building a portfolio with stocks, bonds and mutual funds

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  • 1. Building Portfolios with Stocks, Bonds, and Mutual Funds Financial & Retirement Planning Jay Taparia, CFA Managing Director, Sanskar Investments, Inc.Lecturer of Finance, University of Illinois @ Chicago 1

2. The Client Is A Human Being& Is Capable Of Having Emotion attached to wealth Goals (if) that are ST, MT or LT A limited life span Uncertainty about the future Irrationality associated with decision-making A gambling attitude toward the markets over- confidence Dreams that could be impossible to reach Dreams that are very possible to reach An aversion toward risk whatever that may be Annoying you at times And dont forget that Life Happens2 3. Because Of This Building portfolios is not only a science, but it is an art Having a nice irrelevant conversation with the client is necessary to build a relationship, but also to discover new needs and objectives Client needs & objectives change over time (years even days) Portfolios are managed with continuously changing objectives 3 4. Individual Investor Life Cycle Spending Phase Accumulation Gifting Phase Consolidation Long-term: Retirement, Long-term: ChildrensRetirementLong-term: college Estate Planning Short-term: Short-term: Vacations,Short-term: House, CarChildrens CollegeLifestyle Needs, GiftsPhases are ShiftingAge 25 354555 65 75 4 5. Portfolio Management Process State the Objective Mission statement of the portfolio, who and what it serves and why: income, and/or capital appreciation. Identify the Constraints there are always going to be constraints: taxes, legal, emotions, etc. Formulate the Investment Policy develop the business plan of the portfolio listing out return, risk and all the other issues associated with the portfolio Study Market and Economic Conditions to forecast future trends This is everything that you learned in Economic, Industry, Financial Statements, etc. Monitor Performance keep in touch with what is going on in the portfolio, and Reevaluate & Modify the Portfolio rebalance and/or reconfigure according to the policy and markets 5 6. Role of the Portfolio Manager Bottom Line? You need someone to manage the whole process of investing Minimizing individual security risk (company, industry, or unsystematic risk) Making sure that the portfolio is well-diversified among industry, country and company Managing the tax consequences of the portfolio esp. for expensive people Most importantly, making sure the portfolio caters to the client needs via an Investment Policy Statement Return capital gain vs.income Risk Tolerance varies typically according to age Tax Issues maximizing after-tax returns Time retirement, college payments Liquidity usually driven by time needs Legal Issues trust and pensions have special legal issues Other Unique Needs of the client6 7. Realistic Investor Goals Current income generate spendable funds Capital preservation minimize risk of real loss strongly risk-averse or cash needs are soon Capital appreciation capital gains for real growth for future needs growth strategy with accepted risk Total Return Capital Gains & Income Desire to have medium risk exposure 7 8. What Is Asset Allocation?Asset allocation is the process of combining asset classes such as stocks, bonds, and cash in aStocks Bonds portfolio in order to meet your goals.Cash 9. The Need For Asset Allocation An investment strategy is based on four decisions What asset classes to consider for investment What normal or policy weights to assign to each eligible class The allowable allocation ranges based on policy weights What specific securities to purchase for the portfolio to satisfy the strategy 90+% of the overall investment return is due to the first two decisions, not the selection of individual investments (BHB 1991) 70% of the overall investment return is due to style (Sharpe 1992) 9 10. Is Asset Allocation Important? Contributing Factors of Portfolio PerformanceAsset Allocation Policy 91.5% Asset Allocation Policy + 93.3% Market TimingAsset Allocation Policy + 97.9% Market Timing + Security SelectionAsset Allocation Policy +100% Market Timing + Security Selection + Other 0 20 40 60 80 100Percent 11. Returns & Risk Of Different Asset Classes Higher returns should compensate for risk Policy statements must provide risk guidelines Measuring risk by standard deviation of returns overtime indicates stocks are more risky than T-bills Measuring risk by probability of not meeting yourinvestment return objective indicates risk of equitiesis small and risk of T-bills is large because of differentexpected returns Focusing only on return variability ignoresreinvestment risk and many other types of risk 11 12. Historical Asset Performances: A Guide 12 13. Asset Class ReturnsHighs and Lows: 1926 - 1999Highest Annual Return 150% 142.9%Lowest Annual ReturnAverage Return 100% 54.0%50%40.4%29.1% 14.7%0%12.6% 11.3%5.1%5.2%3.8% -5.1% 0.0% -9.2%-50%-43.3%-58.0% -100% SmallLarge Long-Term Int.