04_Investor Preferences and Portfolio Concept.pptx

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1. Chapter 4 Investor Preferences and Portfolio Concept

2. WHAT IS ASSET ALLOCATION? Asset allocation : It is the process of deciding how to distribute an investor’s wealth among different countries and asset classes for investment purposes. Asset class : It refers to the group of securities that have similar characteristics, attributes, and risk/return relationships. Investor : Depending on the type of investors, investment objectives and constraints vary Individual investors Institutional investors

3. EXHIBIT 2.1

4. 4.2 THE PORTFOLIO MANAGEMENT PROCESS Investment policy statement Specifies investment goals and acceptable risk levels Should be reviewed periodically Guides all investment decisions Study current financial and economic conditions and forecast future trends Determine strategies to meet goals Requires monitoring and updating

5. 4.2 THE PORTFOLIO MANAGEMENT PROCESS

6. 4 .3 THE NEED FOR A POLICY STATEMENT Understand investor’s needs and articulate realistic investment objectives and constraints What are the real risks of an adverse financial outcome, and what emotional reactions will I have? How knowledgeable am I about investments and the financial markets? What other capital or income sources do I have? How important is this particular portfolio to my overall financial position? What, if any, legal restrictions affect me? How would any unanticipated portfolio value change might affect my investment policy?

7. THE NEED FOR A POLICY STATEMENT Sets standards for evaluating portfolio performance. Other benefits It helps reduces the possibility of inappropriate or unethical behavior on the part of the portfolio manager. A clearly written policy statement will help create seamless transition from one money manager to another without costly delays. It also provides the framework to help resolve any potential disagreements between the client and the manager.

8. UNDERSTAND AND ARTICULATE REALISTIC INVESTOR GOALS Constructing the policy statement begins with a profile analysis of the investor’s current and future financial situations and a discussion of investment objectives and constraints. Objectives Risk Return Constraints Liquidity, time horizon, tax factors, legal and regulatory constraints, and unique needs and preferences

9. 4.4 INPUTS INTO THE INVESTMENT POLICY STATEMENT Risk objectives Risk objective should be based on investor’s ability to take risk and willingness to take risk. Risk tolerance depends on an investor’s current net worth and income expectations and age. More net worth allows more risk taking Younger people can take more risk A careful analysis of the client’s risk tolerance should precede any discussion of return objectives.

10. INVESTMENT OBJECTIVES Return objectives The return objective may be stated in terms of an absolute or a relative percentage return. Capital preservation : Minimize risk of real losses Capital appreciation : Growth of the portfolio in real terms to meet future need Current income: Focus is in generating income rather than capital gains Total return: Increase portfolio value by capital gains and by reinvesting current income with moderate risk exposure

11. INVESTMENT CONSTRAINTS Liquidity needs Vary between investors depending upon age, employment, tax status, etc. Planned vacation expenses and house down payment are some of the liquidity needs. Time horizon Influences liquidity needs and risk tolerance. Longer investment horizons generally requires less liquidity and more risk tolerance. Two general time horizons are pre-retirement and post-retirement periods.

12. INVESTMENT CONSTRAINTS Tax concerns Capital gains or losses: Taxed differently from income Unrealised capital gains : Reflect price appreciation of currently held assets that have not yet been sold Realised capital gains : When the asset has been sold at a profit Trade-off between taxes and diversification: Tax consequences of selling company shares for diversification purposes

13. UNIQUE NEEDS AND PREFERENCES Personal preferences such as socially conscious investments could influence investment choice. Time constraints or lack of expertise for managing the portfolio may require professional management. Large investment in employer’s shares may require consideration of diversification needs. Institutional investors needs.

14. 4 .5 THE IMPORTANCE OF ASSET ALLOCATION An investment strategy is based on four decisions What classes should be considered for investment? What policy weights to assign to each eligible class? What are the allowable allocation ranges based on policy weights? What specific securities or funds should be purchased for the portfolio? According to research studies, most (90%) of the overall investment return is due to the first two decisions, not the selection of individual investments

15. RETURNS AND RISKS OF DIFFERENT ASSET CLASSES Historically, small company shares have generated the highest returns, so have the volatility Inflation and taxes have a major impact on returns Returns on Treasury Bills have barely kept pace with inflation Measuring risk by the 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 Focusing only on return variability as a measure of risk ignores reinvestment risk

16. 4 .6 UNDERSTANDING RISK AVERSION As an investor you want to maximise the returns for a given level of risk. Your portfolio includes all of your assets and liabilities. The relationship between the returns for assets in the portfolio is important. A good portfolio is not simply a collection of individually good investments.

