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Chapter 9
Financial Investments
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Chapter Goals
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Apply risk and return principles to investments.
Develop an overall asset allocation.
Evaluate the factors that enter into investing in
financial assets.
Relate financial investing to overall household
operations.
Recognize how portfolio management differs from
individual asset selection.
Distinguish among investment alternatives.
Utilize leading ways of measuring investment risk.
Overview
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The planning system for asset allocation includes the
following steps:
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Establish goals.
Consider personal factors.
Include capital market factors.
Identify and review investment alternatives.
Evaluate specific investment considerations.
Employ portfolio management principles.
Implement portfolio management decisions.
Review and update the portfolio.
We will consider each in turn.
Establish Goals
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Goals are determined by our needs and the things
and activities that we enjoy.
Once we have established our goals we are in
position to identify the role savings and investments
play in the process.
Investments can be viewed as a delivery
mechanism: they help create sufficient assets to fund
our goals.
Our investment focus is on the appropriate asset
allocation to help meet our goals.
Consider Personal Factors
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Personal considerations include:
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Time Horizon for Investments.
Liquidity Needs.
Current Available Resources.
Projected Future Cash Flows.
Taxes.
Restrictions: limitations on freedom of choice in investment
alternatives or investment practices.
Risk Tolerance: The amount of risk you are willing to
undertake.
Consider Personal Factors, cont.
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We can group goals for investment purposes into
five time horizons:
Include Capital Market Factors
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We have established the goals and the
distinguishing features of individuals.
At the same time, we need to examine the
characteristics of the overall financial markets and of
the various types of securities likely to be considered
for the asset allocation.
We begin by discussing two of the most basic
characteristics of finance: risk and return.
Return
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Return is the total of income and growth of monies
invested over a period of time.
Sum of Dividends
or Interest Paid
Gain in Principal
Invested
Holding Period
Return (HPR)
Original Cost
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Return, cont.
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Time-weighted returns give effect to how long you
have owned a security and the timing of income
payments during that period.
The internal rate of return (IRR) is often used to
obtain this return.
By a bond that is expected to be held until it
matures, the IRR is also known as the yield to
maturity (YTM).
Risk
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Risk, is the chance of loss on an investment.
Types of risk for financial assets:
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Market: The risk of a decline in the overall stock or bond
market.
Liquidity: The risk of receiving a lower than market price
upon sale of your holding.
Economic: The risk of unfavorable business conditions
caused by weakness in the overall economy.
Inflation: The risk of an unexpected rise in prices that
reduces purchasing power.
(Continues next slide).
Risk, cont.
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Political: The risk of a change in government or
governmental policy adversely affecting operations.
Regulatory: The risk of a shift in regulatory policy impacting
activities.
Currency: The extra risk in international activities arising
from currency fluctuations.
Technological: The risk of obsolescence of a product line or
inputs in producing it.
Preference: The risk of a shift in consumer taste.
Other Industry: The risks other than the ones given above
that affect companies in an industry.
Company: The operating and financial risks that apply to a
particular firm.
Risk, cont.
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The wider the fluctuations around its average price,
the greater the stock’s risk.
The most common measurement of price fluctuation
is the standard deviation.
Hence, stocks can have identical mean returns and
different risks:
Stock Price
Company A
Company B
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Time
Risk, cont.
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The capital asset pricing model (CAPM) is a
specialized modern investment theory model that is
based on risk-return principles.
Under the CAPM, risk is measured using price
change of a security relative to a benchmark’s price
performance.
The benchmark for large company stocks is usually
the S&P 500, the Standard and Poor’s index of the
500 largest companies in the United States.
Risk, cont.
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The CAPM risk measurement is the beta coefficient.
The greater the price fluctuation of a security
relative to the benchmark’s movements, the greater
the security’s beta coefficient.
The benchmark is automatically given a beta of 1
and stocks or mutual funds of stocks having a beta
coefficient of greater than 1 are deemed to have
more risk than the market, while those having a
beta of less than 1 have below average risk.
Risk, cont.
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The beta coefficient measures systematic risk.
Systematic risk: The risk of overall market factors.
Unsystematic risk: Risk related to an individual
company.
CAPM says individual company risk can be
diversified away when you hold a large portfolio of
securities.
Therefore, CAPM says that all you need to know is
systematic risk as measured by the beta coefficient.
Expected Rate of Return
Expected Rate
of Return
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Risk-Free Rate
Risk Premium
Risk premium: The extra return that compensates
you for the additional amount of risk you are taking
with a particular security over a completely safe
one.
The risk-free rate is the rate of return you require
even if there is no risk. The yield on 30-day U.S.
Government Treasury Bills is generally used.
Risk - Return Tradeoff
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The more risky the security, the greater the risk
premium and the greater the expected or required
rate of return.
The Efficient Market Hypothesis
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The Efficient Market Hypothesis (EMH) says that
the best valuation for an individual security is its
current market price.
A major conclusion of the EMH is that it will not be
profitable to attempt to outperform the market.
