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Copyright, 2004. All Rights Reserved

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Table of Contents

Introduction .............................................................................3

Chapter 1: Decision Making Under Uncertainty .......................6Chapter 2: Screening for High Potential Stocks.....................12Chapter 3: Business Analysis.................................................20Chapter 4: Stock Valuation.....................................................26Chapter 5: Stock Analysis and Valuation in Practice .............41Chapter 6: Tactical Portfolio Management .............................57

Appendix A: Information Sources for Investment Research.77Appendix B: Optimal F Analysis ............................................78Bibliography . .......................................................................83

Visit the Portfolio Insight website at:

http://www.portfolioinsight.com

The Portfolio Insight eBook and Software are designed to assist in the developmentand organization of investment ideas. An investor’s best course of action must bebased on his or her own individual circumstances. By using Portfolio Insight youacknowledge that you understand there is always risk of a loss of principal wheninvesting in securities. You also agree to accept those investment risks as your ownunder all circumstances. Always consult your financial advisor before makinginvestment decisions.

Legal Disclaimer

http://www.portfolioinsight.com/http://www.portfolioinsight.com/


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In the next chapter, we’ll use the magic triangle of; credibility, past

performance, and future prospects, to determine if an investment in a

company’s stock makes good business sense.

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Chapter 3:

Business Analysis

The following questions will help you analyze potential stocks

generated by your stock screen. Remember your goal here is to ensure

you’re investing in excellent businesses. This list of questions is not

comprehensive, you may wish to develop your own additional

criteria, but they will help you differentiate between excellent

businesses that may be mispriced and those which are simply misfits.

A summary checklist for these questions is provided at the end of this

section.

Credibility:

The integrity of company management is a critical metric for

evaluating the long-term success potential of a company. This section

of your analysis relies heavily on historical company information. To

access such information you’ll need to put on your research hat and

go online to venture through a company’s past. The practical

examples at the end of this chapter will show you how to access and

use these free resources to find the information you need to make

informed judgments. With that, here are the credibility questions and

brief explanations for each:

1. Has the company ever restated financial statements?

A financial restatement is never a good sign. Of course,

sometimes during the course of business, events may occur outside of

management’s control that may cause a restatement. Even with this

kind of occurrence, a signal of poor internal controls does not lend

confidence to a company’s management. Restatements that occur as

a result of fraudulent business or accounting practices (such as recentrestatements from Enron, WorldCom, and others) are a clear sign that


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7. Is the Company in a politically or economically sensitive

industry?

Companies in politically sensitive (defense stocks for example) oreconomically sensitive (airlines, automobile manufacturers, luxury

goods etc.) should be excluded from further consideration. While you

may be able to profit in the short term from such stocks, it’s very

difficult to identify entry and exit points for cyclical companies.

We’re looking for companies that have the potential to deliver

consistent, outstanding performance over the LONG term. Cyclicals

rarely provide such opportunities.

8. Does the company have a defensible business model?

Defensible business models are characterized by virtue of

patentable technologies, dominant market share, brand loyalty, or

other means. Microsoft is an example of a company whose biggest

defense against potential competitors is dominant market share. 3M

defends its business through patented technologies. Coke defends via

a massive, concerted effort to maintain brand loyalty. Companies that

lack defensible business models should be excluded from further

consideration.

Past Performance

9. Does the company have a history of adapting to change?

The only constant in business today is change. Some companies

have cultures which are adept at change and those that do not,

generally speaking, go out of business. Intel is an excellent example

of a company adept at change. The company has had three distinct

business models since its inception in the early 1970’s. Look for

instances in each companies’ history which show managementswillingness to change, sometimes drastically, to adjust to new market

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conditions. Companies without such agility should be excluded from

further consideration.

10. Does the company have a history of steadily increasingoperating performance?

The past does not always equal the future, but steadily improving

operating performance (increasing revenues, operating margins,

earnings growth etc.) is generally indicative of able, adept

management and provides a certain margin of safety for investors.