17. UNDERSTANDING RISK AVERSION Given a choice between two assets with equal rates of return, risk-averse investors will select the asset with the lower level of risk Evidence Many investors purchase insurance for: Life, Automobile, Health, and Disability Income. Yield on bonds increases with risk classifications from AAA to AA to A, etc. Not all Investors are risk averse It may depends on the amount of money involved: Risking small amounts, but insuring large losses

18. UNDERSTANDING RISK AVERSION Definition of Risk Uncertainty : Risk means the uncertainty of future outcomes . For instance, the future value of an investment in Google’s stock is uncertain; so the investment is risky. On the other hand, the purchase of a six-month CD has a certain future value; the investment is not risky. Probability : Risk is measured by the probability of an adverse outcome . For instance, there is 10% chance you will receive a return 30%.

19. 4 .7 MARKOWITZ PORTFOLIO THEORY

20. 4 .7 MARKOWITZ PORTFOLIO THEORY Main Results Quantifies risk Derives the expected rate of return for a portfolio of assets and an expected risk measure Shows that the variance of the rate of return is a meaningful measure of portfolio risk Derives the formula for computing the variance of a portfolio, showing how to effectively diversify a portfolio

21. MARKOWITZ PORTFOLIO THEORY Assumptions for investors Consider investments as probability distributions of expected returns over some holding period Maximise one-period expected utility, which demonstrate diminishing marginal utility of wealth Estimate the risk of the portfolio on the basis of the variability of expected returns Base decisions solely on expected return and risk Prefer higher returns for a given risk level. Similarly, for a given level of expected returns, investors prefer less risk to more risk

22. MARKOWITZ PORTFOLIO THEORY Using the five assumptions, a single asset or portfolio of assets is considered to be efficient if no other asset or portfolio of assets offers higher expected return with the same (or lower) risk, or lower risk with the same (or higher) expected return.

23. ALTERNATIVE MEASURES OF RISK Variance or standard deviation of expected return Range of returns Returns below expectations Semi-variance – a measure that only considers deviations below the mean These measures of risk implicitly assume that investors want to minimise the damage from returns less than some target rate

24. ALTERNATIVE MEASURES OF RISK The advantages of using standard deviation of returns This measure is somewhat intuitive It is a correct and widely recognised risk measure It has been used in most of the theoretical asset pricing models

25. EXPECTED RATES OF RETURN For an individual asset It is equal to the sum of the potential returns multiplied with the corresponding probability of the returns See Exhibit 7.1 For a portfolio of investments It is equal to the weighted average of the expected rates of return for the individual investments in the portfolio

26. EXHIBIT 7.1

27. EXPECTED RATES OF RETURN If you want to construct a portfolio of a risky assets, what will be the expected rate of return on the portfolio is you know the expected rates of return on each individual assets? The formula where: w i = the weight of an individual asset in the portfolio, or the per cent of the portfolio in Asset i R i = the expected rate of return for Asset i See Exhibit 7.2

28. EXHIBIT 7.2

29. VARIANCE (STANDARD DEVIATION) OF RETURNS FOR AN INDIVIDUAL INVESTMENT Variance It is a measure of the variation of possible rates of return R i , from the expected rate of return [E(R i )] 7- 31 where P i is the probability of the possible rate of return, R i Standard Deviation ( σ ) Simply the square root of the variance © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

30. EXHIBIT 7.3

31. COVARIANCE AND CORRELATION OF RETURNS FOR A PORTFOLIO A measure of the degree to which two variables move together relative to their individual mean values over time For two assets, i and j, the covariance of rates of return is defined as: Cov ij = E{[R i - E(R i )] [R j - E(R j )]}

32. COVARIANCE AND CORRELATION The correlation coefficient is obtained by standardising (dividing) the covariance by the product of the individual standard deviations Computing correlation from covariance where: r ij = the correlation coefficient of returns σ i = the standard deviation of R it σ j = the standard deviation of R jt 7- 34 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

