Ch01 Portfolio Mgmt

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    Lecture 1

    I ntroduction to Por tfol io

    M anagement and Basic Principles of F inance

    Asst. Prof . Dr . M ete F er idun

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    Investors make two major steps or decisions in

    constructing their own portfolios Portfolio is simply collection of investment assets

    The asset allocation decision is the choice among broad asset classes such as stocks, bonds, realestate, commodities, and so on .

    The security selection decision is the choice of which particular securities to hold within each assetclass.

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    Stock Selection PhilosophyFundamental analysisTechnical analysis

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    Fundamental AnalysisA fundamental analyst tries to discern thelogical worth of a security based on its

    anticipated earnings stream

    The fundamental analyst considers: Financial statements Industry conditions Prospects for the economy

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    Technical AnalysisA technical analyst attempts to predict thesupply and demand for a stock by observing

    the past series of stock prices

    Financial statements and market conditions

    are of secondary importance to the technicalanalyst

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    Security AnalysisA three-step process

    1) The analyst considers prospects for the

    economy, given the state of the business cycle2) The analyst determines which industries are

    likely to fare well in the forecasted economicconditions

    3) The analyst chooses particular companieswithin the favored industries

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    An understanding of the risk/return trade-off

    Assets with higher expected returns have greater risk.Higher risk assets offer higher expected returnsthan lower-risk assets.Risk tolerance: The investors willingness to accepthigher risk to attain higher expected returns.Risk aversion: The investor is also reluctant to

    accept risk An investors objectives can be classified as returnrequirement and risk tolerance

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    Investors Constraints

    Constraints are the kind of financial circumstancesimposed on an investors choice.Five common types of constraints are:1. Liquidity: refers to how easy an asset can beconverted to cash2. Investment horizon: is the planned liquidationduration of investment.3. Regulations: Professional and institutionalinvestors are constrained by regulations- investorswho manage other peoples money have fiduciaryresponsibility to restrict investment to assets thatwould have been approved by a prudent investor.

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    Investors Constraints4.Tax considerations: special considerations

    related to tax position of the investor. The

    performance of any investment strategy arealways measured by its rate of return after tax.5.Unique needs: often centre around the

    investors stage in the life cycle such asretirement, housing and childrens education.

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    Portfolio ManagementLiterature supports the eff icient markets paradigm

    On a well-developed securities exchange,asset prices accurately reflect the tradeoff

    between relative risk and potential returns of asecurity

    Efforts to identify undervalued undervaluedsecurities are fruitless

    Free lunches are difficult to find

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    Portfolio Management (contd) Market efficiency and portfoliomanagement

    A properly constructed portfolio achieves agiven level of expected return with the least

    possible risk Portfolio managers have a duty to create the best

    possible collection of investments for eachcustomers unique needs and circumstances

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    Purpose of Portfolio

    ManagementPortfolio management primarily involvesreducing risk rather than increasing return

    Consider two $10,000 investments:1) Earns 10% per year for each of ten years ( low

    risk )2) Earns 9%, -11%, 10%, 8%, 12%, 46%, 8%, 20%, -

    12%, and 10% in the ten years, respectively ( highrisk )

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    Low Risk vs. High Risk

    Investments$25,937

    $10,000

    $23,642

    $0

    $10,000

    $20,000

    $30,000

    '92 '94 '96 '98 '00 '02

    LowRisk HighRisk

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    Low Risk vs. High Risk

    Investments (contd) 1) Earns 10% per year for each of ten years ( low

    risk ) Terminal value is $25,937

    2) Earns 9%, -11%, 10%, 8%, 12%, 46%, 8%,20%, -12%, and 10% in the ten years,respectively ( high risk )

    Terminal value is $23,642

    The lower the dispersion of returns, the greater the terminal value of equal investments

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    Background, Basic Principles, andInvestment Policy (contd)

    There is a distinction between goodcompanies and good investments The stock of a well-managed company may be

    too expensive

    The stock of a poorly-run company can be agreat investment if it is cheap enough

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    Background, Basic Principles, andInvestment Policy (contd)

