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Lecture 1

Introduction to Portfolio Management and Basic Principles

of Finance

Asst. Prof. Dr. Mete Feridun

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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, real estate, commodities, and so on.

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

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Stock Selection Philosophy Fundamental analysis Technical analysis

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Fundamental Analysis A fundamental analyst tries to discern the

logical 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 Analysis A technical analyst attempts to predict the

supply and demand for a stock by observing the past series of stock prices

Financial statements and market conditions are of secondary importance to the technical analyst

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Security Analysis A three-step process

1) The analyst considers prospects for the economy, given the state of the business cycle

2) The analyst determines which industries are likely to fare well in the forecasted economic conditions

3) The analyst chooses particular companies within 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 returns

than lower-risk assets. Risk tolerance: The investor’s willingness to accept

higher risk to attain higher expected returns. Risk aversion: The investor is also reluctant to

accept risk An investor’s objectives can be classified as return

requirement and risk tolerance

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Investors Constraints Constraints are the kind of financial circumstances imposed

on an investor’s choice. Five common types of constraints are:

1. Liquidity: refers to how easy an asset can be converted to cash2. Investment horizon: is the planned liquidation duration of investment.3. Regulations: Professional and institutional investors are constrained by regulations- investors who manage other people’s money have fiduciary responsibility to restrict investment to assets that would have been approved by a prudent investor.

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Investors Constraints

4.Tax considerations: special considerations related to tax position of the investor. The performance of any investment strategy are always measured by its rate of return after tax.

5.Unique needs: often centre around the investor’s stage in the life cycle such as retirement, housing and children’s education.

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Portfolio Management Literature supports the efficient markets

paradigm• On a well-developed securities exchange,

asset prices accurately reflect the tradeoff between relative risk and potential returns of a security

– Efforts to identify undervalued undervalued securities are fruitless

– Free lunches are difficult to find

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Portfolio Management (cont’d) Market efficiency and portfolio

management• A properly constructed portfolio achieves a

given level of expected return with the least possible risk

– Portfolio managers have a duty to create the best possible collection of investments for each customer’s unique needs and circumstances

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Purpose of Portfolio Management

Portfolio management primarily involves reducing 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 (high risk)

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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

LowRiskHighRisk

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Low Risk vs. High Risk Investments (cont’d)

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, and Investment Policy (cont’d)

There is a distinction between “good companies” and “good investments”• The stock of a well-managed company may be

too expensive• The stock of a poorly-run company can be a

great investment if it is cheap enough

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Background, Basic Principles, and Investment Policy (cont’d)

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

tomorrow

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

These two ideas form the basis for all aspects of financial management

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Portfolio Management Passive management has the following

characteristics:• Follow a predetermined investment strategy

that is invariant to market conditions or

• Do nothing

• Let the chips fall where they may

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Portfolio Management (cont’d) Active management:

• Requires the periodic changing of the portfolio components as the manager’s outlook for the market changes

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Risk Versus Uncertainty Uncertainty 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 you

made 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 returns on the stock A runs from -30% to more than +40%. If the required return on the stock is 10%, then those 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 probable outcomes the greater the risk of the investment.

A is a much riskier investment than BB

A

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Risk and Return

Risk and return are the two most important attributes of an investment.

Research has shown that the two are linked in the capital markets and that generally, higher returns can only be achieved by taking on greater risk.

Risk isn’t just the potential loss of return, it is the potential loss of the entire investment itself (loss of both principal and interest).

Return %

RF

Risk

Risk Premium

Real Return

Expected Inflation Rate

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Relationship Between Risk and Return

The more risk someone bears, the higher the expected return

The appropriate discount rate depends on the risk level of the investment

The risk-less rate of interest can be earned without bearing any risk

25Risk

Expected return

Rf

0

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Returns and Risk of Different Asset Classes

Historically, small company stocks have generated the highest returns. But the volatility of returns have been the highest too

Inflation and taxes have a major impact on returns

Returns 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 annual returns 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 interest rates), and the range of returns has been greater than T-bills but less than stocks

• Common stock returns have experienced the greatest range of returns

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Measuring RiskAnnual 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 B because it offers the same return but for less risk.

A dominates C because it offers a higher return but for the same risk.