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11% -5% = 6% X 1/2 = 3% risk premium

Adding back the inflation rate of 5%, you would arrive at a discount

rate of 8%. Using the new rate to recalculate the present value of yourfuture earnings in Brother Inc., you would get:

Table 4.3 Present Value Using

Risk Adjusted Discount Rate

TimeFuture Valueof Earnings

Present Value(using discountrate of 8%)

Year 1 $500,000 $462,963 Year 2 $600,000 $514,403

Year 3 $720,000 $571,559

Year 4 $864,000 $635,066

Year 5 $1,036,800 $705,629

Year 6 $1,088,640 $686,028

Year 7 $1,143,072 $666,972

Year 8 $1,200,226 $648,445

Year 9 $1,260,237 $630,432

Year 10 $1,323,249 $612,920

Future Value $9,736,224

Fair Value $6,134,417

Using the 8% discount rate to calculate the present value of your

earnings now yields a fair value estimate of $6,134,416, or $12.27 per

share. The increased discount rate has lowered the estimated value ofyour shares by $2.18.

Now let’s see what happens if we assume that the Brother Inc.

faces a great deal of uncertainty and you presume that its earnings

prospects are twice as risky as the overall market’s. Using the formula

for calculating discount rates:

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Discount Rate = (Market Rate – Inflation) x (Riskiness)

Or in this case:

11%-5% = 6% x 2 = 12% risk premium.

Adding back inflation of 5% would give you a discount rate of 17%.

Using 17% as the discount rate would result in the following present

values for your expected future earnings:

Table 4.4 – Present Value under High Risk

TimeFuture Valueof Earnings

Present Valueusing 17%Discount Rate

Year 1 $500,000 $427,350

Year 2 $600,000 $438,308

Year 3 $720,000 $449,547

Year 4 $864,000 $461,074

Year 5 $1,036,800 $472,896

Year 6 $1,088,640 $424,394

Year 7 $1,143,072 $380,866

Year 8 $1,200,226 $341,803

Year 9 $1,260,237 $306,746

Year 10 $1,323,249 $275,285

Future Value $9,736,224

Fair Value $3,978,269

Under the assumption of high risk, the value of your stake in

Brother Inc. (again obtained by adding up the present value of years

1-10) drops to $3,978,270 or $7.96 a share. It is likely your brother

would push for the latter scenario because it would be financially

favorable for him to do so. He would get your stock for much less

than under the low or no-risk scenarios. You of course want to

maximize the selling price and may wish to negotiate a higher price


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to 5% in the outer years under consideration. The simple two-stage

model is subject to greater estimation error than formulas which

provide a smooth transition to a lower growth rate. To alleviate this

shortcoming, the Portfolio Insight valuation tool uses a variation ofthe simple two-stage model, the H Model. While the math is slightly

different, the relationship between growth, discount rates and value

remain the same.

H Model

Fuller and Hsia’s [R.J. Fuller and C. Hsia, 1984. A SimplifiedCommon Stock Valuation Model . Financial Analysts Journal, 40] H

Model overcomes the limitations of the Two-Stage Growth Model by

transitioning the initial growth rate linearly during the initial

estimated growth period to the normal growth rate for the second

period. The H model is usually preferable to the two-stage growth

model because it offers a more conservative and realistic estimation

of a stocks value.

Mathematically, the H Model is formulated by:

Formula 4.2 Fuller and Hsia’s H-Model

00 [(1 )] ( )]n a n

n

E p g H g g

r g

⎛ ⎞= + + −⎜ ⎟

−⎝ ⎠

Where a g

= high initial growth rate,

n g = long run growth rate,

E = Earnings Estimate,

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r = required rate of return (discount rate)

H= length of high initial growth period divided by two.

With the H Model, Initial growth rates, earnings estimates, and

required rates of return are estimated using the same process outlined

in the Brother Inc example. Keep in mind that, for the math to work,

the Long run growth rate must be less than your discount rate. Long

run growth rates higher than your discount rate would mathematically

imply a negative stock value.