Even if there are those not fully informed or capable
of appraising shares, and their actions could create
particularly appealing prices, other investors would
quickly step in to take advantage.
By doing so these investors would eliminate any
above-average profit opportunities.
The Efficient Market Hypothesis, cont.
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Three forms of the EMH:
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The Weak Form: Looking at current and past information
on stock price patterns and the number of shares traded is
not useful.
The Semi-Strong Form: All publicly available information is
incorporated in a stock’s price. The
Strong Form: The share prices fully reflect both public and
private information.
Mean Reversion and Efficient Markets
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Mean reversion: Returns for securities tend to move
toward average performance when returns are
examined over longer time frames.
Therefore, if securities underperform for a period,
they may be more likely to outperform later on.
When their results are highly favorable for a period
of time, they can be vulnerable to poor returns in the
period beyond.
Thus, in contrast to efficient markets beliefs, future
stock price movements may be somewhat
predictable.
Identify and Review Investment
Alternatives
Bonds
 Bonds: Contracts in which an investor lends money
to a borrower. As compensation for receiving the
money, the borrower agrees to pay interest.
 Maturity date: The date that the loan is to be repaid.
 Bonds are relatively safe investments as:
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The annual income is generally fixed in advance.
The principal is likely to be fully repaid on the stated date.
The company will be faced with bankruptcy if it defaults, at
which time bondholders have priority in receiving the
proceeds from liquidation of business assets.
Identify and Review Investment
Alternatives, cont.
Common Stocks (Equities)
 A common stockholder is an owner, and is entitled
to participate in the current profits and anticipated
future growth of the enterprise.
 Stocks present potentially higher returns than
bonds, but the shareholder must be prepared to
take greater risk.
 We categorize common stocks based on relative
growth rates, sector and industry, geographic area,
company size, and quality.
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Identify and Review Investment
Alternatives, cont.
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Relative Growth Rates
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Growth stocks: Companies that grow more rapidly in sales
and earnings than the overall economy and are less
affected by cyclical business conditions.
Defensive stocks: Companies that generally grow at
average or below-average rates but are also less affected
by business conditions.
Cyclical stocks: Firms whose growth rates are at or below
those for the overall economy but whose operations are
highly sensitive to aggregate business conditions.
Identify and Review Investment
Alternatives, cont.
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Sector and Industry
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Economic sectors include basic materials, capital goods,
consumer cyclicals, consumer noncyclicals, energy,
financial, healthcare, services, technology, transportation,
and utility.
Each sector, in turn, is divided into a number of industries.
For example, consumer cyclicals would include among
others autos, consumer appliances, and retail chains.
Since sectors tend to share some similar characteristics,
some active managers use these categories and industries
to decide which areas to over- or underemphasize.
Identify and Review Investment
Alternatives, cont.
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Geographic Area
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Company Size
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One may wish to invest in faster-growing sections of the
U.S. or in parts of the world that present potentially more
rapid growth rates than the U.S.
Larger companies are generally more secure, often having
entrenched positions in major markets.
Smaller companies can be more flexible since they may
have more entrepreneurial management, but may be risky.
Medium sized companies are a blend of the previous two.
Identify and Review Investment
Alternatives, cont.
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Quality
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Quality measure how confident we are that the anticipated
prospects for a company will be fulfilled.
High quality (blue chips ) companies are likely to be large
and have a strong position in their markets.
Often they have good returns on investment and are less
likely to have large noneconomic related disappointments
in earnings.
Speculative investments are companies whose operations
are less predictable, their profitability more precarious with
current or potential losses possible.
Sometimes these companies have a large amount of debt
in relation to the value of their equity.
Identify and Review Investment
Alternatives, cont.
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Mutual Funds
Combine stock or bond assets for investors who receive
centralized administration and investment management.
Year
Industry Net Assets
(billions of dollars)
Stock Funds
Bond Funds
Total1
1970
45.1
2.5
47.6
1975
37.5
4.7
45.9
1980
44.4
14.0
134.8
1985
111.3
122.7
495.4
1990
239.5
291.3
1,065.2
1995
1,249.1
598.9
2,811.3
2000
3,961.9
811.2
6,964.7
2004
4,384.1
1,290.3
8,106.9
1Hybrid and money market funds are also included in total.
Source: Investment Company Institute, Mutual Fund Fact Book 42nd ed.
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Total Number of
Funds
361
426
564
1,528
3,079
5,725
8,155
8,044
Identify and Review Investment
Alternatives, cont.
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Mutual Funds, cont.
Mutual fund characteristics include strengths and
weaknesses.
Strengths:
Expertise.
Diversification.
Professional Recordkeeping.
Safety.
Reinvestment and Payout.
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Low Cost.
Low Minimum Investment.
General Information.
Daily Pricing.
Weaknesses:
Cost.
Performance.
Tax.
Liquidity.
Identify and Review Investment
Alternatives, cont.
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Mutual Fund Classification System
Size: Small, medium, and large size categories,
based on the overall stock market worth of the
companies in the mutual fund.
