be considered. Multi-factor models were developed as an alternative to

the CAPM, allowing a better description of portfolio risks and an accurate evaluation of managers’

performance. For example, Fama and French (1993) have highlighted two important factors that

characterise a company's risk in addition to market risk. These factors are the book-to-market ratio

and the company's size as measured by its market capitalisation. Fama and French therefore

proposed three-factor model to describe portfolio normal returns (Fama-French three-factor model).

Carhart (1997) proposed to add momentum as a fourth factor to allow the persistence of the returns to

be taken into account. Also of interest for performance measurement is Sharpe’s (1992) style analysis

model, in which factors are style indices. This model allows a custom benchmark for each portfolio to

be developed, using the linear combination of style indices that best replicate portfolio style allocation,

and leads to an accurate evaluation of portfolio alpha.

[edit]Education or certification

Increasingly, international business schools are incorporating the subject into their course outlines

and some have formulated the title of 'Investment Management' or 'Asset Management' conferred as

specialist bachelors degrees (e.g. Cass Business School, London). Due to global cross-recognition

agreements with the 2 major accrediting agencies AACSB and ACBSPwhich accredit over 560 of the

best business school programs, the Certification of MFP Master Financial Planner Professional from

the American Academy of Financial Management is available to AACSB and ACBSP business school

graduates with finance or financial services-related concentrations. For people with aspirations to

become an investment manager, further education may be needed beyond a bachelors in business,

finance, or economics. A graduate degree or an investment qualification such as the Chartered

Financial Analystdesignation (CFA) or the Certified Financial Markets Practitioner (CFMP) Exam by

the Management Laboratory may help in having a career in investment management.[citation needed]

There is no evidence that any particular qualification enhances the most desirable characteristic of an

investment manager, that is the ability to select investments that result in an above average (risk

weighted) long-term performance[citation needed]. The industry has a tradition of seeking out, employing

and generously rewarding such people without reference to any formal qualifications[citation needed].

IT portfolio management is the application of systematic management to large classes of items managed by enterprise Information Technology (IT) capabilities. Examples of IT portfolios would be planned initiatives, projects, and ongoing IT services (such as application support). The promise of IT portfolio management is the quantification of previously mysterious IT efforts, enabling measurement and objective evaluation of investment scenarios.

Overview

Debates exist on the best way to measure value of IT investment. As pointed out by Jeffery and

Leliveld (2004) [1], companies have spent billions of dollars on IT investments and yet the headlines of

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mis-spent money are not uncommon. Nicholas Carr (2003) has caused significant controversy in IT

industry and academia by positioning IT as an expense similar to utilities such as electricity.

IT portfolio management started with a project-centric bias, but is evolving to include steady-state

portfolio entries such as application maintenance and support in portfolios is that IT budgets tend not

to track these efforts at a sufficient level of granularity for effective financial tracking.[2]

The concept is analogous to financial portfolio management, but there are significant differences. IT

investments are not liquid, like stocks and bonds (although investment portfolios may also include

illiquid assets), and are measured using both financial and non-financial yardsticks (for example,

a balanced scorecard approach); a purely financial view is not sufficient.

Financial portfolio assets typically have consistent measurement information (enabling accurate and

objective comparisons), and this is at the base of the concept’s usefulness in application to IT.

However, achieving such universality of measurement is going to take considerable effort in the IT

industry. (See Val IT.)

IT Portfolio management is distinct from IT financial management in that it has an explicitly directive,

strategic goal in determining what to continue investing in versus what to divest from.

At its most mature, IT Portfolio management is accomplished through the creation of Three portfolios:

Application Portfolio - Management of this portfolio focuses on comparing spending on

established systems based upon their relative value to the organization. The comparison can be

based upon the level of contribution in terms of IT investment’s profitability. Additionally, this

comparison can also be based upon the non-tangible factors such as organizations’ level of

experience with a certain technology, users’ familiarity with the applications and infrastructure,

and external forces such as emergence of new technologies and obsolescence of old ones.

Infrastructure Portfolio - This For an organization's information technology, infrastructure

management (IM) is the management of essential operation components, such as policies,

processes, equipment, data, human resources, and external contacts, for overall effectiveness.

Infrastructure management is sometimes divided into categories of systems management,

network management, and storage management. The ability of organizations to exploit IT

infrastructure, operations and management sourcing/service solutions not only depends on the

availability, cost and effectiveness of applications and services, but also with coming to terms with

solution providers, and managing the entire sourcing process. In the rush to reduce costs,

increase IT quality and increase competitiveness by way of selective IT sourcing and services,

many organizations do not consider the management side of the equation. The predictable result

of this neglect is overpayment, cost overruns, unmet expectations and outright failure.

Project Portfolio - This type of portfolio management specially address the issues with spending

on the development of innovative capabilities in terms of potential ROI and reducing investment

overlaps in situations where reorganization or acquisition occurs. The management issues with

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the second type of portfolio management can be judged in terms of data cleanliness,

maintenance savings, suitability of resulting solution and the relative value of new investments to

replace these projects.

Information Technology portfolio management as a systematic discipline is more applicable to larger

IT organizations; in smaller organizations its concerns might be generalized into IT planning and

governance as a whole.

[edit]Benefits of using IT portfolio management

Jeffery and Leliveld (2004) have listed several benefits of applying IT portfolio management approach

for IT investments. They argue that agility of portfolio management is its biggest advantage over

investment approaches and methods. Other benefits include central oversight of budget, risk

management, strategic alignment of IT investments, demand and investment management along with

standardization of investment procedure, rules and plans.

[edit]Implementing IT portfolio management

Jeffery and Leliveld (2004) have pointed out a number of hurdles and success factors that CIOs might

face while attempting to implement IT portfolio management approach. To overcome these hurdles,

simple methods such as proposed by Pisello (2001) can be used.

-Plan- - - - - build retire - - - - Maintain

Other implementation methods include (1) risk profile analysis (figure out what needs to be

measured and what risks are associated with it), (2) Decide on the Diversification of projects,

infrastructure and technologies (it is an important tool that IT portfolio management provides to judge

the level of investments on the basis of how investments should be made in various elements of the

portfolio), (3) Continuous Alignment with business goals (highest levels of organizations should

have a buy-in in the portfolio) and (4) Continuous Improvement (lessons learned and investment

adjustments).

Maizlash and Handler (2007)[3] provide a proven step-by-step methodology for applying IT portfolio

management that has eight stages. In today's past-paced world, waterfall approaches to delivering

anything are proving to less and less effective. Nonetheless, the eight stages are:

1. Developing an IT portfolio management game plan

2. Planning the IT portfolio

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3. Creating the IT portfolio

4. Assessing the IT portfolio

5. Balancing the IT portfolio

6. Communicating the IT portfolio

7. Developing and evolving IT portfolio governance and organization

8. Assessing IT portfolio management process execution

There is no single best way to implement IT portfolio approach and therefore variety of approaches

can applied. Obviously the methods are not set in stone and will need altering depending upon the

individual circumstances of different organizations.

[edit]IT portfolio management vs. balanced scorecard

The biggest advantage of IT portfolio management is the agility of the investment adjustments. While

balanced scorecards also emphasize the use of vision and strategy in any investment decision,

oversight and control of operation budgets is not the goal. IT portfolio management allows

organizations to adjust the investments based upon the feedback mechanism built into the IT portfolio

management.

[edit]History

The first mention of the portfolio concept as related to IT was from Richard Nolan in 1973:

“investments in developing computer applications can be thought of as a portfolio of computer

applications.” [4]

Further mention is found in Gibson and Nolan's Managing the Four Stages of EDP Growth in 1973 [5].

Gibson and Nolan proposed that IT advances in observable stages driven by four "growth processes"

of which the Applications Portfolio was key. Their concepts were operationalized at Nolan, Norton &

Co. with measures of application coverage of business functions, applications functional and technical

qualities, applications age and spending.

McFarlan [6] proposed a different portfolio management approach to IT assets and investments.

Further contributions have been made by Weill and Broadbent,[7], Aitken,[8] Kaplan, [2]and Benson,

Bugnitz, and Walton[9]. The ITIL version 2 Business Perspective[10] and Application

Management[11] volumes and the ITIL v3 Service Strategy volume also cover it in depth.

Various vendors have offerings explicitly branded as "IT Portfolio Management" solutions.

ISACA's Val IT framework is perhaps the first attempt at standardization of IT portfolio management

principles.

In peer-reviewed research, Christopher Verhoef has found that IT portfolios statistically behave more

akin to biological populations than financial portfolios.[12] Verhoef was general chair of the first

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convening of the new IEEE conference, "IEEE Equity," March 2007, which focuses on "quantitative

methods for measuring, predicting, and understanding the relationship between IT and value."[1]

[edit]McFarlan's IT portfolio matrix

High^

|---------------------------------------------------------------||strategic | Turnaround |

Impact|---------------------------------------------------------------|

of IS/IT |Critical to achieving |May be critical to |applications |future business strategy. |achieving future |on future | (Developer) |business success | industry| | (Entrepreneur) |competitiveness|Central Planning | |

| |Leading Edge/Free Market |

|---------------------------------------------------------------||Critical to existing business |Valuable but not

critical ||operations |to success || (Controller) | (Caretaker) || | ||Monopoly | Scarce Resource ||_______________________________ |

_______________________________||Factory | Support

||

<---------------------------------------------------------------LowHigh

Value to the business of existing applications.

Project management is the discipline of planning, organizing, securing and managing resources to

bring about the successful completion of specific engineering project goals and objectives. It is

sometimes conflated with program management, however technically it is actually a higher level

construction: a group of related and somehow interdependent engineering projects. A project is a

temporary endeavor, having a defined beginning and end (usually constrained by date, but can be by

funding or deliverables),[1] undertaken to meet unique goals and objectives,[2] usually to bring about

beneficial change or added value. The temporary nature of projects stands in contrast to business as

usual (or operations),[3] which are repetitive, permanent or semi-permanent functional work to produce

products or services. In practice, the management of these two systems is often found to be quite

different, and as such requires the development of distinct technical skills and the adoption of

separate management.

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The primary challenge of project management is to achieve all of the engineering project goals[4] and

objectives while honoring the preconceived project constraints.[5] Typical constraints are scope, time,

and budget.[1] The secondary—and more ambitious—challenge is to optimize the allocation and

integration of inputs necessary to meet pre-defined objectives.

History

Roman Soldiers Building a Fortress, Trajan's Column 113 AD

Project management has been practiced since early civilization. Until 1900 civil engineering projects

were generally managed by creativearchitects and engineers themselves, among those for

example Vitruvius (1st century BC), Christopher Wren (1632–1723) , Thomas Telford(1757–1834)

and Isambard Kingdom Brunel  (1806–1859).[6] It was in the 1950s that organizations started to

systematically apply project management tools and techniques to complex engineering projects.[7]

Henry Gantt (1861-1919), the father of planning and control techniques.

As a discipline, Project Management developed from several fields of application including

civil construction,engineering, and heavy defense activity.[8] Two forefathers of project management

are Henry Gantt, called the father of planning and control techniques,[9] who is famous for his use of

the Gantt chart as a project management tool; and Henri Fayol for his creation of the 5 management

functions which form the foundation of the body of knowledge associated with project and program

management.[10] Both Gantt and Fayol were students of Frederick Winslow Taylor's theories

of scientific management. His work is the forerunner to modern project management tools

including work breakdown structure (WBS) and resource allocation.