33. COVARIANCE AND CORRELATION Correlation Coefficient The coefficient can vary in the range +1 to -1. A value of +1 would indicate perfect positive correlation. This means that returns for the two assets move together in a positively and completely linear manner. A value of –1 would indicate perfect negative correlation. This means that the returns for two assets move together in a completely linear manner, but in opposite directions. See Exhibit 7.8

34. STANDARD DEVIATION OF A PORTFOLIO The Formula Where: σ port = the standard deviation of the portfolio w i = the weights of an individual asset in the portfolio, where weights are determined by the proportion of value in the portfolio σ 2 i = the variance of rates of return for asset i Cov ij = the covariance between the rates of return for assets i and j , where Cov ij = r ij σ i σ j 7- 36 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

35. STANDARD DEVIATION OF A PORTFOLIO Any asset of a portfolio may be described by two characteristics: The expected rate of return The expected standard deviations of returns The correlation, measured by covariance, affects the portfolio standard deviation Low correlation reduces portfolio risk while not affecting the expected return 7- 37 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

36. STANDARD DEVIATION OF A PORTFOLIO Two assets with different returns and risk 7- 38 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

37. STANDARD DEVIATION OF A PORTFOLIO Assets may differ in expected rates of return and individual standard deviations Negative correlation reduces portfolio risk Combining two assets with +1.0 correlation will not reduces the portfolio standard deviation Combining two assets with -1.0 correlation may reduces the portfolio standard deviation to zero See Exhibits 7.10 and 7.12 7- 39 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

38. EXHIBIT 7.10

39. EXHIBIT 7.12

40. STANDARD DEVIATION OF A PORTFOLIO Constant Correlation with Changing Weights Assume the correlation is 0 in the earlier example and let the weight vary as shown below. Portfolio return and risk are (See Exhibit 7.13 ): 7- 42 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

41. EXHIBIT 7.13

42. STANDARD DEVIATION OF A PORTFOLIO A three-asset portfolio As more assets are added to the portfolio, more risk will be reduced everything else being the same The general computing procedure is still the same, but the amount of computation has increase rapidly For the three-asset portfolio, the computation has doubled in comparison with the two-asset portfolio

43. ESTIMATION ISSUES Results of portfolio allocation depend on accurate statistical inputs Estimates of Expected returns Standard deviation Correlation coefficient Among entire set of assets With 100 assets, 4 950 correlation estimates Estimation risk refers to potential errors

44. ESTIMATION ISSUES With the assumption that share returns can be described by a single market model, the number of correlations required reduces to the number of assets Single index market model: 7- 46 b i = the slope coefficient that relates the returns for security i to the returns for the aggregate market R m = the returns for the aggregate share market © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

45. ESTIMATION ISSUES If all the securities are similarly related to the market and a b i derived for each one, it can be shown that the correlation coefficient between two securities i and j is given as:

46. THE EFFICIENT FRONTIER The efficient frontier represents that set of portfolios with the maximum rate of return for every given level of risk, or the minimum risk for every level of return Efficient frontier are portfolios of investments rather than individual securities except the assets with the highest return and the asset with the lowest risk The efficient frontier curves Exhibit 7.14 shows the process of deriving the efficient frontier curve Exhibit 7.15 shows the final efficient frontier curve

47. EXHIBIT 7.14

48. EXHIBIT 7.15

49. EFFICIENT FRONTIER AND INVESTOR UTILITY An individual investor’s utility curve specifies the trade-offs he is willing to make between expected return and risk The slope of the efficient frontier curve decreases steadily as you move upward The interactions of these two curves will determine the particular portfolio selected by an individual investor The optimal portfolio has the highest utility for a given investor

50. EFFICIENT FRONTIER AND INVESTOR UTILITY The optimal lies at the point of tangency between the efficient frontier and the utility curve with the highest possible utility As shown in Exhibit 7.16 , Investor X with the set of utility curves will achieve the highest utility by investing the portfolio at X As shown in Exhibit 7.16 , with a different set of utility curves, Investor Y will achieve the highest utility by investing the portfolio at Y Which investor is more risk averse?

51. EXHIBIT 7.16