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Smaller capitalization companies provide greater potential
returns, but also have greater risk.
Larger capitalization companies have more consistency of
performance and lower company fundamental and stock
market risk.
Medium capitalization companies provide a blend of the
other two categories.
Identify and Review Investment
Alternatives, cont.
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Mutual Fund Classification System, cont.
Investment Style: Growth, value, and blend.
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Growth style of investing involves selecting companies that
are expected to have rapid growth in revenues and
earnings per share.
Value style of investing emphasizes price in making
purchase decisions. The manager looks for companies
that are out of favor or otherwise mispriced in relation to
their outlook for earnings growth.
The blend category may entail a manager who moves from
value to growth style or buys a mix of the two, or a style of
investing that cannot be defined in value or growth terms.
Evaluate Specific Investment
Considerations
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Passive approach to investing: No attempt is made
to receive greater than market returns.
Proponents believe efforts can better be used to
diversify in order to reduce risk and keep costs low.
Passive investors tend to purchase index mutual
funds of all types.
Active approach to investing: changes are made in
holdings over time to take advantage of new
opportunities. Based on the belief that it is possible
to outperform the market.
Evaluate Specific Investment
Considerations, cont.
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Individual securities purchased by the household
involve no fund-overhead expenses and allow one
to buy and sell for tax planning purposes.
Mutual funds offer professional advice at
reasonable cost, the ability to delegate the
investment management and recordkeeping
function, and simple diversification with low
investment minimums by specialists.
Although there are notable exceptions, the majority
of mutual funds underperform the market.
Employ Portfolio Management
Principles
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Portfolio: a grouping of assets held by an individual
or a business.
A portfolio is more than the sum of its parts because
the individual assets are often related to each other.
A portfolio that holds a diversified grouping of
assets can be said to be attractively balanced and
not easily influenced by events other than those that
affect overall markets.
Under portfolio theory we strive to achieve the
highest return we can, given the risk we are willing
to undertake.
Employ Portfolio Management
Principles, cont.
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Portfolio return is the sum of the returns for each
security multiplied by the weighting it has in the
portfolio.
The correlation coefficient measures the degree to
which investment in a portfolio is related to other
investments in that portfolio.
By reducing correlations we lessen price
fluctuations and overall risk in the portfolio.
Under Markowitz, forecasts of return, risk, and
correlation are combined to form what is called the
mean-variance model.
Employ Portfolio Management
Principles, cont.
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Total Portfolio Management (TPM) is a model of the
individual household.
It proposes that households make investment
decisions based not only on marketable financial
securities but on all assets that it possesses.
Under TPM, all household assets interact and their
correlations are taken into account.
Investment decisions that are made incorporate
individual asset returns, risks, and the degree to
which they are correlated.
Implement Portfolio Management
Decisions
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We implement portfolio management decisions
through the following steps:
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Establish an active or passive management style: Active
management requires belief that changes can add to
portfolio performance. Passive management makes no
attempt to anticipate future events.
Construct a strategic asset allocation: the normal portfolio
makeup over the longer term
Develop a tactical asset allocation: modifies the breakdown
of the portfolio to attempt to profit from current
circumstances.
Implement Portfolio Management
Decisions, cont.
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Select individual assets: the goal is to select the assets that
provide the highest returns for the overall risk taken.
Finalize and implement the portfolio: Questions to ask
include:
 Is the portfolio consistent with the overall tolerance for
risk?
 Can risk be reduced with little sacrifice in return?
 Am I properly diversified and will my portfolio produce
attractive returns?
Review and update the portfolio
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As time moves on, the economic outlook and
relative valuations change, as do household
circumstances.
Both passive and active investors must take into
account current actual allocations relative to
strategic ones and consider making changes.
Active investors may want to purchase newly
attractive securities and sell old ones that no longer
fit performance requirements.
Review and update the portfolio, cont.
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A performance evaluation should answer the
following questions:
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How did I do?
What were the reasons for the under or overperformance?
What can I do to improve future performance?
The evaluation should also be done when
examining a potential future holding, as, for
example, a mutual fund.
Chapter Summary
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Financial assets consist primarily of stocks, bonds,
and mutual funds.
Having an appropriate asset allocation is the goal of
most investors.
Important personal factors in asset allocations
include time horizon, liquidity needs, available
current resources, projected future resources,
taxes, restrictions, and risk tolerance.
Risk and return are a basic finance concept. In
theory the two factors move in proportion.
Chapter Summary, cont.
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A securities’ expected rate of return includes the risk
free rate plus a risk premium.
The efficient market hypothesis indicates that efforts
to systematically outperform the market will be
unsuccessful.
Mean reversion indicates that there may be patterns
in stocks that can lead to outperformance.
Portfolio management looks at all financial
investments overall in making decisions, and the
Markowitz approach includes correlations among
them.
Chapter Summary, cont.
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Total Portfolio Management incorporates all assets
and liabilities and includes correlations in its riskreturn framework.
A strategic asset allocation looks at investment
policy over the long term while at tactical one makes
cyclical changes based on opportunities at the time.