    The two key concepts in finance are:1) A dollar today is worth more than a dollar

    tomorrow2) A safe dollar is worth more than a risky dollar

    These two ideas form the basis for allaspects of financial management

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    Portfolio ManagementPassive management has the followingcharacteristics:

    Follow a predetermined investment strategythat is invariant to market conditions or

    Do nothing

    Let the chips fall where they may

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    Portfolio Management (contd) Active management :

    Requires the periodic changing of the portfolio components as the managersoutlook for the market changes

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    Risk Versus UncertaintyUncertainty involves a doubtful outcome What you will get for your birthday

    If a particular horse will win at the track

    Risk involves the chance of loss

    If a particular horse will win at the track if youmade a bet

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    Measuring Risk

    Risk = Probability of incurring harm

    For investors, risk is the probability of earning an inadequate return. If investors require a 10% rate of return on a

    given investment, then any return less than 10%is considered harmful.

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    Risk

    Possible Returns on the Stock

    Probability

    -30% -20% -10% 0% 10% 20% 30% 40%

    Outcomes that produce harm

    The range of total possible returnson the stock A runs from -30% tomore than +40%. If the requiredreturn on the stock is 10%, thenthose outcomes less than 10%represent risk to the investor.

    A

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    Differences in Levels of Risk

    Possible Returns on the Stock

    Probability

    -30% -20% -10% 0% 10% 20% 30% 40%

    Outcomes that produce harm The wider the range of probableoutcomes the greater the risk of theinvestment.

    A is a much riskier investment than BB

    A

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    Risk and Return

    Risk and return are the two mostimportant attributes of aninvestment.

    Research has shown that the twoare linked in the capitalmarkets and that generally,higher returns can only beachieved by taking on greater risk.

    Risk isnt just the potential lossof return, it is the potentialloss of the entire investmentitself (loss of both principaland interest).

    Return%

    RF

    Risk

    Risk Premium

    Real Return

    Expected Inflation Rate

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    Relationship Between Risk and

    ReturnThe more risk someone bears, the higher theexpected return

    The appropriate discount rate depends onthe risk level of the investmentThe r isk-l ess rate of interest can be earned

    without bearing any risk

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    Expected return

    R f

    0

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    Returns and Risk of Different

    Asset Classes Historically, small company stocks havegenerated the highest returns. But the

    volatility of returns have been the highesttooInflation and taxes have a major impact on

    returnsReturns on Treasury Bills have barely kept pace with inflation

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    Historical Returns on Different

    Asset Classes Next figure illustrates the volatility in annualreturns on three different assets classes from 1938

    2005. Note:

    Treasury bills always yielded returns greater than 0% Long Canadian bond returns have been less than 0% in

    some years (when prices fall because of rising interestrates), and the range of returns has been greater than T- bills but less than stocks

    Common stock returns have experienced the greatestrange of returns

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    Measuring Risk Annual Returns by Asset Class, 1938 - 2005

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    Portfolio Size and Total Risk

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    Investment ChoicesThe Concept of Dominance Illustrated

    A B

    C

    Return%

    Risk

    10%

    5%

    To the risk-averse wealth maximizer, the choices are clear, A dominates B, A dominates C.

    A dominates Bbecause it offersthe same returnbut for less risk.

    A dominates Cbecause it offers ahigher return butfor the same risk.

    20%5%

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    Risk AversionMost investors are r isk averse People will take a risk only if they expect to be

    adequately rewarded for taking it

    People have different degrees of risk

    aversion Some people are more willing to take a chance

    than others

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    Dispersion and Chance of LossThere are two material factors we use in

    judging risk:

    The average outcome

    The scattering of the other possibilities around

    the average

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    Dispersion and Chance of Loss

    (contd)

    Investment AInvestment B

    Time

    Investment value

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    Dispersion and Chance of Loss

    (contd) Investments A and B have the samearithmetic mean

    Investment B is riskier than Investment A

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    Types of Risk Total r isk refers to the overall variability of the returns of financial assets

