Course 103. Agenda. What is a challenge candidate? This is not a formal review course

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1 Course 103 Investment Planning in 2019 Prepared With Kaplan Study Materials by: William Kline, Ph.D., CFA Agenda 1. CFP/Kaplan Continuing Education Material Overview 2. Investor Policy Statements Review 3. Asset Class Basics 4. Bonds Fundamentals 5. Stock Fundamentals 6. Risk Basics 7. Return Calculations 8. Asset Allocation 9. Performance/Rebalancing What is a challenge candidate? We are offering this course in partnership with Kaplan Education. Through this partnership, we can cover Kaplan Certified Financial Planner exam preparation materials in a continuing education format. This is especially valuable because Licensed CPAs and attorneys are automatically eligible to apply to take the CFP exam with Challenge Status. This means you can bypass the education requirements (Courses 101 through 106), provided you complete the Financial Plan Development Course (Course 107). Course 107, the capstone course, is offered through Kaplan and must be taken by all. This is not a formal review course Note, this is not a formal review course. We are using Kaplan review materials as a foundation for our continuing education seminars/webinars. Some review materials will be omitted and other topics, which are not on the CFP exam will be included

2 Course Objectives 1. Introduce the Challenge Concept 2. Shift the obligation mindset to an opportunity mindset A. Cover 40-50% of CFP Review Materials in Book 103 B. Allow for a more customizable continuing education experience 3. Gather feedback about course materials and delivery method Learning Outcomes What are main categories in the investment management process? Describe the main components in each. E.39.4 Explain the various components of an Investor Policy Statement (IPS) : See Handout The Investment Management Process Client Due Diligence Financials Goals Risk Tolerance Planning Execution Performance Rebalancing Asset Classes Stock/Bond Basics Expected Risk and Return Asset Allocation Investment Strategy Return Analysis Attribution Types of Rebalancing Traditional Asset Classes Domestic fixed income Domestic common equity Non-domestic fixed income Non-domestic common equity Real estate Commodities Currencies Hedge funds Private equity Cash and cash equivalents Crypto Currencies?

3 Learning Outcomes Unit 2 E.33.2 Explain terminology, characteristics, and sources of risk of debt securities. Debt Investments Debt Securities Treasuries Bills, Notes, Bonds Strips and TIPS Savings Bonds Government Agency - Government National Mortgage Association (Ginnie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac), Federal National Mortgage Association (Fannie Mae), Student Loan Marketing Association (Sallie Mae) Municipal Bonds Corporate Bonds (Convertible, callable, etc.) Bond Terminology Par value $1,000 Coupon rate (nominal yield) Stated annual interest rate % of par Basis point 1/100 of 1% of yield

4 Bond Terminology Discount bond: sells par OID bond: issued at discount Premium bond: sells > par Bond Types Secured bond: pledges specific assets, may be sold upon default Debenture: unsecured bond Investment grade bond: BBB or higher High-yield (junk) bond: BB+ or lower Returns Dealing Primarily With Bonds Current Yield (CY) Current Yield (CY) Yield to maturity (YTM) Taxable equivalent yield (TEY) CY = annual interest current market price Jeff has a bond with a coupon rate of 3% currently trading at $965 CY = $30 $965 = , or 3.11%

5 Yield to Maturity (YTM) Includes Bond s market price Capital gains or losses if held to maturity Interest payments reinvested at calculated YTM Bond Risks Interest rate risk Purchasing power risk Reinvestment rate risk Does not apply to zero-coupon bonds Default (credit) risk Bond Ratings Municipal Bonds Standard & Poor s Moody s Investment Grade High Grade AAA AA Aaa Aa Medium Grade A BBB- A Baa Noninvestment Grade Speculative BB+ B Ba B Default CCC D Caa C Overall Ratings AAA D Aaa C Debt obligations States, counties, parishes, cities, towns Interest free from federal income tax State income tax exemption Gains from sale subject to federal taxation General obligation, revenue bonds, etc

6 Taxable Equivalent Yield (TEY) TEY Example (1 of 2) Compare yields of municipal tax-exempt issues to corporate taxable issues TEY = tax-exempt yield 1 marginal tax rate 6% municipal bond 33% federal income tax bracket Corporate bond coupon 8.96% TEY = = , or 8.96% TEY Example (2 of 2) After-Tax Yield 6% municipal bond 15% federal income tax bracket Corporate bond coupon 7.06% TEY = = , or 7.06% Compare yields of corporate taxable issues to municipal tax-exempt issues after-tax yield = pretax return (1 marginal tax rate)

