Ch01 Portfolio Mgmt

7/27/2019 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!

Documents

Ch01 Portfolio Mgmt