Chapter 13

• Managing Your Own Portfolio

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Administering Your Own Portfolio

• Learning Goals1. Explain how to use an asset allocation scheme to

construct a portfolio consistent with investor objectives.

2. Discuss the data and indexes needed to measure and compare investment performance.

3. Understand the techniques used to measure income, capital gains, and total portfolio return.

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Administering Your Own Portfolio

• Learning Goals (cont’d)

4. Use the Sharpe, Treynor, and Jensen measures to compare a portfolio’s return with risk-adjusted, market-adjusted rate of return, and discuss portfolio revision.

5. Describe the role and logic of dollar-cost averaging, constant-dollar plans, and variable-ratio plans.

6. Explain the role of limit and stop-loss orders in investment timing, warehousing liquidity, and timing investment sales.

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Constructing a Portfolio Using Asset Allocation

• Individual investor characteristics and objectives determine relative income needs and ability to bear risk

• Investor characteristics to consider:– Level and stability of income, net worth– Age and family factors– Investment experience and ability to handle risk– Tax considerations

• Investor objectives to consider:– High level of current income– Significant capital appreciation

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Portfolio Objectives and Policies

• Current Income/Capital Preservation Objective– Low-risk, conservative investment strategy– Emphasis on current income and capital preservation– Normally contains low-beta securities

• Capital Growth Objective– Higher-risk investment strategy– Emphasis on more speculative investments– Normally contains higher-beta securities

• Tax Efficient Objective– Emphasis on capital gains and longer holding periods to

defer income taxes

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Constructing a Portfolio Using Asset Allocation

• Asset Allocation is the process of dividing an investment portfolio into various asset classes to preserve capital by protecting against negative developments while taking advantage of positive ones.

• In other words, don’t put all of your eggs in one basket, and choose your baskets carefully.

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Constructing a Portfolio Using Asset Allocation

• An asset allocation scheme must be developed before buying any investment vehicles.

• Focus is on investment in various asset classes, rather than emphasis on selecting specific securities.

• As much as 90% or more of a portfolio’s return comes from asset allocation between various asset classes.

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Approaches to Asset Allocation

• Fixed-Weightings Approach: asset allocation plan in which a fixed percentage of the portfolio is allocated to each asset category

• Flexible-Weightings Approach: asset allocation plan in which weights for each asset category are adjusted periodically based on market analysis

• Tactical Approach: asset allocation plan that uses stock-index futures and bond futures to change a portfolio’s asset allocation based on market behavior

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Table 13.1 Alternative Asset Allocations

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Applying Asset Allocation

• Consider impact of economic and other factors on your investment objective

• Design your asset allocation plan for the long haul (at least 7 to 10 years)

• Stress capital preservation

• Provide for periodic reviews to maintain consistency with changing investments goals

• Consider using mutual funds, especially for portfolios under $100,000

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Evaluating Performance of Individual Investments

• Step 1: Obtain Needed Data– Returns on owned investments– Economic and market activity

• Step 2: Compare Returns with Broad-Based Market Measures– DJIA, S&P 500, Nasdaq Composite Index, Lipper indexes

• Step 3: Compare Performance to Investment Goals– “Am I getting the proper return for the amount of investment risk

I am taking?”– “Do I have a problem investment?”

• Step 4: Determine appropriate action on each investment– Keep, sell, or monitor closely

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Calculating Return: Holding Period Return

• Returns include current income and capital gains/losses

• Return for specific holding period

Holding period return

Current incomeduring period

Capital gain (or loss)

during period

Beginning investment value

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Measuring Portfolio Return:Holding Period Return

• Returns include current income and capital gains/losses for all investments held in portfolio

Holdingperiod

return fora portfolio

Dividends andinterest received

Realized

gain

Unrealizedgain

Initialequity

investment

Newfunds

Number ofmonths inportfolio

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Withdrawn

funds

Number of monthswithdrawn

from portfolio

12

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Measuring Portfolio Return:Sharpe’s Measure

• Compares the risk premium on a portfolio to the portfolio’s standard deviation of return

• In general, the higher the Sharpe’s measure, the better

Sharpe's measure Total portfolio return Risk-free rate

Portfolio standard deviation of return

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Measuring Portfolio Return:Treynor’s Measure