Software Installation

Before proceeding further, you will want to have the Portfolio

Insight software installed and ready to use on your PC. The software

will enable you to quickly work through the stock valuation examples

later in this chapter.

Software Installation Steps:

1. Purchase (download available online for $39.95) and

download the Portfolio Insight software at

http://www.portfolioinsight.com

2. or Insert the Portfolio Insight software disk

3. Open Windows Explorer and navigate to the folder or drivecontaining the Portfolio Insight files.

4. Double Click the file labeled JRE 1.4. This file will install the

Java Runtime Environment required to run the Portfolio

Insight Software on your PC.

5. Next, double-click the file labeled PortfolioInsight.exe

6. Navigate to Start>Programs>Portfolio Insight, and open the

program.

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Portfolio Insight Stock Valuation Tool

The Portfolio Insight Stock Valuation tool uses the H Model,

along with your estimates for earnings per share, expected growth,

and the discount rate to estimate stock values. This section will help

familiarize you with the Portfolio Insight stock valuation software’s

interface.

Stock Valuation Screen View

Click the Stock

Valuation Tab toopen the StockValuationWorksheet.

Double click columns to

View model stock valuationestimates and com arisons.

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Portfolio Insight allows you to save multiple portfolios of up to

20 stocks. To save simply click “Save” in the upper left hand corner

of the Insight Interface. To retrieve saved portfolios, click “load” and

select the appropriate file. Finally, Portfolio Insight has interactivehelp information that pops up when you scroll your mouse over text

in the interface. For example, if you forget what “1 st period Growth”

means simply scroll over the identifying row label in the far left of the

interface and a pop-up help text will appear.

To familiarize you with the Stock Valuation tool, the following

example takes you through a sample valuation, step-by-step, usingfigures from the Brother Inc. example.

1. Click Start>>Programs>>Portfolio Insight to open

Portfolio Insight

2. Click the Stock Valuation Tab

3. Double click the first cell in the far left column of the stock

valuation worksheet.

This brings up the “New Stock Data Entry Window” (shown below).


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4. In the “New Stock Data Entry Window”:

a. Enter the BTRS in the Stock Name cell.

b. enter “$5.00” for the stock’s current price per share

in the Current Price cellc. Enter “1.00” for the Earnings per Share for the most

recent 12 months in the Earnings per Share cell.

d. Enter “.20” for the Initial Period Growth rate in the

1 st Period Growth cell. (all percentage growth rates

must be entered as decimals)

e. Enter ‘5’ for the # of Years Cell

f. Enter “.05” for your long run growth estimate in the2nd Period Growth cell.

g. Enter “.08” for your required rate of return in the

Discount Rate cell

5. Click OK

After clicking OK, you’ll see your input

estimates for Earnings, Growth etc.

entered into the worksheet. Below these

inputs, in the Results section, you’ll find

Your input estimates

Fair value estimates andcom arisons.

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the estimate for fair value along with a graphical comparison showing

the current price compared to estimated value. To value additional

stocks, simply repeat steps 1 through five using another valuation

column.

Once you’ve valued your portfolio of stocks, use the graphical

comparison chart to quickly scan for stocks that are exceptionally

over or undervalued. If a stock’s fair value is estimated to be far

lower than the current price you should consider excluding the

company from further consideration. The next section will guide you

through the valuation and situational analysis process in step-by-step practical examples for two different companies. Once you’re

mastered valuation and situational analysis, you’ll be ready to begin

the portfolio building process using tactical allocation.


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Stock Analysis Example #2:

Radian Group

As with the last example, to learn more about Radian Group, prospective investors should visit the company website at

http://www.radiangroupinc.com. Under the ‘Investors Information

Overview’ link on the site, the company describes itself as “a leading

credit enhancement provider to the global financial and capital

markets, headquartered in Philadelphia, with operations in New York

City, London and Dayton, Ohio. Radian’s subsidiaries provide

products and services through three business lines: financial guaranty,mortgage insurance and mortgage services.”

