Modern Portfolio Theory and Investment Analysis, 9th Edition

27

Evaluation of Security Analysis

The selection of a portfolio of securities can be thought of as a multistage process. The first stage consists of studying the economic and social environment and the characteristics of individual companies to produce a set of forecasts of individual company variables. The second stage consists of turning these forecasts of fundamental data about the corporation and its environment into a set of forecasts of security prices and/or returns and risk measures. This stage is often called the valuation process. The third and last stage consists of forming portfolios of securities based on the forecast of security returns. Although, as we have seen in Chapter 26, a great deal of attention has been paid, both in the academic literature and in practice, to evaluating how well the entire process works, almost no attention has been paid to evaluating the components of the process. This is particularly surprising because the bulk of the evidence seems to indicate that the overall process does not work very well. The lack of extraordinary performance could be due to any of several causes, such as a lack of forecast ability, an inability to turn good forecasts of fundamental company data into good forecasts of returns, or a lack of ability to turn good forecasts of return into efficient portfolios. For example, it is perfectly possible that an organization has superior forecasting ability with respect to fundamental firm variables and market returns but does ...