The Investment Settings & The Asset Allocation Decision Chapter 1 The Investment Setting nQuestions to be answered: nWhy do individuals invest ? nWhat is an investment ? nHow do we measure the rate of return on an investment ? nHow do investors measure risk related to alternative investments ? Chapter 1 The Investment Setting nWhat factors contribute to the rates of return that investors require on alternative investments ? nWhat macroeconomic and microeconomic factors contribute to changes in the required rate of return for individual investments and investments in general ? Why Do Individuals Invest ? nBy saving money (instead of spending it), individuals trade-off present consumption for a larger future consumption. nSometime, you may have more money than you want to spend, at the other times, you want to buy more than you can afford. nBorrow or save to maximalise long-run benefits from you income. nWhen your income exceeds current consumption, people tend to invest income. qTrade-off of present consumption for a higher level of future consumption nReason of saving nWhat you have to do with savings to make them increase over time is investment n n How Do We Measure The Rate Of Return On An Investment ? nThe pure rate of interest is the exchange rate between future consumption and present consumption. Market forces determine this rate. nPay for borrowed funds nWish to receive on savings nBase on market conditions qSupply and demand n n People’s willingness to pay the difference for borrowing today and their desire to receive a surplus on their savings give rise to an interest rate referred to as the pure time value of money. How Do We Measure The Rate Of Return On An Investment ? n If the future payment will be diminished in value because of inflation, then the investor will demand an interest rate higher than the pure time value of money to also cover the expected inflation expense. nInflation: n1986: 1,1 percent n1979: 13,3 percent n1970-2001: average 5,4 percent n How Do We Measure The Rate Of Return On An Investment ? n If the future payment from the investment is not certain, the investor will demand an interest rate that exceeds the pure time value of money plus the inflation rate to provide a risk premium to cover the investment risk. How Do We Measure The Rate Of Return On An Investment ? Defining an Investment n A current commitment of $ for a period of time in order to derive future payments that will compensate for: qthe time the funds are committed qthe expected rate of inflation quncertainty of future flow of funds. nInvestor qIndividual, a government, a pension fund or a corporation nInvestments qIn corporation plants, equipments, individual bonds, stocks, etc. nInvestor is trading known dollar amount today some expected future stream of payments that will be greater than the current outlay. nRate of return qCompensation for investor time, expected rate of inflation and uncertainty of the return nHow to choose among alternative investment assets? qEstimate and evaluate the expected risk-return trade-offs for the alternative investment available nQuantify return and risk qMeasure both historical and expected rates of return and risk Measures of Historical Rates of Return nEvaluation alternative investments qDifferent prices and different lives nStocks paying and not paying dividends qCompare their historical rate of returns nChange in wealth qCash flows qChange in price Measures of Historical Rates of Return nHPR greater or equal to zero qGreater than 1 qLess than 1 qEqual to 0 nPercentage change to annual basis q Holding Period Yield HPY = HPR - 1 1.10 - 1 = 0.10 = 10% 1.2 nAnnual Holding Period Return qAnnual HPR = HPR 1/n qwhere n = number of years investment is held nAnnual Holding Period Yield qAnnual HPY = Annual HPR - 1 Measures of Historical Rates of Return Measures of Historical Rates of Return nHPY for single investment for single year qMean rate of return nHighest or lower returns during some period qTake in consideration all of these returns but have some summarized figure nTypical experience nSingle investment qA set of annual HPYs nThe arithmetic mean AM q Measures of Historical Rates of Return nGeometric Mean q 1.5 nGM superior measure of the long-term mean rate of return nAM good indicator of the expected rate of return for an investment during a future individual years n nAM is greater or equal to GM A Portfolio of Investments n The mean historical rate of return for a portfolio of investments is measured as the weighted average of the HPYs for the individual investments in the portfolio. Computation of Holding Period Yield for a Portfolio Exhibit 1.1 This table is in the book on page 11. It is also provided in the Investment Templates spreadsheet in an interactive spreadsheet form. Expected Rates of Return nRisk is uncertainty that an investment will earn its expected rate of return nSetting of expected returns means qSetting probability values to all