Credibility

1. Has the company ever restated financial statements?

After running several searches of Radian Group’s news archives,

no evidence was found of the company having ever restated its

financial results.

2. Has the company employed accounting tricks such as

“special charges” to try and cover up poor operating

performance?

No evidence was found that showed Radian Group ever used

special charges enhance operating performance.

3. Is management turnover high? Have any officers of the

company recently left under unusual or ambiguous

circumstances? (if yes, exclude)

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Radian’s CEO, CFO and COO have all been with the company

since it was born out of a merger between mortgage insurers CMAC

and Amerin in 1999. There is no evidence of high managementturnover.

4. Are there any shareholder lawsuits pending? (if yes, exclude)

None

5. Have members of management and/or directors recently soldlarge amounts of stock?

Recent insider sales at RDN have been primarily small stock sales

and the exercising of options by management. Nothing unusual, in

terms of the amount of stock being sold, is present. However it would

be encouraging to see more buying activity on the part of officers and

directors. Here’s a look at recent RDN activity (link to Quicken.com)

http://www.quicken.com/investments/insider/?p=RDN&tag=1

Long Term Prospects

6. Is the business simple and understandable?

Radian Group is in the insurance business. Insurance can be a

very profitable business, it’s one of Warren Buffett’s favorites (he

owns General Reinsurance and Geico). Buffett loves insurance

businesses because, if run well, they can provide a highly predictable

profit stream. Insurers make most of their money off of what’s known

as the “float”. Float is the difference between money collected in

premiums versus the expected payout in insurance claims. Insurers

http://www.radiangroupinc.com/http://www.radiangroupinc.com/http://www.quicken.com/investments/insider/?p=RDN&tag=1http://www.quicken.com/investments/insider/?p=RDN&tag=1http://www.radiangroupinc.com/


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10. Does the company have a history of steadily increasing

operating performance?

Here are RDN’s five year income numbers:

5-yrIncomeGrowth

5-yr Revenue Growth

5-yr EPS Growth

RDN 42.8% 32.2% 23.9%

Industry 17.32% 17.30% 5.73%

Relative to the overall industry, the company has significantly

outperformed. Radian gets a pass here.

Stock Valuation

The final step in the stock

selection process is to perform

valuation analysis. For RDN,

Net Income or $4.41 per share,5 year analysts’ growth rate

estimates for RDN earnings or

14%, a discount rate of 9%,

and long-term growth rate of

4.5% are used. All of these

inputs appear to be reasonable

inferences, given thecompany’s operating

performance and future

prospects (refer to the stock

valuation section for

explanations of these inputs).

After entering these inputs in

the Portfolio Insight software’s

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stock valuation tool, a valuation estimate of $51.93 is returned. Given

this valuation, Radian Group appears to be trading at a modest 20%

discount to fair value. Certainly this is not a fire sale but it does

provide some margin of safety and, should the company exceed

earnings expectations in the future, provides some meaningful upside

for investors buying at the current price.


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Faced with this complexity, most investors simply give up and

forego any kind of structured allocation. Or they become passive

investors and invest in strategically diversified portfolios designed

that mimic market risk/returns. Active investors who wish to employ

tactical allocation need a tool, such as Portfolio Insight, that

decomposes the problem into a manageable and repeatable process.

The Portfolio Insight Tactical Portfolio Management software is

designed to break down the allocation problem into simple repeatable

steps using consistent inputs. It uses individual risk tolerance,

required return, and probabilistic expectations to determine the ideal

allocation for each of stock under consideration. Using PortfolioInsight, marginal assets (low return/high risk stocks) are minimized

and/or eliminated and portfolio equity is refocused on higher potential

assets, thereby increasing potential portfolio performance.