    Undiversif iable r isk is risk that must be borne by virtue of being in the market

    Arises from systematic factors that affect allsecurities of a particular type

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    Types of Risk (contd) Diversif iable r isk can be removed by proper

    portfolio diversification

    The ups and down of individual securities dueto company-specific events will cancel eachother out

    The only return variability that remains will bedue to economic events affecting all stocks

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    Growth of IncomeBenefits from time value of money

    Sacrifices some current return for some

    purchasing power protection

    Differs from income objective

    Income lower in earlier years Income higher in later years

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    Growth of Income (contd) Often seek to have the annual incomeincrease by at least the rate of inflation

    Requires some investment in equitysecurities

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    Growth of Income (contd) Example

    Two portfolios have an initial value of $50,000. Interestrates are expected to remain at a constant 10% per yearfor the next ten years.

    Portfolio A has an income objective and seeks to providemaximum income each year. The portfolio is invested100% in debt securities. Thus, Portfolio A generates$5,000 in income each year.

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    Growth of Income (contd) Example (contd)

    Portfolio B seeks growth of income and contains both debtand equity securities. Portfolio B has an annual totalreturn of 13%. In the first year, Portfolio B provides$3,500 in income (a 7% income yield) and experiencescapital appreciation of 5%.

    The income generated by both portfolios over the next tenyears is shown graphically on the following slide.

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    Growth of Income (contd) Example (contd)

    $5,000

    $6,180

    $0

    $1,000$2,000

    $3,000

    $4,000

    $5,000

    $6,000

    $7,000

    1999 2001 2003 2005 2007 2009

    Portfolio APortfolio B

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    Categories of Stock Blue chip stock Income stocks

    Cyclical stocksDefensive stocksGrowth stocksSpeculative stocksPenny stocks

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    Blue Chip Stock Blue chip has become a colloquial termmeaning high quality Some define blue chips as firms with a long,

    uninterrupted history of dividend payments The term blue chip lacks precise meaning, but

    some examples are:

    Coca-Cola Union Pacific General Mills

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    Income StocksI ncome stocks are those that historicallyhave paid a larger-than-average percentageof their net income as dividends The proportion of net income paid out as

    dividends is the payout r atio The proportion of net income retained is the

    retenti on ratio Examples include Consolidated Edison andAllegheny Energy

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    Defensive StocksDefensive stocks are the opposite of cyclical stocks

    They are largely immune to changes in themacroeconomy and have low betas

    Examples include retail food chains,tobacco and alcohol firms, and utilities

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    Growth StocksGrowth stocks do not pay out a high

    percentage of their earnings as dividends

    They reinvest most of their earnings intoinvestment opportunities

    Many growth stocks do pay dividends

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    Speculative StocksSpeculative stocks are those that have the

    potential to make their owners rich quickly

    Speculative stocks carry an above-averagelevel of risk Most speculative stocks are relatively newcompanies with representation in thetechnology, bioresearch, and

    pharmaceutical industries

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    Categories Are NotMutually Exclusive

    An income stock or a growth stock can also be a blue chip

    E.g., Potomac Electric Power

    Defensive or cyclical stocks can be growth

    stocks E.g., Dow Chemical is a cyclical growth stock

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    CapitalizationCapitalization refers to the aggregate valueof a companys common stock

    Typical divisions (for U.S.) are: Large cap ($1 billion or more) Mid-cap (between $500 million and $1 billion) Small cap (less than $500 million) Micro cap

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    Investment Styles1-Value investing

    2-Growth investing

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    1-Value InvestingValue investors look for undervalued stock

    Utilize the firms earnings history and balance sheet

    PE ratio, price/book ratio

    Place much emphasis on known facts

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    Price/Earnings RatioThe PE ratio is stock price divided by EPS

    A forward-looking PE uses earningsforecasts

    A trai l ing PE uses historical earnings

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    2-Growth InvestingGrowth investors look for price momentum Look for stocks that are in favor and have been

    advancing Look for stocks that are likely to be propelled

    even higher

    The market moves in cycles Many investors own both growth and value

    stocks

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    Why Do IndividualsInvest ?