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The 1950s marked the beginning of the modern Project Management era where core engineering

fields come together working as one. Project management became recognized as a distinct discipline

arising from the management discipline with engineering model.[11] In the United States, prior to the

1950s, projects were managed on an ad hoc basis using mostly Gantt Charts, and informal

techniques and tools. At that time, two mathematical project-scheduling models were developed. The

"Critical Path Method" (CPM) was developed as a joint venture between DuPont

Corporation and Remington Rand Corporation for managing plant maintenance projects. And the

"Program Evaluation and Review Technique" or PERT, was developed by Booz-Allen & Hamilton as

part of the United States Navy's (in conjunction with the Lockheed Corporation) Polaris

missile submarine program;[12] These mathematical techniques quickly spread into many private

enterprises.

PERT network chart for a seven-month project with five milestones

At the same time, as project-scheduling models were being developed, technology for project cost

estimating, cost management, and engineering economics was evolving, with pioneering work by

Hans Lang and others. In 1956, the American Association of Cost Engineers (now AACE

International; the Association for the Advancement of Cost Engineering) was formed by early

practitioners of project management and the associated specialties of planning and scheduling, cost

estimating, and cost/schedule control (project control). AACE continued its pioneering work and in

2006 released the first integrated process for portfolio, program and project management (Total Cost

Management Framework).

The International Project Management Association (IPMA) was founded in Europe in 1967,[13] as a

federation of several national project management associations. IPMA maintains its federal structure

today and now includes member associations on every continent except Antarctica. IPMA offers a

Four Level Certification program based on the IPMA Competence Baseline (ICB).[14] The ICB covers

technical competences, contextual competences, and behavioral competences.

In 1969, the Project Management Institute (PMI) was formed in the USA.[15] PMI publishes A Guide to

the Project Management Body of Knowledge (PMBOK Guide), which describes project management

practices that are common to "most projects, most of the time." PMI also offers multiple certifications.

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The American Academy of Project Management (AAPM) International Board of Standards 1996 was

the first to institute post-graduate certifications such as the MPM Master Project Manager, PME

Project Management E-Business, CEC Certified-Ecommerce Consultant, and CIPM Certified

International Project Manager. The AAPM also issues the post-graduate standards body of knowledge

for executives.

[edit]Approaches

There are a number of approaches to managing project activities including agile, interactive,

incremental, and phased approaches.

Regardless of the methodology employed, careful consideration must be given to the overall project

objectives, timeline, and cost, as well as the roles and responsibilities of all participants and

stakeholders.

[edit]The traditional approach

A traditional phased approach identifies a sequence of steps to be completed. In the "traditional

approach", we can distinguish 5 components of a project (4 stages plus control) in the development of

a project:

Typical development phases of a engineering project

Project initiation stage;

Project planning  and design stage;

Project execution and construction stage;

Project monitoring and controlling systems;

Project completion.

Not all the projects will visit every stage as projects can be terminated before they reach completion.

Some projects do not follow a structured planning and/or monitoring stages. Some projects will go

through steps 2, 3 and 4 multiple times.

Many industries use variations on these project stages. For example, when working on a brick and

mortar design and construction, projects will typically progress through stages like Pre-Planning,

Conceptual Design, Schematic Design, Design Development, Construction Drawings (or Contract

Documents), and Construction Administration. In software development, this approach is often known

as the waterfall model,[16] i.e., one series of tasks after another in linear sequence. In software

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development many organizations have adapted the Rational Unified Process (RUP) to fit this

methodology, although RUP does not require or explicitly recommend this practice. Waterfall

development works well for small, well defined projects, but often fails in larger projects of undefined

and ambiguous nature. The Cone of Uncertainty explains some of this as the planning made on the

initial phase of the project suffers from a high degree of uncertainty. This becomes especially true as

software development is often the realization of a new or novel product. In projects

where requirements have not been finalized and can change, requirements management is used to

develop an accurate and complete definition of the behavior of software that can serve as the basis

for software development.[17] While the terms may differ from industry to industry, the actual stages

typically follow common steps to problem solving — "defining the problem, weighing options, choosing

a path, implementation and evaluation."

[edit]Critical Chain Project Management

Critical Chain Project Management (CCPM) is a method of planning and managing projects that puts

more emphasis on the resources (physical and human) needed in order to execute project tasks. The

most complex part involves engineering professionals of different fields (Civil, Electrical, Mechanical

etc) working together. It is an application of the Theory of Constraints (TOC) to projects. The goal is to

increase the rate of throughput (or completion rates) of projects in an organization. Applying the first

three of the five focusing steps of TOC, the system constraint for all projects is identified as are the

resources. To exploit the constraint, tasks on the critical chain are given priority over all other

activities. Finally, projects are planned and managed to ensure that the resources are ready when the

critical chain tasks must start, subordinating all other resources to the critical chain.

Regardless of project type, the project plan should undergo Resource Leveling, and the longest

sequence of resource-constrained tasks should be identified as the critical chain. In multi-project

environments, resource leveling should be performed across projects. However, it is often enough to

identify (or simply select) a single "drum" resource—a resource that acts as a constraint across

projects—and stagger projects based on the availability of that single resource.

Planning and feedback loops inExtreme Programming (XP) with the time frames of the multiple loops.

[edit]Extreme Project Management

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In critical studies of Project Management, it has been noted that several of these

fundamentally PERT-based models are not well suited for the multi-project company environment of

today.[citation needed] Most of them are aimed at very large-scale, one-time, non-routine projects, and

nowadays all kinds of management are expressed in terms of projects.

Using complex models for "projects" (or rather "tasks") spanning a few weeks has been proven to

cause unnecessary costs and low maneuverability in several cases[citation needed]. Instead, project

management experts try to identify different "lightweight" models, such as Agile Project

Managementmethods including Extreme Programming for software development

and Scrum techniques.

The generalization of Extreme Programming to other kinds of projects is extreme project

management, which may be used in combination with theprocess modeling and management

principles of human interaction management.

[edit]Event chain methodology

Event chain methodology is another method that complements critical path method and critical

chain project management methodologies.

Event chain methodology is an uncertainty modeling and schedule network analysis technique that is

focused on identifying and managing events and event chains that affect project schedules. Event

chain methodology helps to mitigate the negative impact of psychological heuristics and biases, as

well as to allow for easy modeling of uncertainties in the project schedules. Event chain methodology

is based on the following principles.

Probabilistic moment of risk: An activity (task) in most real life processes is not a continuous

uniform process. Tasks are affected by external events, which can occur at some point in the

middle of the task.

Event chains: Events can cause other events, which will create event chains. These event

chains can significantly affect the course of the project. Quantitative analysis is used to determine

a cumulative effect of these event chains on the project schedule.

Critical events or event chains: The single events or the event chains that have the most

potential to affect the projects are the “critical events” or “critical chains of events.” They can be

determined by the analysis.

Project tracking with events: Even if a project is partially completed and data about the project

duration, cost, and events occurred is available, it is still possible to refine information about future

potential events and helps to forecast future project performance.

Event chain visualization: Events and event chains can be visualized using event chain

diagrams on a Gantt chart.

[edit]PRINCE2

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The PRINCE2 process model

PRINCE2 is a structured approach to project management, released in 1996 as a generic project

management method.[18] It combined the original PROMPT methodology (which evolved into the

PRINCE methodology) with IBM's MITP (managing the implementation of the total project)

methodology. PRINCE2 provides a method for managing projects within a clearly defined framework.

PRINCE2 describes procedures to coordinate people and activities in a project, how to design and

supervise the project, and what to do if the project has to be adjusted if it does not develop as

planned.

In the method, each process is specified with its key inputs and outputs and with specific goals and

activities to be carried out. This allows for automatic control of any deviations from the plan. Divided

into manageable stages, the method enables an efficient control of resources. On the basis of close

monitoring, the project can be carried out in a controlled and organized way.

PRINCE2 provides a common language for all participants in the project. The various management

roles and responsibilities involved in a project are fully described and are adaptable to suit the

complexity of the project and skills of the organization.

[edit]Process-based management

Capability Maturity Model, predecessor of theCMMI Model

Also furthering the concept of project control is the incorporation of process-based management. This

area has been driven by the use of Maturity models such as the CMMI (Capability Maturity Model

Integration) and ISO/IEC15504 (SPICE - Software Process Improvement and Capability Estimation).

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Agile Project Management approaches based on the principles of human interaction management are

founded on a process view of human collaboration. This contrasts sharply with the traditional

approach. In the agile software development or flexible product developmentapproach, the project is

seen as a series of relatively small tasks conceived and executed as the situation demands in an

adaptive manner, rather than as a completely pre-planned process.

[edit]Processes

This section relies largely or entirely upon a single source. Please help improve this articleby introducing appropriate citations to additional sources. (August 2010)

Traditionally, project management includes a number of elements: four to five process groups, and a

control system. Regardless of the methodology or terminology used, the same basic project

management processes will be used.

The project development stages[19]

Major process groups generally include:

Initiation

Planning or development

Production or execution

Monitoring and controlling

Closing

In project environments with a significant exploratory element (e.g., Research and development),

these stages may be supplemented with decision points (go/no go decisions) at which the project's

continuation is debated and decided. An example is the Stage-Gate model.

[edit]Initiation

Initiating Process Group Processes[19]

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The initiation processes determine the nature and scope of the project. If this stage is not performed

well, it is unlikely that the project will be successful in meeting the business’ needs. The key project

controls needed here are an understanding of the business environment and making sure that all

necessary controls are incorporated into the project. Any deficiencies should be reported and a

recommendation should be made to fix them.

The initiation stage should include a plan that encompasses the following areas:

Analyzing the business needs/requirements in measurable goals

Reviewing of the current operations

Financial analysis  of the costs and benefits including a budget

Stakeholder analysis , including users, and support personnel for the project

Project charter  including costs, tasks, deliverables, and schedule

[edit]Planning and design

Planning Process Group Activities[19]

After the initiation stage, the project is planned to an appropriate level of detail. The main purpose is

to plan time, cost and resources adequately to estimate the work needed and to effectively manage

risk during project execution. As with the Initiation process group, a failure to adequately plan greatly

reduces the project's chances of successfully accomplishing its goals.

Project planning generally consists of

determining how to plan (e.g. by level of detail or rolling wave);

developing the scope statement;

selecting the planning team;

identifying deliverables and creating the work breakdown structure;

identifying the activities needed to complete those deliverables and networking the activities in

their logical sequence;

estimating the resource requirements for the activities;

estimating time and cost for activities;[20]

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developing the schedule;

developing the budget;

risk planning;

gaining formal approval to begin work.

Additional processes, such as planning for communications and for scope management, identifying

roles and responsibilities, determining what to purchase for the project and holding a kick-off meeting

are also generally advisable.

For new product development projects, conceptual design of the operation of the final product may be

performed concurrent with the project planning activities, and may help to inform the planning team

when identifying deliverables and planning activities.

[edit]Executing

Executing Process Group Processes[19]

Executing consists of the processes used to complete the work defined in the project management

plan to accomplish the project's requirements. Execution process involves coordinating people and

resources, as well as integrating and performing the activities of the project in accordance with the

project management plan. The deliverables are produced as outputs from the processes performed

as defined in the project management plan.