Fig 6.1 identifying the strong stocks in your portfolio with TPM:

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The first step in the Portfolio Insight TPM allocation process is to

characterize each stock’s prospects using best, most likely, and worst

case probability scenarios. The inputs for these scenarios are derived

using the Portfolio Insight Stock Valuation Model (by developing

three valuation scenarios for best, most likely, and worst earnings

growth possibilities similar to the Brother’s Inc. example discussed in

the Stock Valuation chapter). The TPM software then calculates

which stocks have the most risk-adjusted upside potential and

attributes capital according to the strength of each stock relative to the

overall portfolio. To see how this works, try the following practice

exercise.

TPM Exercise 1: Two Stock Portfolio

Select Start>>Programs>>Portfolio Insight Pro to open the

program.

Figure 6.2 – Tactical Portfolio Management


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half their current expected growth rates. Discount rates (required rate

of return) vary for each company. A good rule of thumb for low risk

stocks like Exxon and Allstate is to use the long term rate of return

for the S&P500 (around 11%) for the discount rate. Higher risk

stocks, of course, require a higher discount rate. For the purposes of

this example, a discount rate of 15% is used for stocks perceived to

have higher than market risk. Graphic 6.4 shows all the stock

valuation inputs mentioned above for our Most Likely scenarios and

the resulting valuations.

Once Most Likely Scenario valuation estimates are completed,

you should begin inputting figures into the Tactical Portfolio

Management model. Click the "Tactical Portfolio Management" tab

and then click anywhere on the table to bring up the data entry

window for your first stock. Since you only have ‘Most likely’ stock

valuation figures, simply enter dummy prices and probabilities for the

Best and Worst case scenarios. This will allow you to input all the

Most Likely Case Valuation Scenarios and then come back later toquickly update the remaining Best and Worst case probabilities.

Quick Tip: Enter your probability estimates for Best and Worst Case

scenarios on your first run through, this will save you time when you

return to finish up your TPM worksheet).

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Figure 6.4 - Most Likely Valuation Estimates

For Most Likely TPM Scenarios, the Most Likely stock valuation

estimates for each stock are entered from the Stock Valuation Model

worksheet. Here is a screen shot showing the Radian Group entries.

Default probability estimates of .16 for Best and Worst Case

scenarios and .68 for the most likely scenarios are used here. You canadjust these probabilities depending on your assessment of a stocks

likelihood of achieving your valuation estimates; however you must

remember that the sum of the probabilities for all three Best, Most

Likely, and Worst Case scenarios must equal 1.0 (a probability of

occurrence cannot be greater than 1!).


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Figure 6.5 – Radian Group Data Entry

Once Radian Group's numbers are entered, the process is repeated

for the remaining nine stocks in the portfolio. Here is a screen shot of

all the Most Likely TPM entries (dummy variables for the Best and

Worst case scenarios are used here). Next, you must estimate stock

valuations for "Best Case" scenarios. To keep things simple Five year

earnings estimates for each stock are increased here by 20%. This is

by no means a rule of thumb, you can assign different "Best Case"

growth rates according to your own analysis of an individual stocks

situation and prospective performance potential.

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Figure 6.6 - Most Likely Scenario Inputs and Dummy Variables

To do this, switch back to the Stock Valuation Model worksheet andadjust the "First Period Growth" for each stock to reflect your best

case growth expectations (simply click the respective "1st period

Growth" field for each stock to change the earnings estimate). After

your ‘best case’ estimates are completed, return to the TPM

worksheet to enter the results for each stock. Next, return to the Stock

Valuation Worksheet and enter worst case "1st Period Growth"

projections.


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Figure 6.7 Best Case Scenario Valuation Estimates

For worst case valuation estimates 5 year analyst projections are

cut by 50% and the second period growth rate is cut to 25% of the 5

year analyst growth estimates. These are fairly pessimistic scenarios, but market history tells us that things could be even much worse, so

cutting estimates in half is a fair assumption for "worst case"

scenarios. Here are the Stock Valuation Worst Case results:

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Figure 6.8 Worst Case Scenario Valuation Estimates

Next, enter these valuation estimates into the "Worst Case" fields

of the Tactical Portfolio Management worksheet. Once the "Worst

Case" fields are entered click the "Click to Analyze Portfolio Button".

