ch01 portfolio mgmt
TRANSCRIPT
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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!