[edit]Monitoring and controlling

Monitoring and controlling consists of those processes performed to observe project execution so that

potential problems can be identified in a timely manner and corrective action can be taken, when

necessary, to control the execution of the project. The key benefit is that project performance is

observed and measured regularly to identify variances from the project management plan.

Monitoring and Controlling Process Group Processes[19]

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Monitoring and Controlling includes:

Measuring the ongoing project activities ('where we are');

Monitoring the project variables (cost, effort, scope, etc.) against the project management plan

and the project performance baseline (where we should be);

Identify corrective actions to address issues and risks properly (How can we get on track again);

Influencing the factors that could circumvent integrated change control so only approved changes

are implemented

In multi-phase projects, the monitoring and controlling process also provides feedback between

project phases, in order to implement corrective or preventive actions to bring the project into

compliance with the project management plan.

Project Maintenance is an ongoing process, and it includes:

Continuing support of end users

Correction of errors

Updates of the software over time

Monitoring and Controlling cycle

In this stage, auditors should pay attention to how effectively and quickly user problems are resolved.

Over the course of any construction project, the work scope may change. Change is a normal and

expected part of the construction process. Changes can be the result of necessary design

modifications, differing site conditions, material availability, contractor-requested changes, value

engineering and impacts from third parties, to name a few. Beyond executing the change in the field,

the change normally needs to be documented to show what was actually constructed. This is referred

to as Change Management. Hence, the owner usually requires a final record to show all changes or,

more specifically, any change that modifies the tangible portions of the finished work. The record is

made on the contract documents – usually, but not necessarily limited to, the design drawings. The

end product of this effort is what the industry terms as-built drawings, or more simply, “as built.” The

requirement for providing them is a norm in construction contracts.

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When changes are introduced to the project, the viability of the project has to be re-assessed. It is

important not to lose sight of the initial goals and targets of the projects. When the changes

accumulate, the forecasted result may not justify the original proposed investment in the project.

[edit]Closing

Closing Process Group Processes.[19]

Closing includes the formal acceptance of the project and the ending thereof. Administrative activities

include the archiving of the files and documenting lessons learned.

This phase consists of:

Project close: Finalize all activities across all of the process groups to formally close the project

or a project phase

Contract closure: Complete and settle each contract (including the resolution of any open items)

and close each contract applicable to the project or project phase.

[edit]Project control systems

Project control is that element of a project that keeps it on-track, on-time and within budget. Project

control begins early in the project with planning and ends late in the project with post-implementation

review, having a thorough involvement of each step in the process. Each project should be assessed

for the appropriate level of control needed: too much control is too time consuming, too little control is

very risky. If project control is not implemented correctly, the cost to the business should be clarified in

terms of errors, fixes, and additional auditfees.

Control systems are needed for cost, risk, quality, communication, time, change, procurement, and

human resources. In addition, auditors should consider how important the projects are to the financial

statements, how reliant the stakeholders are on controls, and how many controls exist. Auditors

should review the development process and procedures for how they are implemented. The process

of development and the quality of the final product may also be assessed if needed or requested. A

business may want the auditing firm to be involved throughout the process to catch problems earlier

on so that they can be fixed more easily. An auditor can serve as a controls consultant as part of the

development team or as an independent auditor as part of an audit.

Businesses sometimes use formal systems development processes. These help assure that systems

are developed successfully. A formal process is more effective in creating strong controls, and

auditors should review this process to confirm that it is well designed and is followed in practice. A

good formal systems development plan outlines:

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A strategy to align development with the organization’s broader objectives

Standards for new systems

Project management policies for timing and budgeting

Procedures describing the process

Evaluation of quality of change

[edit]Topics

[edit]Project managers

A project manager is a professional in the field of project management. Project managers can have

the responsibility of the planning, execution, and closing of any project, typically relating

to construction industry, engineering, architecture, computing, or telecommunications. Many other

fields in the production engineering and design engineering and heavy industrial also have project

managers.

A project manager is the person accountable for accomplishing the stated project objectives. Key

project management responsibilities include creating clear and attainable project objectives, building

the project requirements, and managing the triple constraint for projects, which is cost, time, and

scope.

A project manager is often a client representative and has to determine and implement the exact

needs of the client, based on knowledge of the firm they are representing. The ability to adapt to the

various internal procedures of the contracting party, and to form close links with the nominated

representatives, is essential in ensuring that the key issues of cost, time, quality and above all, client

satisfaction, can be realized.

[edit]Project Management Triangle

The Project Management Triangle.

Like any human undertaking, projects need to be performed and delivered under certain constraints.

Traditionally, these constraints have been listed as "scope," "time," and "cost".[1] These are also

referred to as the "Project Management Triangle", where each side represents a constraint. One side

of the triangle cannot be changed without affecting the others. A further refinement of the constraints

separates product "quality" or "performance" from scope, and turns quality into a fourth constraint.

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The time constraint refers to the amount of time available to complete a project. The cost constraint

refers to the budgeted amount available for the project. The scope constraint refers to what must be

done to produce the project's end result. These three constraints are often competing constraints:

increased scope typically means increased time and increased cost, a tight time constraint could

mean increased costs and reduced scope, and a tight budget could mean increased time and reduced

scope.

The discipline of Project Management is about providing the tools and techniques that enable the

project team (not just the project manager) to organize their work to meet these constraints.

[edit]Work Breakdown Structure

Example of a Work breakdown structureapplied in a NASA reporting structure.[21]

The Work Breakdown Structure (WBS) is a tree structure, which shows a subdivision of effort required

to achieve an objective; for example a program, project, and contract. The WBS may

be hardware, product, service, or process oriented.

A WBS can be developed by starting with the end objective and successively subdividing it into

manageable components in terms of size, duration, and responsibility (e.g., systems, subsystems,

components, tasks, subtasks, and work packages), which include all steps necessary to achieve the

objective.[17]

The Work Breakdown Structure provides a common framework for the natural development of the

overall planning and control of a contract and is the basis for dividing work into definable increments

from which the statement of work can be developed and technical, schedule, cost, and labor hour

reporting can be established.[21]

[edit]Project Management Framework

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Example of an IT Project Management Framework.[19]

The Program (Investment) Life Cycle integrates the project management and system development life

cycles with the activities directly associated with system deployment and operation. By design, system

operation management and related activities occur after the project is complete and are not

documented within this guide.[19]

For example, see figure, in the US United States Department of Veterans Affairs (VA) the program

management life cycle is depicted and describe in the overall VA IT Project Management Framework

to address the integration of OMB Exhibit 300 project (investment) management activities and the

overall project budgeting process. The VA IT Project Management Framework diagram illustrates

Milestone 4 which occurs following the deployment of a system and the closing of the project. The

project closing phase activities at the VA continues through system deployment and into system

operation for the purpose of illustrating and describing the system activities the VA considers part of

the project. The figure illustrates the actions and associated artifacts of the VA IT Project and Program

Management process.[19]

[edit]International standards

There have been several attempts to develop Project Management standards, such as:

Capability Maturity Model  from the Software Engineering Institute.

GAPPS, Global Alliance for Project Performance Standards- an open source standard describing

COMPETENCIES for project and program managers.

A Guide to the Project Management Body of Knowledge

HERMES method , Swiss general project management method, selected for use in Luxembourg

and international organizations.

The ISO standards ISO 9000, a family of standards for quality management systems, and the ISO

10006:2003, for Quality management systems and guidelines for quality management in projects.

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PRINCE2 , PRojects IN Controlled Environments.

Team Software Process  (TSP) from the Software Engineering Institute.

Total Cost Management  Framework, AACE International's Methodology for Integrated Portfolio,

Program and Project Management)

V-Model , an original systems development method.

The Logical framework approach, which is popular in international development organizations.

IAPPM , The International Association of Project & Program Management, guide to Project

Auditing and Rescuing Troubled Projects.

[edit]Project portfolio management

An increasing number of organizations are using, what is referred to as, project portfolio

management (PPM) as a means of selecting the right projects and then using project management

techniques[22] as the means for delivering the outcomes in the form of benefits to the performing

private or not-for-profit organization.

Project management methods are used 'to do projects right' and the methods used in PPM are used

'to do the right projects'. In effect PPM is becoming the method of choice for selection and prioritising

among resource inter-related projects in many industries and sectors.[citation needed]

Project Portfolio Management (PPM) is a term used by project managers and project

management (PM) organizations to describe methods for analyzing and collectively managing a group

of current or proposed projects based on numerous key characteristics. The fundamental objective of

PPM is to determine the optimal mix and sequencing of proposed projects to best achieve the

organization's overall goals - typically expressed in terms of hard economic measures, business

strategy goals, or technical strategy goals - while honoring constraints imposed by management or

external real-world factors. Typical attributes of projects being analyzed in a PPM process include

each project's total expected cost, consumption of scarce resources (human or otherwise) expected

timeline and schedule of investment, expected nature, magnitude and timing of benefits to be

realized, and relationship or inter-dependencies with other projects in the portfolio.

The key challenge to implementing an effective PPM process is typically securing the mandate to do

so. Many organizations are culturally inured to an informal method of making project investment

decisions, which can be compared to political processes observable in the U.S. legislature.[citation

needed] However this approach to making project investment decisions has led many organizations to

unsatisfactory results, and created demand for a more methodical and transparent decision making

process. That demand has in turn created a commercial marketplace for tools and systems which

facilitate such a process.

Some commercial vendors of PPM software emphasize their products' ability to treat projects as part

of an overall investment portfolio. PPM advocates see it as a shift away from one-off, ad hoc

approaches to project investment decision making. Most PPM tools and methods attempt to establish

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a set of values, techniques and technologies that enable visibility, standardization, measurement and

process improvement. PPM tools attempt to enable organizations to manage the continuous flow of

projects from concept to completion.

Treating a set of projects as a portfolio would be, in most cases, an improvement on the ad hoc, one-

off analysis of individual project proposals. The relationship between PPM techniques and existing

investment analysis methods is a matter of debate. While many are represented as "rigorous" and

"quantitative", few PPM tools attempt to incorporate established financial portfolio optimization

methods like modern portfolio theory or Applied Information Economics, which have been applied to

project portfolios, including even non-financial issues.[1][2][3][4]

Controversy over the "investment discipline" of PPM

Developers of PPM tools see their solutions as borrowing from the financial investment world.

However, other than using the word "portfolio", few can point to any specific portfolio optimization

methods implemented in their tools.

A project can be viewed as a composite of resource investments such as skilled labour and

associated salaries, IT hardware and software, and the opportunity cost of deferring other project

work. As project resources are constrained, business management can derive greatest value by

allocating these resources towards project work that is objectively and relatively determined to meet

business objectives more so than other project opportunities. Thus, the decision to invest in a project

can be made based upon criteria that measures the relative benefits (eg. supporting business

objectives) and its relative costs and risks to the organization.

In principle, PPM attempts to address issues of resource allocation, e.g., money, time, people,

capacity, etc. In order for it to truly borrow concepts from the financial investment world, the portfolio

of projects and hence the PPM movement should be grounded in some financial objective such as

increasing shareholder value, top line growth, etc. Equally important, risks must be computed in a

statistically, actuarially meaningful sense. Optimizing resources and projects without these in mind

fails to consider the most important resource any organization has and which is easily understood by

people throughout the organization whether they be IT, finance, marketing, etc and that resource is

money.

