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FIN 200: Personal Finance

Topic 21–Diversification and Portfolio Theory

Lawrence Schrenk, Instructor

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Learning Objectives

1. Describe mutual fund styles. ▪

2. Define index fund and compare it with actively managed funds.

3. Define diversification and explain its impact on the risk of a portfolio. ▪

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Mutual Fund Style Analysis

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Mutual Fund Style Analysis Style Analysis: Style analysis identifies the

process of investing by fund managers that leads them to pick certain kinds of securities.

Three factors of style analysis: Growth Value Company Size

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Mutual Fund Style Factors Growth Managers buy stocks in companies

whose earnings are growing rapidly. Value Managers are bargain hunters seeking

stocks with low prices compared to intrinsic value.

Company Size Managers specialize in small or large companies.

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Mutual Fund Style Analysis Style determines 85-90% of a fund portfolio’s

return. Compares a fund against different indexes. The mix of indexes that are most highly

correlated determines the style of the mutual fund manager.

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Mutual Fund Style Types The mutual fund universe can be divided into

six basic styles: Small cap growth funds Large cap growth funds Small cap value Large cap value International funds Fixed income funds

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Mutual Fund Style

Investment style should remain constant Investment fund managers have no authority to

change the asset class If you purchase a small cap fund, you don't want

the manager to purchase international shares. Prospectus should clearly define the market,

size company, and style tilt for the portfolio.

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Manager Style Drift

Managers Style Box

The style box should not change over time

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Fund Information

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Internet Sources of Fund Information

Use web sites to research a fund. http://finance.yahoo.com www.businessweek.com www.morningstar.com (also other advisory services, such

as Value Line). www.smartmoney.com

Check mutual fund companies Internet sites. www.trendstarfunds.com www.vanguard.com

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Other Sources of Fund Information

Mutual Fund Annual Report Performance, investments, assets and liabilities

Financial Publications Business Week, Forbes, Kiplinger's Personal

Finance and Money are sources of information. Business Week’s mutual fund survey includes

information such as the... Fund’s overall rating compared to all other funds, and to

funds in the same category. Fund size, sales charge and expense ratio. Performance for best and worst quarters.

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Index Funds

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Index Funds Index Funds

Mutual Funds or Exchange Traded Funds which hold specific shares in proportion to those held by an index

Their goal is to match the benchmark performance Why have they come about?

Most actively managed funds have not been able to beat their benchmarks after all fees, taxes and costs.

In an index fund investors accept the index return and risk.

Interestingly, in the process, index funds have tended to outperform most actively managed funds

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Index Funds Advantages No correlation between last year’s and this

year’s winners for actively managed funds Actively managed funds tend to hurt

performance through excessive trading, which also generates taxes

Actively managed funds generally have higher management fees 0.18% for an index fund 0.80-2.50% for an actively managed fund

It is very difficult to beat index funds on a consistent basis after fees and taxes

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Exchange-Traded Funds

Exchange-traded funds (ETFs) invest in the stocks contained in a specific stock market index, like the Standard and Poor’s 500 stock index.

Low management fees since there is less need for decisions made by a portfolio manager.

Baskets of stocks similar to mutual funds which trade on organized exchanges (661 as of March 2008 - Morningstar)

Trade more like stocks

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Diversification

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Diversification

As I start adding more stocks to my portfolio, the volatility begins to go down. The changes in one stock are cancelling the

changes in another stock. But volatility can never reach zero.

All stocks respond to some common factors: inflation, taxes, government policy, etc.

Diversifiable Risk versus Market Risk

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What Happens in Diversification?

Number of Stocks

Vol

atili

ty o

f P

ortf

olio

Market Risk

Diversifiable Risk

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Diversification Example

Five Companies Ford (F) Walt Disney (DIS) IBM Marriott International (MAR) Wal-Mart (WMT)

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Diversification Example (cont’d)

Five Equally Weighted Portfolios

Portfolio Equal Value in Each of…

F Ford

F,D Ford, Disney

F,D,I, Ford, Disney, IBM

F,D,I,M Ford, Disney, IBM, Marriott

F,D,I,M,W Ford, Disney, IBM, Marriott, Wal-Mart

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Individual Returns

Individual Monthly Returns

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WMT

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F Portfolio

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F,D Portfolio

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F,D,I Portfolio

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F,D,I,M Portfolio

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F,D,I,M,W Portfolio

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F,D,I,M,W versus F Portfolio

F,D,I,M,W versus F Portfolio Monthly Return

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LCP versus F Portfolio

LCP versus F Portfolio Monthly Return

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LCP

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Decreasing RiskPortfolio Standard Deviation

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F F,D F,D,I F,D,I,M F,D,I,M,W LCP

F F,D F,D,I F,D,I,M F,D,I,M,W LCPAverage -0.90% -0.26% 0.00% 0.27% 0.29% 0.51%

Standard Deviation 10.92% 7.83% 6.82% 6.45% 5.64% 5.01%

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Diversification Diversification is your key defense

against market risk Stay diversified at all times. Pick a fund

with many companies in their portfolios within your asset class

Remember where you are in the hourglass. Avoid sector (industry) funds, individual stocks or

concentrated portfolios of any kind until you have sufficient education, experience, and assets

And even then, keep that percentage of these assets small in relation to your overall assets.

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Diversification Dimensions

Numbers Total: Number of Stock and Bond Holdings

Type Type of holdings (stocks, bonds, cash)

Industry/Sector Types of firms held

Location Location of companies (geographic area)

Project Note

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Ethical Dilemma