-Term TreasuryCompanyCompanyGovernment Government Bills Stocks StocksBonds Bonds Each bar shows the range of annual total returns for each asset class over the period 1926-1999. 14. Diversify To Reduce Risk Or Increase Return Fixed Income Portfolio Cash 1970 - 1999 10% Lower Risk Portfolio Higher Return Portfolio Bonds Stocks90%Cash 12%20% Stocks Cash 35% 39%Return 9.0%Risk 8.5%BondsBonds 53%41% Return 9.0%Return 10.9% Risk 6.1%Risk8.5%Risk is measured by standard deviation. Risk and return are based on annual data over the period 1970-1999. Portfolios presented are based on Modern Portfolio Theory. 15. Return Before & After Inflation15%1926 - 1999 Compound Annual Return11.3% 10% 8.0%5.1%5%3.8%2.0%0.7%0%Stocks StocksBondsBonds Cash Cash after after after Inflation Inflation Inflation Assumes reinvestment of income and no transaction costs or taxes. 16. Monitor Performance Revise IPS as needed Modify investment strategy accordingly Evaluate portfolio performance not only with market return or benchmark portfolio Consider that relative performance will mean little when relative progress is on track 16 17. Reevaluate & Modify Portfolio Asset Allocation has fixed income/equity balance changed from the design Style Under/Over-weights is the portfolio tilted in style? Industry Selection based on the economic environment what might the best sectors be, or is the portfolio weighted too much in any 1 sector (i.e. 25%)? Security Concentrations usually anything greater than 10% of the portfolio must be reduced in size Security Selection sell stocks that have poor fundamental issues in the future and buy those that have positive changes ahead. Key point LT focus not ST turnarounds. Why? Tax constraints.17 18. Understanding How Stocks Work 18 19. What is a Stock? Legal ownership in a company through shares purchase of stock implies you own a slice or share of the company Stockholders have 1st right to purchase new shares issued by the company gives them right to maintain % share of ownership19 20. 4 Characteristics of Stocks Voting Power - Ownership implies control having the right to appoint Board of Directors, who in turn, elect management Residual Claim you are last on the food chain to collect your investment if the company goes bankrupt Limited Liability can only lose the investment you make into the company not more than that Stock Market Listing stocks are traded between buyers and sellers in stock exchange 20 21. Return & Risk of Stocks Two Ways to Earn a Return on a Stock Appreciation in Stock Price if the investorsperceive strong growth in the companys sales &earnings, then investors will demand to buy more ofthe stock. As demand increases, the price of the stockincreases. Dividend Payment if the company pays dividends 21 22. Caveats of Stock Ownership No Guarantee of Return you can lose your investment % Ownership Can Be Small you are just 1 of many owners you have some, but not a whole lot of influence Mergers & Acquisitions other companies can offer to buy your share out and replace your shares with theirs Voting Proxy Statements - investors should take an active role in voting for directors and management they are owners 22 23. Conceptualizing Financial Statements Financial statements are guided by a set of accounting rules, called GAAP (Generally Accepted Accounting Principles). Because of flexibility, financial statements can be manipulated to give a better-than-expected view of earnings. Ratio Analysis & Footnotes is one of the key tools to understanding a company. 23 24. Conceptualizing Companies Companies are dynamic, financial statements are static One date of release: summary of 3, 6, 9 or 12-monthactivity Lagged: released approximately one month afterquarter- or year-end Past-tense: information possibly already incorporatedinto the stock price (barring any major surprises) Dynamic forces on companies are qualitative The economic cycle Industry analysis Management strategy24 25. Conceptualizing the 3 Financial Statements Think of analyzing your own finances Financial analysis of companies is similar to personal financial planning Your balance sheet = a loan application Income statement = your tax return Cash & cash flow statement = Your checking accountand salary Footnotes to financial statements =how you wouldexplain what the numbers really mean to an IRSauditor or loan agent25 26. Balance SheetIncome StatementStatement of Cash Flows (or ... what have you got?) (or ... what do you tell the Government you made?)(or ... what REALLY happened this year)AssetsCurrent assetsCash flows from operationsCash and temporary investments SalesIncome from operationsAccounts receivable- Cost of sales (including depreciation Net income (Profits)Inventoryexpense)+DepreciationPrepaid expenses+Restructuring charge not spent Total current assets= Gross profit o


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