A prompt for "Required Return and Risk Aversion" entries pops up.

For this example we’ll use 15% for required return (yours can be

lower or higher but remember Stocks with expected returns less than

your required return will be kicked out of the portfolio). For "Risk

Aversion" an aversion multiplier of 2 is used, that is we want the

expected upside for each stock in the portfolio to be at least twice the


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expected downside before making an investment (again you can

adjust this to account for your own preference). "1" is Risk Neutral,

"5" would be highly risk averse (you want 5 times as much expected

upside than expected downside). Once the Risk Aversion and

Required Return variables are entered, click ok to see the results.

Here are the results using our sample projection and estimates:

Figure 6.9 - TPM Results

The TPM portfolio distribution in this case is highly concentrated.

The main reason for this is that some of the stocks (Best Buy, Sun

Microsystems, Home Depot) had valuation estimates that were below

the current market price in all three scenarios, while others (Exxon,

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Verizon, ETrade) had expected valuations that did not achieve the

15% required return and were thus kicked out. So the example

portfolio is reduced to just four stocks (Radian Group, Del Monte

Fresh Produce, Allstate, and WebMd).

While highly concentrated, the expected return for the four

strongest stocks is nearly triple than the original evenly distributed

portfolio consisting of all ten stocks. The "Return Current" of 9.57%

is the estimated annual return for an evenly distributed portfolio. The

"Return Model" of 31.18% is the estimated annual return for the four

stocks that remained in our portfolio once analyzed for Best, Most

Likely, and Worst Case scenarios. Warren Buffet once said

"Diversification is protection against ignorance". In this example, so

long as the valuation scenarios and business prospects for each of the

model portfolio stocks were accurate, it is better to invest more

capital in just four stocks than to buy all ten. It is important to

remember however that concentrated portfolios tend to be more

volatile in the short run, and thus investors should only invest in thismanner when they have a long-term (3-5 years) investment horizon.


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period return for each stock. In game theory these formulas are

designed to maximize returns by estimating the optimal fraction of

your total stake to risk with each play in a game of chance.

Conceptually it easy to understand the utility of the Optimal F

algorithm for trading if you think of the stock market as having

infinitely varying risk characteristics which are a product of infinitely

varying investment horizons. Buy Coke stock and hold it for 5 years

and you're likely to make money. Hold it for only five days and you

may lose or gain money. The investment performances associated

with a long investment horizon are very different than those

associated with a short time horizon. Optimal F analysis helps attune

your trading decisions to these differences. The Optimal F formula

was formalized by Vince (The New Money Management) and is

given by:

1/

1

1

Pii p

T

i

AG

W

f

∑

=

⎞⎛ ⎞⎛ ⎞⎛ ⎛ ⎞

⎟⎜ ⎟⎜ ⎟⎜ ⎜ ⎟ ⎟⎜ ⎟⎜ ⎟⎜ ⎜ ⎟= + ⎟⎜ ⎟⎜ ⎟⎜ ⎜ ⎟ ⎟⎜ ⎟⎜ ⎟⎜⎜ ⎟⎜ ⎟⎟⎝ ⎠⎝ ⎝ ⎠⎝ ⎠ ⎠

∏

• where T= Number of different scenarios

• Ai = outcome of ith scenario

• Pi = probability of the ith scenario

• W = worst outcome of all n scenarios

• f = value for f which we are testing

The inputs used for the Rational Expectations model used by the

Tactical Portfolio Management algorithm are the same inputs needed

to perform Optimal F analysis. There are two ways to use Optimal F.