possible returns qProbability range from 0 to 1 qTotal value of probabilities is equal to 1 nProbability is the likelihood of an outcome Expected Rates of Return 1.6 Risk Aversion n The assumption that most investors will choose the least risky alternative, all else being equal and that they will not accept additional risk unless they are compensated in the form of higher return Probability Distributions nRisk-free Investment Exhibit 1.2 Probability Distributions nRisky Investment with 3 Possible Returns Exhibit 1.3 Probability Distributions nRisky investment with ten possible rates of return Exhibit 1.4 Measuring the Risk of Expected rates of Return nWe can calculate the expected rate of return and evaluate the uncertainty qIdentifying the range of possible return and setting probability that it will occur qGraph helps to visualize the dispersion of possible returns qBut investors want to quantify this dispersion by using statistical techniques nPossible to compare the return and risk of alternative investments directly Measuring the Risk of Expected Rates of Return 1.7 Measuring the Risk of Expected Rates of Return nStandard Deviation is the square root of the variance 1.8 A Relative Measure of Risk nIn some cases using variance or standars deviation can be misleading qIf conditions of two or more investment alternatives are not similar nMajor differences in the expected rates of return qUsing relative variability to identify risk per unit of expected return Measuring the Risk of Expected Rates of Return n Coefficient of variation (CV) a measure of relative variability that indicates risk per unit of return n Standard Deviation of Returns nExpected Rate of Returns 1.9 Measuring the Risk of Historical Rates of Return nvariance of the series nholding period yield during period I nexpected value of the HPY that is equal to the arithmetic mean of the series nthe number of observations 1.10 Determinants of Required Rates of Return nIf you selection securities in your portfolio qTime value of money qExpected rate of inflation qRisk involved n-> required rate of return The Real Risk Free Rate (RRFR) nBasic interest rate qAssumes no inflation. qAssumes no uncertainty about future cash flows. qInfluenced by time preference for consumption of income and investment opportunities in the economy Factors Influencing the Nominal Risk-Free Rate nTrade-off between current and future consumption qRisk free rate of interest qMeasured in real terms qReal vs. Nominal rate of interest nAdjusted for changes in price level vs. Stated in money terms Adjusting For Inflation nReal RFR = 1.12 Nominal Risk-Free Rate n Dependent upon qConditions in the Capital Markets nShort-run: temporary disequilibrium in the supply and demand for capital qFiscal or monetary policy nLong-run: changes in interest rates help to return to long-run equilibrium qExpected Rate of Inflation Adjusting For Inflation nNominal RFR = q(1+Real RFR) x (1+Expected Rate of Inflation) - 1 1.11 Risk Premium nA risk-free investment qOne for which is investor certain of the amount and timing of expected return nA return of the most investment is different nRisk-free securities T-Bills nSpeculative securities – stocks, bonds of small companies nHighest return than risk free return qRisk premium RP Facets of Fundamental Risk nComposite of all uncertainty, main fundamentals of risk qBusiness risk qFinancial risk qLiquidity risk qExchange rate risk qCountry risk Business Risk nUncertainty of income flows caused by the nature of a firm’s business nSales volatility and operating leverage determine the level of business risk. Financial Risk nUncertainty caused by the use of debt financing. nBorrowing requires fixed payments which must be paid ahead of payments to stockholders. nThe use of debt increases uncertainty of stockholder income and causes an increase in the stock’s risk premium. Liquidity Risk nUncertainty is introduced by the secondary market for an investment. qHow long will it take to convert an investment into cash? qHow certain is the price that will be received? q Exchange Rate Risk nUncertainty of return is introduced by acquiring securities denominated in a currency different from that of the investor. nChanges in exchange rates affect the investors return when converting an investment back into the “home” currency. Country Risk nPolitical risk is the uncertainty of returns caused by the possibility of a major change in the political or economic environment in a country. nIndividuals who invest in countries that have unstable political-economic systems must include a country risk-premium when determining their required rate of return Risk Premium nf (Business Risk, Financial Risk, Liquidity Risk, Exchange Rate Risk, Country Risk) nor nf (Systematic Market Risk) n Risk Premium and Portfolio Theory nAlternative view of risk nExternal market measure of risk qRational, profit-maximizing investors want to hold a completely diversified market