• Uses the portfolio beta to measure the portfolio’s risk

• In general, the higher the Treynor’s measure, the better

Treynor's measure Total portfolio return Risk-free rate

Portfolio beta

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Measuring Portfolio Return:Jensen’s Measure

• Uses the Capital Asset Pricing Model (CAPM) to calculate the portfolio’s excess return (actual return compared to required return)

• Positive returns are preferred; negative returns indicate required return was not earned

Jensen's measure Total portfolio return Risk-free rate Portfolio beta Market return Risk-free rate

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Assessing Portfolio Performance

• Portfolio Revision: the process of selling certain issues in a portfolio and purchasing new ones to replace them

• Periodic reallocation and rebalancing are necessary

• Reasons to revise portfolio:– Changes in economic conditions– Major life event– Proportion of one asset class increases or decreases

substantially– Expect to reach specific goal within two years– Percentage allocation of asset class varies from original

allocation by 10% or more.

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Timing Transactions

• Dollar-Cost Averaging

– Fixed dollar amount is invested at fixed intervals

– Discipline to invest on regular basis is vital

– Purchase more shares when prices are low and fewer shares when prices are high

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Timing Transactions (cont’d)

• Constant-Dollar Plan– Speculative portion seeks capital gains

– Conservative portion seeks low risk

– When speculative portion increases to a predetermined dollar amount, profits are transferred to conservative portion

– If speculative portion decreases, funds are added from conservative portion

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Timing Transactions (cont’d)

• Constant-Ratio Plan– Similar to constant-dollar plan, only the ratio between

the speculative and conservative portions is fixed

• Variable-Ratio Plan– Similar to constant-ratio plan, only the ratio between

the speculative and conservative portions is allowed to fluctuate to predetermined levels

– Moderately aggressive strategy which tries to “buy low and sell high”

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Using Limit and Stop-Loss Orders

• Limit Orders– May be used to purchase additional securities

only at desired purchase price or below

• Stop-Loss Orders– Used to limit downside loss or protect a profit

by selling security when price falls below predetermined price

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Other Portfolio Considerations

• Warehousing Liquidity– Keep portion of portfolio in low-risk, highly liquid investments to

protect against loss or to wait for future investment opportunities

• Tax Consequences– Use long-term capital gains when possible– Use capital losses to offset capital gains

• Achieving Investment Goals– When an investment becomes more or less risky, or it does not

meet its return objective, sell it– Don’t hold out for top price; take your profits and reinvest in

more suitable investment

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Chapter 13 Review

• Learning Goals1. Explain how to use an asset allocation scheme to

construct a portfolio consistent with investor objectives.

2. Discuss the data and indexes needed to measure and compare investment performance.

3. Understand the techniques used to measure income, capital gains, and total portfolio return.

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Chapter 13 Review (cont’d)

• Learning Goals (cont’d)

4. Use the Sharpe, Treynor, and Jensen measures to compare a portfolio’s return with risk-adjusted, market-adjusted rate of return, and discuss portfolio revision.

5. Describe the role and logic of dollar-cost averaging, constant-dollar plans, and variable-ratio plans.

6. Explain the role of limit and stop-loss orders in investment timing, warehousing liquidity, and timing investment sales.

Chapter 13

• Additional Chapter Art

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Table 13.2 Calculation of Pretax HPR on a Common Stock

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Table 13.3 Calculation of Pretax HPR on a Bond

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Table 13.4 Calculation of Pretax HPR on a Mutual Fund

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Table 13.5 Bob Hathaway’s Portfolio (January 1, 2008)

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Table 13.6 Dividend Income on Hathaway’s Portfolio (Calendar year 2008)

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Table 13.7 Unrealized Gains in Value of Hathaway’s Portfolio

(January 1, 2008, to December 31, 2008)

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Table 13.8 Holding Period Return Calculation on Hathaway’s Portfolio

(January 1, 2008, to December 31, 2008, holding period)

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Table 13.9 Dollar-Cost Averaging($500 per month, Wolverine Mutual Fund

shares)

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Table 13.10 Constant-Dollar Plan

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Table 13.11 Constant-Ratio Plan

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Table 13.12 Variable-Ratio Plan