While being tied largely to IT and fairly synonymous with IT portfolio management, PPM is ultimately a

subset of corporate portfolio management and should be exportable/utilized by any group selecting

and managing discretionary projects.[citation needed] However, most PPM methods and tools opt for various

subjective weighted scoring methods, not quantitatively rigorous methods based on options

theory, modern portfolio theory, Applied Information Economics or operations research.

Beyond the project investment decision, PPM aims to support ongoing measurement of the project

portfolio so each project can be monitored for its relative contribution to business goals. If a project is

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either performing below expectations (cost overruns, benefit erosion) or is no longer highly aligned to

business objectives (which change with natural market and statutory evolution), management can

choose to decommit from a project and redirect its resources elsewhere. This analysis, done

periodically, will "refresh" the portfolio to better align with current states and needs.

Historically, many organizations were criticized for focusing on "doing the wrong things well." PPM

attempts to focus on a fundamental question: "Should we be doing this project or this portfolio of

projects at all?" One litmus test for PPM success is to ask "Have you ever canceled a project that was

on time and on budget?" With a true PPM approach in place, it is much more likely that the answer is

"yes." As goals change so should the portfolio mix of what projects are funded or not funded no matter

where they are in their individual lifecycles. Making these portfolio level business investment decisions

allows the organization to free up resources, even those on what were before considered "successful"

projects, to then work on what is really important to the organization.

[edit]Optimizing for payoff

One method PPM tools or consultants might use is the use of decision trees with decision nodes that

allow for multiple options and optimize against a constraint. The organization in the following example

has options for 7 projects but the portfolio budget is limited to $10,000,000. The selection made are

the projects 1, 3, 6 and 7 with a total investment of $7,740,000 - the optimum under these conditions.

The portfolio's payoff is $2,710,000.

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Presumably, all other combinations of projects would either exceed the budget or yield a lower payoff.

However, this is an extremely simplified representation of risk and is unlikely to be realistic. Risk is

usually a major differentiator among projects but it is difficult to quantify risk in a statistically and

actuarially meaningful manner (with probability theory, Monte Carlo Method, statistical analysis, etc.).

This places limits on the deterministic nature of the results of a tool such as a decision tree (as

predicted by modern portfolio theory).

[edit]Resource allocation

Resource allocation is a critical component of PPM. Once it is determined that one or many projects

meet defined objectives, the available resources of an organization must be evaluated for its ability to

meet project demand (aka as a demand "pipeline" discussed below). Effective resource allocation

typically requires an understanding of existing labor or funding resource commitments (in either

business operations or other projects) as well as the skills available in the resource pool. Project

investment should only be made in projects where the necessary resources are available during a

specified period of time.

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Resources may be subject to physical constraints. For example, IT hardware may not be readily

available to support technology changes associated with ideal implementation timeframe for a project.

Thus, a holistic understanding of all project resources and their availability must be conjoined with the

decision to make initial investment or else projects may encounter substantial risk during their lifecycle

when unplanned resource constraints arise to delay achieving project objectives.

Beyond the project investment decision, PPM involves ongoing analysis of the project portfolio so

each investment can be monitored for its relative contribution to business goals versus other portfolio

investments. If a project is either performing below expectations (cost overruns, benefit erosion) or is

no longer aligned to business objectives (which change with natural market and statutory evolution),

management can choose to decommit from a project to stem further investment and redirect

resources towards other projects that better fit business objectives. This analysis can typically be

performed on a periodic basis (eg. quarterly or semi-annually) to "refresh" the portfolio for optimal

business performance. In this way both new and existing projects are continually monitored for their

contributions to overall portfolio health. If PPM is applied in this manner, management can more

clearly and transparently demonstrate its effectiveness to its shareholders or owners.

Implementing PPM at the enterprise level faces a challenge in gaining enterprise support because

investment decision criteria and weights must be agreed to by the key stakeholders of the

organization, each of whom may be incentivised to meet specific goals that may not necessarily align

with those of the entire organization. But if enterprise business objectives can be manifested in and

aligned with the objectives of its distinct business unit sub-organizations, portfolio criteria agreement

can be achieved more easily. (Assadourian 2005)

From a requirements management perspective Project Portfolio Management can be viewed as the

upper-most level of business requirements management in the company, seeking to understand the

business requirements of the company and what portfolio of projects should be undertaken to achieve

them. It is through portfolio management that each individual project should receive its allotted

business requirements (Denney 2005).

[edit]Pipeline management

In addition to managing the mix of projects in a company, Project Portfolio Management must also

determine whether (and how) a set of projects in the portfolio can be executed by a company in a

specified time, given finite development resources in the company. This is called pipeline

management. Fundamental to pipeline management is the ability to measure the planned allocation of

development resources according to some strategic plan. To do this, a company must be able to

estimate the effort planned for each project in the portfolio, and then roll the results up by one or more

strategic project types e.g., effort planned for research projects. (Cooper et al. 1998); (Denney 2005)

discusses project portfolio and pipeline management in the context of use case driven development.

[edit]Organizational applicability

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The complexity of PPM and other approaches to IT projects (e.g., treating them as a capital

investment) may render them not suitable for smaller or younger organizations. An obvious reason for

this is that a few IT projects doesn't make for much of a portfolio selection. Other reasons include the

cost of doing PPM—the data collection, the analysis, the documentation, the education, and the

change to decision-making processes.

Modern portfolio theoryFrom Wikipedia, the free encyclopedia

Modern portfolio theory (MPT) is a theory of investment which attempts to maximize portfolio

expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of

expected return, by carefully choosing the proportions of various assets. Although MPT is widely used in

practice in the financial industry and several of its creators won a Nobel prize for the theory, in recent years

the basic assumptions of MPT have been widely challenged by fields such as behavioral economics .

MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a

collection of investment assets that has collectively lower risk than any individual asset. That this is

possible can be seen intuitively because different types of assets often change in value in opposite ways.

For example, when prices in the stock market fall, prices in the bond market often increase, and vice

versa[citation needed]. A collection of both types of assets can therefore have lower overall risk than either

individually. But diversification lowers risk even if assets' returns are not negatively correlated—indeed,

even if they are positively correlated.

More technically, MPT models an asset's return as a normally distributed (or more generally as

an elliptically distributed random variable), defines risk as the standard deviation of return, and models a

portfolio as a weighted combination of assets so that the return of a portfolio is the weighted combination of

the assets' returns. By combining different assets whose returns are not perfectly positively correlated,

MPT seeks to reduce the total variance of the portfolio return. MPT also assumes that investors

are rational and markets are efficient.

MPT was developed in the 1950s through the early 1970s and was considered an important advance in the

mathematical modeling of finance. Since then, many theoretical and practicalcriticisms have been leveled

against it. These include the fact that financial returns do not follow a Gaussian distribution or indeed any

symmetric distribution, and that correlations between asset classes are not fixed but can vary depending on

external events (especially in crises). Further, there is growing evidence that investors are not rational and

markets are notefficient.[1][2]

Concept

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The fundamental concept behind MPT is that the assets in an investment portfolio cannot be selected individually, each on their own merits. Rather, it is important to consider how each asset changes in price relative to how every other asset in the portfolio changes in price.

Investing is a tradeoff between risk and expected return. In general, assets with higher expected returns are riskier. For a given amount of risk, MPT describes how to select a portfolio with the highest possible expected return. Or, for a given expected return, MPT explains how to select a portfolio with the lowest possible risk (the targeted expected return cannot be more than the highest-returning available security, of course, unless negative holdings of assets are possible.)[3]

MPT is therefore a form of diversification. Under certain assumptions and for specific quantitative definitions of risk and return, MPT explains how to find the best possible diversification strategy.

[edit]History

Harry Markowitz introduced MPT in a 1952 article[4] and a 1959 book.[5] See also[3].

[edit]Mathematical model

In some sense the mathematical derivation below is MPT, although the basic concepts behind the model have also been very influential.[3]

This section develops the "classic" MPT model. There have been many extensions since.

[edit]Risk and expected return

MPT assumes that investors are risk averse, meaning that given two portfolios that offer the same expected return, investors will prefer the less risky one. Thus, an investor will take on increased risk only if compensated by higher expected returns. Conversely, an investor who wants higher expected returns must accept more risk. The exact trade-off will be the same for all investors, but different investors will evaluate the trade-off differently based on individual risk aversion characteristics. The implication is that a rational investor will not invest in a portfolio if a second portfolio exists with a more favorable risk-expected return profile – i.e., if for that level of risk an alternative portfolio exists which has better expected returns.

Note that the theory uses standard deviation of return as a proxy for risk. There are problems with this, however; see criticism.

Under the model:

Portfolio return is the proportion-weighted combination of the constituent assets' returns.

Portfolio volatility is a function of the correlations ρij of the component assets, for all asset pairs (i, j).

In general:

Expected return:

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where Rp is the return on the portfolio, Ri is the return on asset i and wi is the weighting of component asset i (that is, the share of asset i in the portfolio).

Portfolio return variance:

where ρij is the correlation coefficient between the returns on assets i and j. Alternatively the expression can be written as:

,

where ρij = 1 for i=j.

Portfolio return volatility (standard deviation):

For a two asset portfolio:

Portfolio return:

Portfolio variance:

For a three asset portfolio:

Portfolio return:

Portfolio variance:

[edit]Diversification

An investor can reduce portfolio risk simply by holding combinations of instruments which are not

perfectly positively correlated (correlation coefficient )). In other words, investors can reduce their exposure to individual asset risk by holding a diversified portfolio of assets. Diversification may allow for the same portfolio expected return with reduced risk.

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If all the asset pairs have correlations of 0—they are perfectly uncorrelated—the portfolio's return variance is the sum over all assets of the square of the fraction held in the asset times the asset's return variance (and the portfolio standard deviation is the square root of this sum).

[edit]The efficient frontier with no risk-free asset

Efficient Frontier. The hyperbola is sometimes referred to as the 'Markowitz Bullet', and is the efficient frontier if no risk-free asset is available.

As shown in this graph, every possible combination of the risky assets, without including any holdings of the risk-free asset, can be plotted in risk-expected return space, and the collection of all such possible portfolios defines a region in this space. The left boundary of this region is a hyperbola,[6] and the upper edge of this region is the efficient frontier in the absence of a risk-free asset (sometimes called "the Markowitz bullet"). Combinations along this upper edge represent portfolios (including no holdings of the risk-free asset) for which there is lowest risk for a given level of expected return. Equivalently, a portfolio lying on the efficient frontier represents the combination offering the best possible expected return for given risk level.

Matrices are preferred for calculations of the efficient frontier. In matrix form, for a given "risk

tolerance" , the efficient frontier is found by minimizing the following expression:

wTΣw − q * RTw

where

w is a vector of portfolio weights and

∑ wi = 1.

i

(The weights can be negative, which means investors can short a security.);

Σ is the covariance matrix for the returns on the assets in the portfolio;

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is a "risk tolerance" factor, where 0 results in the portfolio with minimal risk and results in the portfolio infinitely far out the frontier with both expected return and risk unbounded; and

R is a vector of expected returns.

wTΣw is the variance of portfolio return.

RTw is the expected return on the portfolio.