portfolio of risk assets, and they borrow and lend to arrive at a risky level, that is consistent with their risky preferences nThe relevant risk measure for an individual asset is its co-movement with the market portfolio qCovariance between an asset and market portfolio nSystematic risk relates the variance of the investment to the variance of the market nBeta measures this systematic risk of an asset Fundamental Risk versus Systematic Risk •Fundamental risk comprises business risk, financial risk, liquidity risk, exchange rate risk, and country risk •Systematic risk refers to the portion of an individual asset’s total variance attributable to the variability of the total market portfolio Relationship Between Risk and Return nExhibit 1.7 shows relations between risk and return nInvestor increase their required rates of return as risk uncertainty increase nLine SML – Security Market Line qRisk-return combinations available for all risky assets in capital market at given time qSML can changes nPosition on SML for investment – investor perceive of risk is changed nSlope – change attitude of investor toward risk qChanges in return that is require per unit nParallel shift qChanges in RRFR of expected rate of inflation NRFR q Relationship Between Risk and Return Exhibit 1.7 (Expected) Changes in the Required Rate of Return Due to Movements Along the SML Exhibit 1.8 Changes in the Slope of the SML nRPi = E(Ri) - NRFR n where: nRPi = risk premium for asset i nE(Ri) = the expected return for asset i nNRFR = the nominal return on a risk-free asset 1.13 Market Portfolio Risk n The market risk premium for the market portfolio (contains all the risky assets in the market) can be computed: nRPm = E(Rm)- NRFR where: nRPm = risk premium on the market portfolio nE(Rm) = expected return on the market portfolio nNRFR = expected return on a risk-free asset 1.14 Change in Market Risk Premium Exhibit 1.10 NRFR Expected Return Rm´ Rm Capital Market Conditions, Expected Inflation, and the SML Exhibit 1.11 NRFR NRFR´ Expected Return Capital Market Conditions, Expected Inflation, and the SML nExpected real growth of economy nCapital market conditions nExpected rate of inflation Summary of Changes in the Required Rate of Return The Portfolio Management Process nThe process of managing a portfolio never stops qIf funds are invested according to plan nThe real work begins in monitoring and updating the statues of the portfolio and investor needs The Portfolio Management Process n1. Policy statement - Focus: Investor’s short-term and long-term needs, familiarity with capital market history, and expectations n2. Examine current and project financial, economic, political, and social conditions - Focus: Short-term and intermediate-term expected conditions to use in constructing a specific portfolio n3. Implement the plan by constructing the portfolio - Focus: Meet the investor’s needs at the minimum risk levels n4. Feedback loop: Monitor and update investor needs, environmental conditions, portfolio performance Exhibit 2.2 The Portfolio Management Process n 1. Policy statement qspecifies investment goals and acceptable risk levels qshould be reviewed periodically qguides all investment decisions qperiodicaly reviewed and updated q The Portfolio Management Process n 2. Study current financial and economic conditions and forecast future trends qdetermine strategies to meet goals qrequires monitoring and updating The Portfolio Management Process n 3. Construct the portfolio qallocate available funds to minimize investor’s risks and meet investment goals The Portfolio Management Process n 4. Monitor and update qevaluate portfolio performance nCompare with expectation and the requirements set in the policy statement qMonitor investor’s needs and market conditions qrevise policy statement as needed qmodify investment strategy accordingly q The Need For A Policy Statement nHelps investors understand their own needs, objectives, and investment constraints nSets standards for evaluating portfolio performance nReduces the possibility of inappropriate behavior on the part of the portfolio manager Constructing A Policy Statement n Questions to be answered: nWhat are the real risks of an adverse financial outcome, especially in the short run? nWhat probable emotional reactions will I have to an adverse financial outcome? nHow knowledgeable am I about investments and the financial markets? Constructing A Policy Statement nWhat other capital or income sources do I have? How important is this particular portfolio to my overall financial position? nWhat, if any, legal restrictions may affect my investment needs? nWhat, if any, unanticipated consequences of interim fluctuations in portfolio value might affect my investment policy? Investment Objectives nInvestor goals in the term of qRisk and return qOnly return can by misleading nRisk Tolerance q„double my investment in five years…“ qA careful analysis and of the client risk