20%5%

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Risk Aversion Most investors are risk 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 Loss There 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 (cont’d)

Investment A Investment B

Time

Investment value

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Dispersion and Chance of Loss (cont’d)

Investments A and B have the same arithmetic mean

Investment B is riskier than Investment A

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Types of Risk Total risk refers to the overall variability of

the returns of financial assets

Undiversifiable risk is risk that must be borne by virtue of being in the market• Arises from systematic factors that affect all

securities of a particular type

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Types of Risk (cont’d) Diversifiable risk can be removed by

proper portfolio diversification• The ups and down of individual securities due

to company-specific events will cancel each other out

• The only return variability that remains will be due to economic events affecting all stocks

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Growth of Income Benefits 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 (cont’d) Often seek to have the annual income

increase by at least the rate of inflation

Requires some investment in equity securities

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Growth of Income (cont’d)Example

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

Portfolio A has an income objective and seeks to provide maximum income each year. The portfolio is invested 100% in debt securities. Thus, Portfolio A generates $5,000 in income each year.

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Growth of Income (cont’d)Example (cont’d)

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

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

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Growth of Income (cont’d)Example (cont’d)

$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 stocks Defensive stocks Growth stocks Speculative stocks Penny stocks

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Blue Chip Stock Blue chip has become a colloquial term

meaning “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 Stocks Income stocks are those that historically

have paid a larger-than-average percentage of their net income as dividends• The proportion of net income paid out as

dividends is the payout ratio• The proportion of net income retained is the

retention ratio Examples include Consolidated Edison and

Allegheny Energy

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Cyclical Stocks Cyclical stocks are stocks whose fortunes

are directly tied to the state of the overall national economy

Examples include steel companies, industrial chemical firms, and automobile producers

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Defensive Stocks Defensive stocks are the opposite of

cyclical stocks• They are largely immune to changes in the

macroeconomy and have low betas

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

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Growth Stocks Growth stocks do not pay out a high

percentage of their earnings as dividends• They reinvest most of their earnings into

investment opportunities

• Many growth stocks do pay dividends

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Speculative Stocks Speculative stocks are those that have the

potential to make their owners rich quickly Speculative stocks carry an above-average

level of risk Most speculative stocks are relatively new

companies with representation in the technology, bioresearch, and pharmaceutical industries

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Penny Stocks Penny stocks are inexpensive shares

Penny stocks sell for $1 per share or less

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Categories Are Not Mutually 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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Capitalization Capitalization refers to the aggregate value

of a company’s 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 Styles 1-Value investing

2-Growth investing

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1-Value Investing Value investors look for undervalued stock

Utilize the firm’s earnings history and balance sheet• PE ratio, price/book ratio

Place much emphasis on known facts

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Price/Earnings Ratio The PE ratio is stock price divided by EPS

A forward-looking PE uses earnings forecasts

A trailing PE uses historical earnings

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Price/Book Ratio The price/book ratio is the stock price

divided by book value per share• Book value is the firm’s assets minus its

liabilities• Book value is different from market value

Value investors look for low price/book ratios

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2-Growth Investing Growth 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 Individuals Invest ?

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 future consumption and present consumption. Market forces determine this rate.

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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.

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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.

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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.

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Defining an InvestmentA current commitment of $ for a period of time in order to derive future payments that will compensate 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 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

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Probability DistributionsRisk-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

0.60

0.80

1.00

-30% -10% 10% 30%

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Probability DistributionsRisky 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 CONCEPTS

Risk 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 Fluctuations in the market And...

Decreased Safety

Risk vs Safety

“No Loss” due toPrincipal decline

Various Investment Options

Substantial TrackRecord

1) As we go down the Risk list, your return will decrease

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

1) As we go down the Safety list, your potential return increases

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First Let’s Review the Risk Investments

1) Stocks a) Company risk b) Market risk c) Macro risk d) Historic 11.1% return2) Mutual Funds a) Diminished company risk b) Still has market & macro risk c) Could return 8-10%3) Variable Annuities a) Uses sub-accounts b) Can be more expensive c) Returns of 6-9%4) Long-Term Bonds a) Subject to interest rate risk

Risk vs Safety

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1) Stocks a) Company risk b) Market risk c) Macro risk d) Historic 11.1% return2) Mutual Funds a) Diminished company risk b) Still has market & macro risk c) Could return 8-10%3) Variable Annuities a) Uses sub-accounts b) Can be more expensive c) Returns of 6-9%4) Long-Term Bonds a) Subject to interest rate risk

Risk vs Safety

1) CD’s a) Temporary parking spot 4 - 5% b) After tax and inflation, results in minimal returns2) Short Term – Medium Term U.S. Government Bonds3) Fixed Annuities a) Tax-deferred b) Earnings add up c) Higher interest rates paid4) Equity Indexed Annuities 5 – 8 a) Over Time - No Market Risk b) Links to major indexes Usually S&P 500 c) 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!