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Scenario estimates for either individual investments or the market in

general can be used. In the case where the scenarios are based on

market expectations the Optimal F algorithm estimates the optimal

fraction of portfolio equity to have invested in stocks in order to

maximize returns. Consider the following example:

Market Scenarios

Expected Return Probability

Outcome A 20% 50%

Outcome B -10% 10%

Outcome C -15% 5%

Outcome D 15% 25%

Outcome E 10% 10%

Optimal f= 86%

In this case the expected market returns and associated

probabilities for a one year holding period are used. For this example,

we project:

• a 50% chance the market will go up 20% (outcome A)

• a 10% chance the market will decline by 10% (outcome

B)

• a 5% chance the market will decline by 15% (outcome C)

• a 25% chance the market will go up by 15% (outcome D)

• a 10% chance the market will go up by 10% (outcome E).

Given these different market scenarios the Optimal F algorithm

estimates 86% of portfolio equity should be in the market index with

the remainder in cash, bonds, or other assets.

Individual Stock Scenarios Low Risk Scenario


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Individual Stock Scenarios


Outcome A 100% 25%

Outcome B -50% 15%

Outcome C -30% 20%

Outcome D -10% 25%

Outcome E 50% 15%

Optimal f= 31%

Individual stocks all have infinitely varying risk characteristics.

Intuitively we know that some stocks are more volatile than others.

Price swings for Amazon.com and EBay will be much greater than

those for Coke and GE. Optimal F can help you maximize your

holding period returns by estimating the optimum number of trades to

make when taking or drawing down a position in a particular stock.

Riskier stocks will require more trades to get into and get out of than

less risky stocks. Consider the example above where one year holding

period scenarios for stock in company XYZ.com are outlined. XYZ

has some pretty extreme scenarios. Expected outcomes vary from a

return of 100% to a loss of 50%. Given these varying scenarios the

Optimal F algorithm estimates that approximately 3 trades (1 divided

by Optimal f or 1/.31) should be made during the holding period to

maximize returns. Using this information an investor in XYZ.com

would take their position with three separate trades, buying when the price of the stock swings low relative to some benchmark metric such

as its 50 day or 200 day moving average.

Consider one more example where the stock is less risky, a stock

like GE or Coke, where all the expected outcome scenarios are

positive for a two year investment horizon.

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Low Risk Scenario


Outcome A 100% 30%

Outcome B 50% 40%

Outcome C 0% 5%

Outcome D 30% 15%

Outcome E 20% 10%

Optimal f= 100%

In this case the optimal fraction to invest is 100%. Intuitively this

makes sense because the stock's variance is expected to be positively

biased during the two year holding period. If you tried to dollar-cost

average you would, in all probability, just average up the price of

your shares. Dollar-cost averaging in this case would result in a

decreased average holding period return. Since your goal is to

maximize HPR you should simply invest in this stock in one single

trade as soon as you are ready to invest.


42/43

Comments: Insight gained from Chaos and Order and


43/43

85

Comments: Insight gained from Chaos and Order and

Fractal Market Analysis helped eliminate a good deal of

extraneous research (Thank You Edgar!) and set a clear

path towards Portfolio Insight's creation.

19. Peters, Edgar. Fractal Market Analysis. New York: John

Wiley and Sons, 1994

20. Taggart, Robert. Quantitative Analysis For Investment

Management. New Jersey: Prentice Hall, 1996

Comments: Fuller and Hsia's H-Model DCF valuation

formula, referenced in Taggart, was used for Portfolio

Insight's Stock Valuation Model

21. Thomsett, Michael. Mastering Fundamental Analysis.

Chicago: Dearborn Financial Publishing, 1998

22. Trippi, Robert and Lee, Jae. Artificial Intelligence In

Finance and Investing. Chicago: Irwin, 1996

23. Vince, Ralph. The New Money Management: A New

Framework For Asset Allocation. New York: John

Wiley and Sons, 1995Comment: Vince's Optimal f formula, in its basic form,

was used for the Optimal f analysis tool in Portfolio

Insight Pro.

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