The above optimization finds the point on the frontier at which the inverse of the slope of the frontier would be q if portfolio return variance instead of standard deviation were plotted horizontally. The frontier in its entirely is parametric on q.

Many software packages, including Microsoft Excel, MATLAB, Mathematica and R, provide optimization routines suitable for the above problem.

An alternative approach to specifying the efficient frontier is to do so parametrically on expected portfolio return RTw. This version of the problem requires that we minimize

wTΣw

subject to

RTw = μ

for parameter μ. This problem is easily solved using a Lagrange multiplier.

[edit]The two mutual fund theorem

One key result of the above analysis is the two mutual fund theorem.[6] This theorem states that any portfolio on the efficient frontier can be generated by holding a combination of any two given portfolios on the frontier; the latter two given portfolios are the "mutual funds" in the theorem's name. So in the absence of a risk-free asset, an investor can achieve any desired efficient portfolio even if all that is accessible is a pair of efficient mutual funds. If the location of the desired portfolio on the frontier is between the locations of the two mutual funds, both mutual funds will be held in positive quantities. If the desired portfolio is outside the range spanned by the two mutual funds, then one of the mutual funds must be sold short (held in negative quantity) while the size of the investment in the other mutual fund must be greater than the amount available for investment (the excess being funded by the borrowing from the other fund).

[edit]The risk-free asset and the capital allocation line

Main article: Capital allocation line

The risk-free asset is the (hypothetical) asset which pays a risk-free rate. In practice, short-term government securities (such as US treasury bills) are used as a risk-free asset, because they pay a fixed rate of interest and have exceptionally low default risk. The risk-free asset has zero variance in returns (hence is risk-free); it is also uncorrelated with any other asset (by definition, since its

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variance is zero). As a result, when it is combined with any other asset, or portfolio of assets, the change in return is linearly related to the change in risk as the proportions in the combination vary.

When a risk-free asset is introduced, the half-line shown in the figure is the new efficient frontier. It is tangent to the hyperbola at the pure risky portfolio with the highest Sharpe ratio. Its horizontal intercept represents a portfolio with 100% of holdings in the risk-free asset; the tangency with the hyperbola represents a portfolio with no risk-free holdings and 100% of assets held in the portfolio occurring at the tangency point; points between those points are portfolios containing positive amounts of both the risky tangency portfolio and the risk-free asset; and points on the half-line beyond the tangency point are leveraged portfolios involving negative holdings of the risk-free asset (the latter has been sold short—in other words, the investor has borrowed at the risk-free rate) and an amount invested in the tangency portfolio equal to more the 100% of the investor's initial capital. This efficient half-line is called the capital allocation line (CAL), and its formula can be shown to be

In this formula P is the sub-portfolio of risky assets at the tangency with the Markowitz bullet, F is the risk-free asset, and C is a combination of portfolios P and F.

By the diagram, the introduction of the risk-free asset as a possible component of the portfolio has improved the range of risk-expected return combinations available, because everywhere except at the tangency portfolio the half-line gives a higher expected return than the hyperbola does at every possible risk level. The fact that all points on the linear efficient locus can be achieved by a combination of holdings of the risk-free asset and the tangency portfolio is known as the one mutual fund theorem,[6] where the mutual fund referred to is the tangency portfolio.

[edit]Asset pricing using MPT

The above analysis describes optimal behavior of an individual investor. Asset pricing theory builds on this analysis in the following way. Since everyone holds the risky assets in identical proportions to each other—namely in the proportions given by the tangency portfolio—in market equilibrium the risky assets' prices, and therefore their expected returns, will adjust so that the ratios in the tangecy portfolio are the same as the ratios in which the risky assets are supplied to the market. Thus relative supplies will equal relative demands. MPT derives the required expected return for a correctly priced asset in this context.

[edit]Systematic risk and specific risk

Specific risk is the risk associated with individual assets - within a portfolio these risks can be reduced through diversification (specific risks "cancel out"). Specific risk is also called diversifiable, unique, unsystematic, or idiosyncratic risk. Systematic risk (a.k.a. portfolio risk or market risk) refers to the risk common to all securities - except for selling short as noted below, systematic risk cannot be diversified away (within one market). Within the market portfolio, asset specific risk will be diversified away to the extent possible. Systematic risk is therefore equated with the risk (standard deviation) of the market portfolio.

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Since a security will be purchased only if it improves the risk-expected return characteristics of the market portfolio, the relevant measure of the risk of a security is the risk it adds to the market portfolio, and not its risk in isolation. In this context, the volatility of the asset, and its correlation with the market portfolio, are historically observed and are therefore given. (There are several approaches to asset pricing that attempt to price assets by modelling the stochastic properties of the moments of assets' returns - these are broadly referred to as conditional asset pricing models.)

Systematic risks within one market can be managed through a strategy of using both long and short positions within one portfolio, creating a "market neutral" portfolio.

[edit]Capital asset pricing model

Main article: Capital Asset Pricing Model

The asset return depends on the amount paid for the asset today. The price paid must ensure that the market portfolio's risk / return characteristics improve when the asset is added to it. The CAPM is a model which derives the theoretical required expected return (i.e., discount rate) for an asset in a market, given the risk-free rate available to investors and the risk of the market as a whole. The CAPM is usually expressed:

β, Beta, is the measure of asset sensitivity to a movement in the overall market; Beta is usually found via regression on historical data. Betas exceeding one signify more than average "riskiness" in the sense of the asset's contribution to overall portfolio risk; betas below one indicate a lower than average risk contribution.

is the market premium, the expected excess return of the market portfolio's expected return over the risk-free rate.

This equation can be statistically estimated using the following regression equation:

where αi is called the asset's alpha , βi is the asset's beta coefficient and SCL is the Securities Characteristics Line.

Once an asset's expected return, E(Ri), is calculated using CAPM, the future cash flows of the asset can be discounted to their present value using this rate to establish the correct price for the asset. A riskier stock will have a higher beta and will be discounted at a higher rate; less sensitive stocks will have lower betas and be discounted at a lower rate. In theory, an asset is correctly priced when its observed price is the same as its value calculated using the CAPM derived discount rate. If the observed price is higher than the valuation, then the asset is overvalued; it is undervalued for a too low price.

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(1) The incremental impact on risk and expected return when an additional risky asset, a, is added to the market portfolio, m, follows from the formulae for a two-asset portfolio. These results are used to derive the asset-appropriate discount rate.

Market portfolio's risk =

Hence, risk added to portfolio =

but since the weight of the asset will be relatively low,

i.e. additional risk =

Market portfolio's expected return =

Hence additional expected return =

(2) If an asset, a, is correctly priced, the improvement in its risk-to-expected return ratio achieved by adding it to the market portfolio, m, will at least match the gains of spending that money on an increased stake in the market portfolio. The assumption is that the investor will purchase the asset

with funds borrowed at the risk-free rate,Rf; this is rational if .

Thus:

i.e. :

i.e. :

is the “beta”, β -- the covariance between the asset's return and the market's return divided by the variance of the market return— i.e. the sensitivity of the asset price to movement in the market portfolio's value.

[edit]Criticism

Despite its theoretical importance, some people question whether MPT is an ideal investing strategy, because its model of financial markets does not match the real world in many ways.

[edit]Assumptions

The mathematical framework of MPT makes many assumptions about investors and markets. Some are explicit in the equations, such as the use of Normal distributions to model returns. Others are implicit, such as the neglect of taxes and transaction fees. None of these assumptions are entirely true, and each of them compromises MPT to some degree.

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Asset returns are (jointly) normally distributed random variables. In fact, it is frequently observed that returns in equity and other markets are not normally distributed. Large swings (3 to 6 standard deviations from the mean) occur in the market far more frequently than the normal distribution assumption would predict.[7] While the model can also be justified by assuming any return distribution which is jointly elliptical [8] [9] , all the joint elliptical distributions are symmetrical whereas asset returns empirically are not.

Correlations between assets are fixed and constant forever. Correlations depend on systemic relationships between the underlying assets, and change when these relationships change. Examples include one country declaring war on another, or a general market crash. During times of financial crisis all assets tend to become positively correlated, because they all move (down) together. In other words, MPT breaks down precisely when investors are most in need of protection from risk.

All investors aim to maximize economic utility (in other words, to make as much money as possible, regardless of any other considerations). This is a key assumption of the efficient market hypothesis, upon which MPT relies.

All investors are rational and risk-averse. This is another assumption of the efficient market hypothesis, but we now know from behavioral economics that market participants are not rational. It does not allow for "herd behavior" or investors who will accept lower returns for higher risk. Casino gamblers clearly pay for risk, and it is possible that some stock traders will pay for risk as well.

All investors have access to the same information at the same time. This also comes from the efficient market hypothesis. In fact, real markets contain information asymmetry,insider trading, and those who are simply better informed than others.

Investors have an accurate conception of possible returns, i.e., the probability beliefs of investors match the true distribution of returns. A different possibility is that investors' expectations are biased, causing market prices to be informationally inefficient. This possibility is studied in the field of behavioral finance, which uses psychological assumptions to provide alternatives to the CAPM such as the overconfidence-based asset pricing model of Kent Daniel, David Hirshleifer, and Avanidhar Subrahmanyam (2001).[10]

There are no taxes or transaction costs. Real financial products are subject both to taxes and transaction costs (such as broker fees), and taking these into account will alter the composition of the optimum portfolio. These assumptions can be relaxed with more complicated versions of the model.[citation needed]

All investors are price takers, i.e., their actions do not influence prices. In reality, sufficiently large sales or purchases of individual assets can shift market prices for that asset and others (via cross-elasticity of demand.) An investor may not even be able to assemble the theoretically optimal portfolio if the market moves too much while they are buying the required securities.

Any investor can lend and borrow an unlimited amount at the risk free rate of interest. In reality, every investor has a credit limit.

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All securities can be divided into parcels of any size. In reality, fractional shares usually cannot be bought or sold, and some assets have minimum orders sizes.

More complex versions of MPT can take into account a more sophisticated model of the world (such as one with non-normal distributions and taxes) but all mathematical models of finance still rely on many unrealistic premises.

[edit]MPT does not really model the market

The risk, return, and correlation measures used by MPT are based on expected values, which means that they are mathematical statements about the future (the expected value of returns is explicit in the above equations, and implicit in the definitions of variance and covariance.) In practice investors must substitute predictions based on historical measurements of asset return and volatility for these values in the equations. Very often such expected values fail to take account of new circumstances which did not exist when the historical data were generated.

More fundamentally, investors are stuck with estimating key parameters from past market data because MPT attempts to model risk in terms of the likelihood of losses, but says nothing about why those losses might occur. The risk measurements used are probabilistic in nature, not structural. This is a major difference as compared to many engineering approaches torisk management.

Options theory and MPT have at least one important conceptual difference from the probabilistic risk assessment done by nuclear power [plants]. A PRA is what economists would call a structural model. The components of a system and their relationships are modeled in Monte Carlo simulations. If valve X fails, it causes a loss of back pressure on pump Y, causing a drop in flow to vessel Z, and so on.

But in the Black-Scholes equation and MPT, there is no attempt to explain an underlying structure to price changes. Various outcomes are simply given probabilities. And, unlike the PRA, if there is no history of a particular system-level event like a liquidity crisis, there is no way to compute the odds of it. If nuclear engineers ran risk management this way, they would never be able to compute the odds of a meltdown at a particular plant until several similar events occurred in the same reactor design.