    By saving money (instead of spending it), individuals tradeoff

    present consumption for a larger future consumption.

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    04.1$%400.1$

    How Do We Measure The Rate of

    Return on An Investment ?The pure rate of interest is the

    exchange rate between futureconsumption and presentconsumption. Market forces

    determine this rate.

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    Peoples willingness to pay thedifference for borrowing today andtheir desire to receive a surplus ontheir savings give rise to an interest

    rate referred to as the pure timevalue of money.

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    If the future payment will bediminished in value because of

    inflation, then the investor willdemand an interest rate higher thanthe pure time value of money toalso cover the expected inflationexpense.

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    If the future payment from theinvestment is not certain, theinvestor will demand an interestrate that exceeds the pure timevalue of money plus the inflationrate to provide a risk premium tocover the investment risk.

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    Defining an Investment A current commitment of $ for a

    period of time in order to derivefuture payments that willcompensate for:

    the time the funds are committed the expected rate of inflation uncertainty of future flow of funds.

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    Risk AversionThe assumption that most investorswill choose the least riskyalternative, all else being equal andthat they will not accept additional

    risk unless they are compensated inthe form of higher return

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    Probability Distributions

    Risk-free Investment

    0.00

    0.20

    0.40

    0.60

    0.80

    1.00

    -5% 0% 5% 10% 15%

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    Probability DistributionsRisky Investment with 3 Possible Returns

    0.00

    0.20

    0.40

    0.600.80

    1.00

    -30% -10% 10% 30%

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    Probability Distributions Risky investment with ten possible rates of return

    0.00

    0.20

    0.40

    0.60

    0.80

    1.00

    -40% -20% 0% 20% 40%

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    ALL INVESTING

    INVOLVES TWO CONCEPTSRisk vs Safety

    Question: What percentage of my assets should be in At-Risk Investments?

    Answer: Age 100 Your Age = Percentage of Risk

    Example: 100 60 = 40%

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    Remember, When You Invest Your $s

    Higher PotentialReturnsBut...

    Daily Fluctuationsin the marketAnd...

    Decreased Safety

    Risk vs Safety

    No Loss due to Principal decline

    Various InvestmentOptions

    Substantial TrackRecord

    1) As we go down theRisk list, your returnwill decrease

    2) As we go down theRisk list, your risk of loss declines

    1) As we go down theSafety list, your potential returnincreases

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    First Lets Review the Risk Investments

    1) Stocks

    a) Company riskb) Market risk c) Macro riskd) Historic 11.1% return

    2) Mutual Funds

    a) Diminished company riskb) Still has market & macro riskc) Could return 8-10%

    3) Variable Annuitiesa) Uses sub-accountsb) Can be more expensivec) Returns of 6-9%

    4) Long-Term Bondsa) Subject to interest rate risk

    Risk vs Safety

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    1) Stocks

    a) Company riskb) Market risk c) Macro riskd) Historic 11.1% return

    2) Mutual Funds

    a) Diminished company riskb) Still has market & macro riskc) Could return 8-10%

    3) Variable Annuitiesa) Uses sub-accountsb) Can be more expensivec) Returns of 6-9%

    4) Long-Term Bondsa) Subject to interest rate risk

    Risk vs Safety

    1) CDs

    a) Temporary parking spot 4 - 5%b) After tax and inflation, results

    in minimal returns2) Short Term Medium Term U.S.

    Government Bonds

    3) Fixed Annuitiesa) Tax-deferredb) Earnings add upc) Higher interest rates paid

    4) Equity Indexed Annuities 5 8a) Over Time - No Market Riskb) Links to major indexes

    Usually S&P 500c) With No Risk of Loss of

    Principal due to market decline

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    FINAL QUESTION

    Which of these three do you want?

    PROTECTION

    GROWTH

    LIQUIDITY

    The market only allows you two out of three!