tolerance should precede any discussions of return objectives qTest for evaluation of tolerance qMerrill Lynch table nAbsolute or relative percentage return nGeneral goals Investment Objectives n General Goals nCapital preservation qminimize risk of real loss nCapital appreciation qGrowth of the portfolio in real terms to meet future need nCurrent income qFocus is in generating income rather than capital gains n Investment Objectives n General Goals nTotal return qIncrease portfolio value by capital gains and by reinvesting current income qMaintain moderate risk exposure Investment Constraints nLiquidity needs qVary between investors depending upon age, employment, tax status, etc. qT-Bills vs. Real estates, joint venture capital nTime horizon qInfluences liquidity needs and risk tolerance nRelations between qLiquidity needs, time horizon and ability to handle risk qLong horizon §Less liquid, greater portfolio risk qShort horizon §More liquid and lower risk of portfolio § Investment Constraints nTax concerns qCapital gains or losses – taxed differently from income qUnrealized capital gain – reflect price appreciation of currently held assets that have not yet been sold qRealized capital gain – when the asset has been sold at a profit qTrade-off between taxes and diversification – tax consequences of selling company stock for diversification purposes Investment Constraints nTax concerns (continued) qinterest on municipal bonds exempt from federal income tax and from state of issue qinterest on federal securities exempt from state income tax qcontributions to an IRA may qualify as deductible from taxable income qtax deferral considerations - compounding Equivalent Taxable Yield Effect of Tax Deferral on Investor Wealth over Time $1,000 Investment Value Time $10,062.66 $5,365.91 Exhibit 2.6 Methods of Tax Deferral nRegular IRA - tax deductible qTax on returns deferred until withdrawal nRoth IRA - not tax deductible qtax-free withdrawals possible nCash value life insurance – funds accumulate tax-free until they are withdrawn nTax Sheltered Annuities nEmployer’s 401(k) and 403(b) plans – tax-deferred investments Legal and Regulatory Factors nLimitations or penalties on withdrawals nFiduciary responsibilities - “prudent man” rule nInvestment laws prohibit insider trading Unique Needs and Preferences nPersonal preferences such as socially conscious investments could influence investment choice nTime constraints or lack of expertise for managing the portfolio may require professional management nLarge investment in employer’s stock may require consideration of diversification needs nInstitutional investors needs Constructing the Policy Statement nObjectives - risk and return nConstraints - liquidity, time horizon, tax factors, legal and regulatory constraints, and unique needs and preferences nDeveloping a plan depends on understanding the relationship between risk and return and the the importance of diversification The Importance of Asset Allocation nAn investment strategy is based on four decisions qWhat asset classes to consider for investment qWhat normal or policy weights to assign to each eligible class qDetermining the allowable allocation ranges based on policy weights qWhat specific securities to purchase for the portfolio The Importance of Asset Allocation nAccording to research studies, most (85% to 95%) of the overall investment return is due to the first two decisions, not the selection of individual investments Returns and Risk of Different Asset Classes nHistorically, small company stocks have generated the highest returns. But the volatility of returns have been the highest too nInflation and taxes have a major impact on returns nReturns on Treasury Bills have barely kept pace with inflation Returns and Risk of Different Asset Classes nMeasuring risk by probability of not meeting your investment return objective indicates risk of equities is small and that of T-bills is large because of their differences in expected returns nFocusing only on return variability as a measure of risk ignores reinvestment risk Asset Allocation Summary nPolicy statement determines types of assets to include in portfolio nAsset allocation determines portfolio return more than stock selection nOver long time periods, sizable allocation to equity will improve results nRisk of a strategy depends on the investor’s goals and time horizon Asset Allocation and Cultural Differences nSocial, political, and tax environments influence the asset allocation decision nEquity allocations of U.S. pension funds average 58% nIn the United Kingdom, equities make up 78% of assets nIn Germany, equity allocation averages 8% nIn Japan, equities are 37% of assets Summary •Identify investment needs, risk tolerance, and familiarity with capital markets •Identify objectives and constraints •Enhance investment plans by accurate formulation of a policy statement •Focus on asset allocation as it determines long-term returns and risk