—Douglas W. Hubbard, 'The Failure of Risk Management', p. 67, John Wiley & Sons, 2009. ISBN 978-0-470-38795-5

Essentially, the mathematics of MPT view the markets as a collection of dice. By examining past market data we can develop hypotheses about how the dice are weighted, but this isn't helpful if the markets are actually dependent upon a much bigger and more complicated chaotic system -- the world. For this reason, accurate structural models of real financial markets are unlikely to be forthcoming because they would essentially be structural models of the entire world. Nonetheless there is growing awareness of the concept of systemic risk in financial markets, which should lead to more sophisticated market models.

Mathematical risk measurements are also useful only to the degree that they reflect investors' true concerns -- there is no point minimizing a variable that nobody cares about in practice. MPT uses the mathematical concept of variance to quantify risk, and this might be justified under the assumption

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of elliptically distributed returns such as normally distributed returns, but for general return distributions other risk measures (like coherent risk measures) might better reflect investors' true preferences.

In particular, variance is a symmetric measure that counts abnormally high returns as just as risky as abnormally low returns. Some would argue that, in reality, investors are only concerned about losses, and do not care about the dispersion or tightness of above-average returns. According to this view, our intuitive concept of risk is fundamentally asymmetric in nature.

MPT does not account for the social, environmental, strategic, or personal dimensions of investment decisions. It only attempts to maximize risk-adjusted returns, without regard to other consequences. In a narrow sense, its complete reliance on asset prices makes it vulnerable to all the standard market failures such as those arising from information asymmetry,externalities, and public goods. It also rewards corporate fraud and dishonest accounting. More broadly, a firm may have strategic or social goals that shape its investment decisions, and an individual investor might have personal goals. In either case, information other than historical returns is relevant.

See also socially-responsible investing, fundamental analysis.

[edit]Extensions

Since MPT's introduction in 1952, many attempts have been made to improve the model, especially by using more realistic assumptions.

Post-modern portfolio theory extends MPT by adopting non-normally distributed, asymmetric measures of risk. This helps with some of these problems, but not others.

Black-Litterman model optimization is an extension of unconstrained Markowitz optimization which incorporates relative and absolute `views' on inputs of risk and returns.

[edit]Other Applications

[edit]Applications to project portfolios and other "non-financial" assets

Some experts apply MPT to portfolios of projects and other assets besides financial instruments.[11] When MPT is applied outside of traditional financial portfolios, some differences between the different types of portfolios must be considered.

1. The assets in financial portfolios are, for practical purposes, continuously divisible while portfolios of projects like new software development are "lumpy". For example, while we can compute that the optimal portfolio position for 3 stocks is, say, 44%, 35%, 21%, the optimal position for an IT portfolio may not allow us to simply change the amount spent on a project. IT projects might be all or nothing or, at least, have logical units that cannot be separated. A portfolio optimization method would have to take the discrete nature of some IT projects into account.

2. The assets of financial portfolios are liquid can be assessed or re-assessed at any point in time while opportunities for new projects may be limited and may appear in limited windows of time and projects that have already been initiated cannot be abandoned

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without the loss of the sunk costs (i.e., there is little or no recovery/salvage value of a half-complete IT project).

Neither of these necessarily eliminate the possibility of using MPT and such portfolios. They simply indicate the need to run the optimization with an additional set of mathematically-expressed constraints that would not normally apply to financial portfolios.

Furthermore, some of the simplest elements of Modern Portfolio Theory are applicable to virtually any kind of portfolio. The concept of capturing the risk tolerance of an investor by documenting how much risk is acceptable for a given return could be and is applied to a variety of decision analysis problems. MPT, however, uses historical variance as a measure of risk and portfolios of assets like IT projects don't usually have an "historical variance" for a new piece of software. In this case, the MPT investment boundary can be expressed in more general terms like "chance of an ROI less than cost of capital" or "chance of losing more than half of the investment". When risk is put in terms of uncertainty about forecasts and possible losses then the concept is transferable to various types of investment.[11]

[edit]Application to other disciplines

In the 1970s, concepts from Modern Portfolio Theory found their way into the field of regional science. In a series of seminal works, Michael Conroy modeled the labor force in the economy using portfolio-theoretic methods to examine growth and variability in the labor force. This was followed by a long literature on the relationship between economic growth and volatility.[12]

More recently, modern portfolio theory has been used to model the self-concept in social psychology. When the self attributes comprising the self-concept constitute a well-diversified portfolio, then psychological outcomes at the level of the individual such as mood and self-esteem should be more stable than when the self-concept is undiversified. This prediction has been confirmed in studies involving human subjects.[13]

Recently, modern portfolio theory has been applied to modelling the uncertainty and correlation between documents in information retrieval. Given a query, the aim is to maximize the overall relevance of a ranked list of documents and at the same time minimize the overall uncertainty of the ranked list [1].

[edit]Comparison with arbitrage pricing theory

The SML and CAPM are often contrasted with the arbitrage pricing theory (APT), which holds that the expected return of a financial asset can be modeled as a linear function of variousmacro-economic factors, where sensitivity to changes in each factor is represented by a factor specific beta coefficient.

The APT is less restrictive in its assumptions: it allows for an explanatory (as opposed to statistical) model of asset returns, and assumes that each investor will hold a unique portfolio with its own particular array of betas, as opposed to the identical "market portfolio". Unlike the CAPM, the APT, however, does not itself reveal the identity of its priced factors - the number and nature of these factors is likely to change over time and between economies.

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Performance Attribution or Investment Performance Attribution is a set of techniques that

performance analysts use to explain why a portfolio's performance differed from the benchmark. This

difference between the portfolio return and the benchmark return is known as the active return. The

active return is the component of a portfolio's performance that arises from the fact that the portfolio is

actively managed.

Different kinds of performance attribution provide different ways of explaining the active return.

Simple example

Consider a portfolio whose benchmark consists of 30% cash and 70% equities. The following table

provides a consistent set of weights and returns for this example.

SectorPortfolio

WeightBenchmark

WeightPortfolio

ReturnBenchmark

ReturnAsset

AllocationStock

SelectionInteraction

Total Active

Equities 90% 70% 5.00% 3.00% 0.12% 1.40% 0.40% 1.92%Cash 10% 30% 1.00% 1.00% 0.28% 0.00% 0.00% 0.28%Total 100% 100% 4.60% 2.40% 0.40% 1.40% 0.40% 2.20%

The portfolio performance was 4.60%, compared with a benchmark return of 2.40%. This leaves an

active return of 2.20%. The task of performance attribution is to explain the decisions that the portfolio

manager took to generate this 2.20% of value added.

Under the most common paradigm for performance attribution, there are two different kinds of

decision that the portfolio manager can make in an attempt to produce added value:

1. Asset Allocation: the manager might choose to allocate 90% of the assets into equities

(leaving only 10% for cash), on the belief that equities will produce a higher return than cash.

2. Stock Selection: Especially within the equities sector, the manager may try to hold securities

that will give a higher return than the overall equity benchmark. In the example, the securities

selected by the equities manager produced an overall return of 5%, when the benchmark

return for equities was only 3%.

The attribution analysis dissects the value added into three components:

Asset allocation is the value added by under-weighting cash (0.28%), and over-weighting equities

(0.12%). The total value added by asset allocation was 0.40%.

Stock selection is the value added by decisions within each sector of the portfolio. In this case,

the superior stock selection in the equity sector added 1.40% to the portfolio's return.

Interaction captures the value added that is not attributable solely to the asset allocation and

stock selection decisions. In this particular case, there was 0.40% of value added from the

combination that the portfolio was overweight equities, and the equities sector also outperfomed

its benchmark.

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The three attribution terms (asset allocation, stock selection, and interaction) sum exactly to the active

return without the need for any "fudge factors".

[edit]History

In 1972, A Working Group of the Society of Investment Analysts (UK) published a paper about

analysing the performance of investment portfolios. This paper introduced the key concept in

performance attribution, that active performance can be analysed by comparing the returns of

different notional portfolios. In particular, if one examines the performance of a portfolio that holds

each sector at the active weight, while earning a passive return within each sector, one can measure

exactly the amount of value that is added by asset allocation decisions.

The 1972 paper introduced the key elements of modern performance attribution: notional portfolios,

asset allocation, and stock selection. The paper presents this analytic paradigm as an extension of

previously known concepts. Since it was not an academic publication, it did not claim novelty, even

though the approach introduced was new and novel. An excerpt from the paper reads:

The working group recommend that the notional fund concept be extended to cover the whole fund,

i.e. fixed interest, equity and cash investments and by using appropriate indices the actual fund is

compared with a notional fund chosen such that the proportions in the different investment sectors

follow those laid down by the trustees.

The 1972 paper is improperly ignored by many of the standard texts on performance attribution (for

example Spaulding 2003).

It is commonly believed that Gary P. Brinson's Brinson et al. 1985 introduced the idea of using

notional portfolios to attribute investment performance. For this reason, many of the standard texts

(e.g.Spaulding 2003)improperly make no acknowledgement of the 1972 paper, while devoting copious

numbers of pages to "Brinson Fachler attribution" (pp. 177-180.) and "Brinson Hood Beebower

attribution" (pp. 29-51).

[edit]Geometric attribution

The most common approach to performance attribution (found in sources such as Brinson et

al. 1985 and Carino 1999 ) can be described as "arithmetic attribution". It is arithmetic in the sense that

it describes the difference between the portfolio return and the benchmark return. For example, if the

portfolio return was 21%, and the benchmark return was 10%, arithmetic attribution would explain

11% of value added.

In Europe and the UK, another approach (known as geometric attribution) has been common. If the

portfolio return was 21% while the benchmark return was 10%, geometric attribution would explain an

active return of 10%. The reasoning behind this is that 10% of active return, when compounded with

10% of benchmark performance, produces a total portfolio return of 21%.

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Adherents of the geometric approach consider it to be highly intuitive. See, for example, Bacon

(2002). However, not everybody agrees on this.

One advantage of doing attribution in geometric form is that the attribution results translate

consistently from one currency to another. It is plausible that this explains the popularity of geometric

approaches in Europe. This is discussed further in the external link by Davies (undated).

Risk management is the identification, assessment, and prioritization of risks (defined in ISO

31000 as the effect of uncertainty on objectives, whether positive or negative) followed by coordinated

and economical application of resources to minimize, monitor, and control the probability and/or

impact of unfortunate events[1] or to maximize the realization of opportunities. Risks can come from

uncertainty in financial markets, project failures, legal liabilities, credit risk, accidents, natural causes

and disasters as well as deliberate attacks from an adversary. Several risk management standards

have been developed including the Project Management Institute, the National Institute of Science

and Technology, actuarial societies, and ISO standards.[2][3] Methods, definitions and goals vary widely

according to whether the risk management method is in the context of project management,

security, engineering, industrial processes, financial portfolios, actuarial assessments, or public health

and safety.

The strategies to manage risk include transferring the risk to another party, avoiding the risk, reducing

the negative effect of the risk, and accepting some or all of the consequences of a particular risk.

Certain aspects of many of the risk management standards have come under criticism for having no

measurable improvement on risk even though the confidence in estimates and decisions increase.[1]

Introduction

This section provides an introduction to the principles of risk management. The vocabulary of risk

management is defined in ISO Guide 73, "Risk management. Vocabulary."[2]

In ideal risk management, a prioritization process is followed whereby the risks with the greatest loss

and the greatest probability of occurring are handled first, and risks with lower probability of

occurrence and lower loss are handled in descending order. In practice the process can be very

difficult, and balancing between risks with a high probability of occurrence but lower loss versus a risk

with high loss but lower probability of occurrence can often be mishandled.

Intangible risk management identifies a new type of a risk that has a 100% probability of occurring but

is ignored by the organization due to a lack of identification ability. For example, when deficient

knowledge is applied to a situation, a knowledge risk materializes. Relationship risk appears when

ineffective collaboration occurs. Process-engagement risk may be an issue when ineffective

operational procedures are applied. These risks directly reduce the productivity of knowledge workers,

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decrease cost effectiveness, profitability, service, quality, reputation, brand value, and earnings

quality. Intangible risk management allows risk management to create immediate value from the

identification and reduction of risks that reduce productivity.

Risk management also faces difficulties in allocating resources. This is the idea of opportunity cost.

Resources spent on risk management could have been spent on more profitable activities. Again,

ideal risk management minimizes spending and minimizes the negative effects of risks.

[edit]Method

For the most part, these methods consist of the following elements, performed, more or less, in the

following order.

1. identify, characterize, and assess threats

2. assess the vulnerability of critical assets to specific threats

3. determine the risk (i.e. the expected consequences of specific types of attacks on specific

assets)

4. identify ways to reduce those risks

5. prioritize risk reduction measures based on a strategy

[edit]Principles of risk management

The International Organization for Standardization (ISO) identifies the following principles of risk

management:[4]

Risk management should:

create value

be an integral part of organizational processes

be part of decision making

explicitly address uncertainty

be systematic and structured

be based on the best available information

be tailored

take into account human factors

be transparent and inclusive

be dynamic, iterative and responsive to change

be capable of continual improvement and enhancement

[edit]Process

According to the standard ISO 31000 "Risk management -- Principles and guidelines on

implementation,"[3] the process of risk management consists of several steps as follows:

[edit]Establishing the context

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Establishing the context involves:

1. Identification of risk in a selected domain of interest

2. Planning the remainder of the process.

3. Mapping out the following:

the social scope of risk management

the identity and objectives of stakeholders

the basis upon which risks will be evaluated, constraints.

4. Defining a framework for the activity and an agenda for identification.

5. Developing an analysis of risks involved in the process.

6. Mitigation or Solution of risks using available technological, human and organizational

resources.

[edit]Identification

After establishing the context, the next step in the process of managing risk is to identify potential

risks. Risks are about events that, when triggered, cause problems. Hence, risk identification can start

with the source of problems, or with the problem itself.

Source analysis[citation needed] Risk sources may be internal or external to the system that is the

target of risk management.

Examples of risk sources are: stakeholders of a project, employees of a company or the weather over

an airport.

Problem analysis[citation needed] Risks are related to identified threats. For example: the threat of

losing money, the threat of abuse of privacy information or the threat of accidents and casualties.

The threats may exist with various entities, most important with shareholders, customers and

legislative bodies such as the government.

When either source or problem is known, the events that a source may trigger or the events that can

lead to a problem can be investigated. For example: stakeholders withdrawing during a project may

endanger funding of the project; privacy information may be stolen by employees even within a closed

network; lightning striking a Boeing 747 during takeoff may make all people onboard immediate

casualties.

The chosen method of identifying risks may depend on culture, industry practice and compliance. The

identification methods are formed by templates or the development of templates for identifying source,

problem or event. Common risk identification methods are:

Objectives-based risk identification[citation needed] Organizations and project teams have objectives.

Any event that may endanger achieving an objective partly or completely is identified as risk.

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Scenario-based risk identification In scenario analysis different scenarios are created. The

scenarios may be the alternative ways to achieve an objective, or an analysis of the interaction of

forces in, for example, a market or battle. Any event that triggers an undesired scenario

alternative is identified as risk - see Futures Studies for methodology used byFuturists.

Taxonomy-based risk identification The taxonomy in taxonomy-based risk identification is a

breakdown of possible risk sources. Based on the taxonomy and knowledge of best practices, a

questionnaire is compiled. The answers to the questions reveal risks.[5]

Common-risk checking In several industries, lists with known risks are available. Each risk in

the list can be checked for application to a particular situation.[6]

Risk charting[7] This method combines the above approaches by listing resources at risk, Threats

to those resources Modifying Factors which may increase or decrease the risk and

Consequences it is wished to avoid. Creating a matrix under these headings enables a variety of

approaches. One can begin with resources and consider the threats they are exposed to and the

consequences of each. Alternatively one can start with the threats and examine which resources

they would affect, or one can begin with the consequences and determine which combination of

threats and resources would be involved to bring them about.

[edit]Assessment

Once risks have been identified, they must then be assessed as to their potential severity of loss and

to the probability of occurrence. These quantities can be either simple to measure, in the case of the

value of a lost building, or impossible to know for sure in the case of the probability of an unlikely

event occurring. Therefore, in the assessment process it is critical to make the best educated guesses

possible in order to properly prioritize the implementation of the risk management plan.

The fundamental difficulty in risk assessment is determining the rate of occurrence since statistical

information is not available on all kinds of past incidents. Furthermore, evaluating the severity of the

consequences (impact) is often quite difficult for immaterial assets. Asset valuation is another

question that needs to be addressed. Thus, best educated opinions and available statistics are the

primary sources of information. Nevertheless, risk assessment should produce such information for

the management of the organization that the primary risks are easy to understand and that the risk

management decisions may be prioritized. Thus, there have been several theories and attempts to

quantify risks. Numerous different risk formulae exist, but perhaps the most widely accepted formula

for risk quantification is:

Rate of occurrence multiplied by the impact of the event equals risk

[edit]Composite Risk Index

The above formula can also be re-written in terms of a Composite Risk Index, as follows:

Composite Risk Index = Impact of Risk event x Probability of Occurrence

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The impact of the risk event is assessed on a scale of 0 to 5, where 0 and 5 represent the minimum

and maximum possible impact of an occurrence of a risk (usually in terms of financial losses).

The probability of occurrence is likewise assessed on a scale from 0 to 5, where 0 represents a zero

probability of the risk event actually occurring while 5 represents a 100% probability of occurrence.

The Composite Index thus can take values ranging from 0 through 25, and this range is usually

arbitrarily divided into three sub-ranges. The overall risk assessment is then Low, Medium or High,

depending on the sub-range containing the calculated value of the Composite Index. For instance, the

three sub-ranges could be defined as 0 to 8, 9 to 16 and 17 to 25.

Note that the probability of risk occurrence is difficult to estimate since the past data on frequencies

are not readily available, as mentioned above.

Likewise, the impact of the risk is not easy to estimate since it is often difficult to estimate the potential

financial loss in the event of risk occurrence.

Further, both the above factors can change in magnitude depending on the adequacy of risk

avoidance and prevention measures taken and due to changes in the external business environment.

Hence it is absolutely necessary to periodically re-assess risks and intensify/relax mitigation

measures as necessary.

[edit]Risk Options

This section needs additional citations for verification.Please help improve this article by adding reliable references. Unsourced material may be challenged and removed. (August 2010)

Risk mitigation measures are usually formulated according to one or more of the following major risk

options, which are:

1. Design a new business process with adequate built-in risk control and containment measures from

the start.

2. Periodically re-assess risks that are accepted in ongoing processes as a normal feature of business

operations and modify mitigation measures.

3. Transfer risks to an external agency (e.g. an insurance company)

4. Avoid risks altogether (e.g. by closing down a particular high-risk business area)

Later research[citation needed] has shown that the financial benefits of risk management are less dependent

on the formula used but are more dependent on the frequency and how risk assessment is performed.

In business it is imperative to be able to present the findings of risk assessments in financial terms.

Robert Courtney Jr. (IBM, 1970) proposed a formula for presenting risks in financial terms.[8] The

Courtney formula was accepted as the official risk analysis method for the US governmental

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agencies. The formula proposes calculation of ALE (annualised loss expectancy) and compares the

expected loss value to the security control implementation costs (cost-benefit analysis).

[edit]Potential risk treatments

Once risks have been identified and assessed, all techniques to manage the risk fall into one or more

of these four major categories:[9]

Avoidance (eliminate, withdraw from or not become involved)

Reduction (optimise - mitigate)

Sharing (transfer - outsource or insure)

Retention (accept and budget)

Ideal use of these strategies may not be possible. Some of them may involve trade-offs that are not

acceptable to the organization or person making the risk management decisions. Another source,

from the US Department of Defense, Defense Acquisition University, calls these categories ACAT, for

Avoid, Control, Accept, or Transfer. This use of the ACAT acronym is reminiscent of another ACAT

(for Acquisition Category) used in US Defense industry procurements, in which Risk Management

figures prominently in decision making and planning.

[edit]Risk avoidance

This includes not performing an activity that could carry risk. An example would be not buying

a property or business in order to not take on the legal liability that comes with it. Another would be

not flying in order not to take the risk that the airplane were to be hijacked. Avoidance may seem the

answer to all risks, but avoiding risks also means losing out on the potential gain that accepting

(retaining) the risk may have allowed. Not entering a business to avoid the risk of loss also avoids the

possibility of earning profits.

[edit]Hazard Prevention

Main article: Hazard prevention

Hazard prevention refers to the prevention of risks in an emergency. The first and most effective stage

of hazard prevention is the elimination of hazards. If this takes too long, is too costly, or is otherwise

impractical, the second stage is mitigation.

[edit]Risk reduction

Risk reduction or "optimisation" involves reducing the severity of the loss or the likelihood of the loss

from occurring. For example, sprinklers are designed to put out a fire to reduce the risk of loss by fire.

This method may cause a greater loss by water damage and therefore may not be suitable. Halon fire

suppression systems may mitigate that risk, but the cost may be prohibitive as a strategy.

Acknowledging that risks can be positive or negative, optimising risks means finding a balance

between negative risk and the benefit of the operation or activity; and between risk reduction and

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effort applied. By an offshore drilling contractor effectively applying HSE Management in its

organisation, it can optimise risk to achieve levels of residual risk that are tolerable.[10]

Modern software development methodologies reduce risk by developing and delivering software

incrementally. Early methodologies suffered from the fact that they only delivered software in the final

phase of development; any problems encountered in earlier phases meant costly rework and often

jeopardized the whole project. By developing in iterations, software projects can limit effort wasted to

a single iteration.

Outsourcing could be an example of risk reduction if the outsourcer can demonstrate higher capability

at managing or reducing risks.[11] For example, a company may outsource only its software

development, the manufacturing of hard goods, or customer support needs to another company, while

handling the business management itself. This way, the company can concentrate more on business

development without having to worry as much about the manufacturing process, managing the

development team, or finding a physical location for a call center.

[edit]Risk sharing

Briefly defined as "sharing with another party the burden of loss or the benefit of gain, from a risk, and

the measures to reduce a risk."

The term of 'risk transfer' is often used in place of risk sharing in the mistaken belief that you can

transfer a risk to a third party through insurance or outsourcing. In practice if the insurance company

or contractor go bankrupt or end up in court, the original risk is likely to still revert to the first party. As

such in the terminology of practitioners and scholars alike, the purchase of an insurance contract is

often described as a "transfer of risk." However, technically speaking, the buyer of the contract

generally retains legal responsibility for the losses "transferred", meaning that insurance may be

described more accurately as a post-event compensatory mechanism. For example, a personal

injuries insurance policy does not transfer the risk of a car accident to the insurance company. The

risk still lies with the policy holder namely the person who has been in the accident. The insurance

policy simply provides that if an accident (the event) occurs involving the policy holder then some

compensation may be payable to the policy holder that is commensurate to the suffering/damage.

Some ways of managing risk fall into multiple categories. Risk retention pools are technically retaining

the risk for the group, but spreading it over the whole group involves transfer among individual

members of the group. This is different from traditional insurance, in that no premium is exchanged

between members of the group up front, but instead losses are assessed to all members of the group.

[edit]Risk retention

Involves accepting the loss, or benefit of gain, from a risk when it occurs. True self insurance falls in

this category. Risk retention is a viable strategy for small risks where the cost of insuring against the

risk would be greater over time than the total losses sustained. All risks that are not avoided or

transferred are retained by default. This includes risks that are so large or catastrophic that they either

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cannot be insured against or the premiums would be infeasible. War is an example since most

property and risks are not insured against war, so the loss attributed by war is retained by the insured.

Also any amounts of potential loss (risk) over the amount insured is retained risk. This may also be

acceptable if the chance of a very large loss is small or if the cost to insure for greater coverage

amounts is so great it would hinder the goals of the organization too much.

[edit]Create a risk management plan

Select appropriate controls or countermeasures to measure each risk. Risk mitigation needs to be

approved by the appropriate level of management. For instance, a risk concerning the image of the

organization should have top management decision behind it whereas IT management would have

the authority to decide on computer virus risks.

The risk management plan should propose applicable and effective security controls for managing the

risks. For example, an observed high risk of computer viruses could be mitigated by acquiring and

implementing antivirus software. A good risk management plan should contain a schedule for control

implementation and responsible persons for those actions.

According to ISO/IEC 27001, the stage immediately after completion of the risk assessment phase

consists of preparing a Risk Treatment Plan, which should document the decisions about how each of

the identified risks should be handled. Mitigation of risks often means selection of security controls,

which should be documented in a Statement of Applicability, which identifies which particular control

objectives and controls from the standard have been selected, and why.

[edit]Implementation

Implementation follows all of the planned methods for mitigating the effect of the risks. Purchase

insurance policies for the risks that have been decided to be transferred to an insurer, avoid all risks

that can be avoided without sacrificing the entity's goals, reduce others, and retain the rest.

[edit]Review and evaluation of the plan

Initial risk management plans will never be perfect. Practice, experience, and actual loss results will

necessitate changes in the plan and contribute information to allow possible different decisions to be

made in dealing with the risks being faced.

Risk analysis results and management plans should be updated periodically. There are two primary

reasons for this:

1. to evaluate whether the previously selected security controls are still applicable and effective,

and

2. to evaluate the possible risk level changes in the business environment. For example,

information risks are a good example of rapidly changing business environment.

[edit]Limitations

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If risks are improperly assessed and prioritized, time can be wasted in dealing with risk of losses that

are not likely to occur. Spending too much time assessing and managing unlikely risks can divert

resources that could be used more profitably. Unlikely events do occur but if the risk is unlikely

enough to occur it may be better to simply retain the risk and deal with the result if the loss does in

fact occur. Qualitative risk assessment is subjective and lacks consistency. The primary justification

for a formal risk assessment process is legal and bureaucratic.

Prioritizing the risk management processes too highly could keep an organization from ever

completing a project or even getting started. This is especially true if other work is suspended until the

risk management process is considered complete.

It is also important to keep in mind the distinction between risk and uncertainty. Risk can be measured

by impacts x probability.

[edit]Areas of risk management

As applied to corporate finance, risk management is the technique for measuring, monitoring and

controlling the financial or operational risk on a firm's balance sheet. See value at risk.

The Basel II framework breaks risks into market risk (price risk), credit risk and operational risk and

also specifies methods for calculating capital requirements for each of these components.

[edit]Enterprise risk management

Main article: Enterprise Risk Management

In enterprise risk management, a risk is defined as a possible event or circumstance that can have

negative influences on the enterprise in question. Its impact can be on the very existence, the

resources (human and capital), the products and services, or the customers of the enterprise, as well

as external impacts on society, markets, or the environment. In a financial institution, enterprise risk

management is normally thought of as the combination of credit risk, interest rate risk or asset liability

management, market risk, and operational risk.

In the more general case, every probable risk can have a pre-formulated plan to deal with its possible

consequences (to ensure contingency if the risk becomes a liability).

From the information above and the average cost per employee over time, or cost accrual ratio, a

project manager can estimate:

the cost associated with the risk if it arises, estimated by multiplying employee costs per unit time

by the estimated time lost (cost impact, C where C = cost accrual ratio * S).

the probable increase in time associated with a risk (schedule variance due to risk, Rs where Rs =

P * S):

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Sorting on this value puts the highest risks to the schedule first. This is intended to cause the

greatest risks to the project to be attempted first so that risk is minimized as quickly as

possible.

This is slightly misleading as schedule variances with a large P and small S and vice versa

are not equivalent. (The risk of the RMS   Titanic  sinking vs. the passengers' meals being

served at slightly the wrong time).

the probable increase in cost associated with a risk (cost variance due to risk, Rc where Rc = P*C

= P*CAR*S = P*S*CAR)

sorting on this value puts the highest risks to the budget first.

see concerns about schedule variance as this is a function of it, as illustrated in the equation

above.

Risk in a project or process can be due either to Special Cause Variation or Common Cause

Variation and requires appropriate treatment. That is to re-iterate the concern about extremal cases

not being equivalent in the list immediately above.

[edit]Risk management activities as applied to project management

In project management, risk management includes the following activities:

Planning how risk will be managed in the particular project. Plan should include risk management

tasks, responsibilities, activities and budget.

Assigning a risk officer - a team member other than a project manager who is responsible for

foreseeing potential project problems. Typical characteristic of risk officer is a healthy skepticism.

Maintaining live project risk database. Each risk should have the following attributes: opening

date, title, short description, probability and importance. Optionally a risk may have an assigned

person responsible for its resolution and a date by which the risk must be resolved.

Creating anonymous risk reporting channel. Each team member should have possibility to report

risk that he/she foresees in the project.

Preparing mitigation plans for risks that are chosen to be mitigated. The purpose of the mitigation

plan is to describe how this particular risk will be handled – what, when, by who and how will it be

done to avoid it or minimize consequences if it becomes a liability.

Summarizing planned and faced risks, effectiveness of mitigation activities, and effort spent for

the risk management.

[edit]Risk management for megaprojects

Megaprojects (sometimes also called "major programs") are extremely large-scale investment

projects, typically costing more than US$1 billion per project. Megaprojects include bridges, tunnels,

highways, railways, airports, seaports, power plants, dams, wastewater projects, coastal flood

protection schemes, oil and natural gas extraction projects, public buildings, information technology

systems, aerospace projects, and defence systems. Megaprojects have been shown to be particularly

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risky in terms of finance, safety, and social and environmental impacts. Risk management is therefore

particularly pertinent for megaprojects and special methods and special education have been

developed for such risk management.[12] [13]

[edit]Risk management techniques in petroleum and natural gas

For the offshore oil and gas industry, operational risk management is regulated by the safety

case regime in many countries. Hazard identification and risk assessment tools and techniques are

described in the international standard ISO 17776:2000, and organisations such as the IADC

(International Association of Drilling Contractors) publish guidelines for HSE Case development which

are based on the ISO standard. Further, diagrammatic representations of hazardous events are often

expected by governmental regulators as part of risk management in safety case submissions; these

are known as bow-tie diagrams. The technique is also used by organisations and regulators in

mining, aviation, health, defence, industrial and finance.[14]

[edit]Risk management and business continuity

Risk management is simply a practice of systematically selecting cost effective approaches for

minimising the effect of threat realization to the organization. All risks can never be fully avoided or

mitigated simply because of financial and practical limitations. Therefore all organizations have to

accept some level of residual risks.

Whereas risk management tends to be preemptive, business continuity planning (BCP) was invented

to deal with the consequences of realised residual risks. The necessity to have BCP in place arises

because even very unlikely events will occur if given enough time. Risk management and BCP are

often mistakenly seen as rivals or overlapping practices. In fact these processes are so tightly tied

together that such separation seems artificial. For example, the risk management process creates

important inputs for the BCP (assets, impact assessments, cost estimates etc.). Risk management

also proposes applicable controls for the observed risks. Therefore, risk management covers several

areas that are vital for the BCP process. However, the BCP process goes beyond risk management's

preemptive approach and assumes that the disaster will happen at some point.

[edit]Risk communication

Risk communication is a complex cross-disciplinary academic field. Problems for risk communicators

involve how to reach the intended audience, to make the risk comprehensible and relatable to other

risks, how to pay appropriate respect to the audience's values related to the risk, how to predict the

audience's response to the communication, etc. A main goal of risk communication is to improve

collective and individual decision making. Risk communication is somewhat related to crisis

communication.

[edit]Bow tie diagrams

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A popular solution to the quest to communicate risks and their treatments effectively is to use bow

tie diagrams. These have been effective, for example, in a public forum to model perceived risks and

communicate precautions, during the planning stage of offshore oil and gas facilities in Scotland.

Equally, the technique is used for HAZID (Hazard Identification) workshops of all types, and results in

a high level of engagement. For this reason (amongst others) an increasing number of government

regulators for major hazard facilities (MHFs), offshore oil & gas, aviation, etc. welcome safety case

submissions which use diagrammatic representation of risks at their core.

Communication advantages of bow tie diagrams: [14]

Visual illustration of the hazard, its causes, consequences, controls, and how controls fail.

The bow tie diagram can be readily understood at all personnel levels.

"A picture paints a thousand words."

[edit]Seven cardinal rules for the practice of risk communication

(as first expressed by the U.S. Environmental Protection Agency and several of the field's founders[15])

Accept and involve the public/other consumers as legitimate partners.

Plan carefully and evaluate your efforts with a focus on your strengths, weaknesses,

opportunities, and threats.

Listen to the public's specific concerns.

Be honest, frank, and open.

Coordinate and collaborate with other credible sources.

Meet the needs of the media.

Speak clearly and with compassion.

Styles of investment strategyFundamentals

Main article: Fundamental analysis

Investing in real assets is generally accepted as one of the best ways to achieve real investment

growth over time. However, the methods used to make investments are manifold and often split

people into opposing camps. Assuming that it is accepted that a number of different holdings are

selected to spread risk then the logical progression is to ask by what method are holdings selected?

At this point when considering Bonds or shares or any other easily definable market then two camps

are formed: those who believe that it is impossible to know which stocks will do well and those who

believe it is possible to predict which stocks will perform better than others. If you believe it is possible

to select the stock which will do well you will actively manage your investment buying and selling upon

whichever principles you decide. If you believe it is not possible to predict performance you will

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purchase your stock upon whichever criteria you feel is appropriate and hold those investments

accordingly.


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