7 After-Tax Yield Example For an investor in the 35% marginal tax bracket, 35 cents of every additional dollar of taxable interest income must be paid in taxes. Taxable corporate bond yielding 4.35% After-tax yield = 4.35% (1 0.35) = , or 2.83% Bond Choice Question John is in the 35% federal marginal income tax bracket and resides in a state with a flat 3% state income tax rate. He has $25,000 to invest and wants to invest it all in a single bond issue. Which bond should John choose? A. Taxable corporate bond with a coupon rate of 9.5% B. Another state s municipal bond with a coupon rate of 5.5% C. His state s municipal bond with a coupon rate of 4.5% D. His county s municipal bond with a coupon rate of 5% Bond Choice Solution John is in the 35% federal marginal income tax bracket and resides in a state with a flat 3% state income tax rate. He has $25,000 to invest and wants to invest it all in a single bond issue. Which bond should John choose? A. Taxable corporate bond with a coupon rate of 9.5% Unit 8 After-tax yields: A. 9.5% [1 ( )] = 5.89% B. 5.5% (1 0.03) = 5.34% Bond Valuation Concepts C. 4.5% D. 5%

8 Learning Outcomes E.38.1 Explain factors that affect the price and yield of fixed income securities. Intrinsic Value of a Bond Formula: CF CF PV = CF 1 2 t 1 2 t ( 1 + y) ( 1 + y) ( 1 + y) CF = future cash flows from bond (interest payments/par value) y = discount rate per period (YTM) t = number of cash flows to be evaluated A General Model and A Simple Bond Example A General Model and A Simple Bond Example Coupon Rate 5% Maturity 3 yrs Yield on similar bonds 6% $1,000 par What should this bond be trading for? Year 1 Year 2 Year 3 $50 $50 $50 + $1,000 (1+.06) 1 (1+.06) 2 (1+.06) 3 $47.17 $44.50 $ $

9 Bond Prices and Interest Rates Move in opposite direction As a bond s price rises, yield declines As a bond s price declines, yield increases Discount bond current yield increases Premium bond current yield decreases Bond Yield Relationships When bonds are at par, coupon and current yield are equal. When bonds are at a premium, the CY is less than the coupon. When bonds are at a discount, the CY is greater than the coupon Bond Yield Relationships Question Which of the following statements regarding a corporate bond that is currently selling at a discount are CORRECT? 1. Current yield is greater than the coupon rate. 2. YTM is greater than the current yield. 3. Coupon rate is less than the YTM. 4. Interest rates have decreased. A. 1 and 2 B. 2 and 3 C. 1, 2, and 3 D. 1, 3, and 4 Bond Yield Relationships Solution Which of the following statements regarding a corporate bond that is currently selling at a discount are CORRECT? 1. Current yield is greater than the coupon rate. 2. YTM is greater than the current yield. 3. Coupon rate is less than the YTM. C. 1, 2, and 3 A bond s price and yield move in opposite directions: as a bond s price decreases, its yield increases. When a bond trades at a discount, its current yield and yield to maturity increases. A discount bond has the following yield relationships: CR < CY < YTM

10 Learning Outcomes E.38.2 Evaluate the investment implications of yield curves. Yield Curves (1 of 3) Graph of interest rate yields for bonds of same quality Generally slopes upward and outward 1-37 Yield (%) Years 1-38 Yield Curves (2 of 3) Normal (positive) Expanding economy Predicts market interest rates will rise Flat Peaking economy No change in future interest rates Inverted Inflationary economy, tight money supply Predicts market interest rates will fall Yield Curves (3 of 3) Term structure of interest rates Theory relating term to maturity of a sample of same quality bonds to their YTM at a given point in time Represents cross section of yields for a category of bonds that are comparable in all respects but their maturity date Different yield curves may be constructed for a variety of bonds

11 Learning Outcomes Unit 3 E.33.4 Explain terminology and characteristics of common stock. E.33.6 Explain terminology and characteristics of preferred stock. Equity Investments Equities Domestic and International Common Stock & Preferred Stock Mutual Funds Exchange Traded Funds Unit Investment Trusts Hedge Funds Funds Can Benchmark: Dow Jones S&P 500 Russell 2000 MSCI EAFE Wilshire 5000 Index Equity vs. Debt Investors entitled to Equity Proportionate share of assets and earnings Stock returns low correlations with bond returns Dividends subject to double taxation Debt Fixed rate of payment; return of principal Liquidation rights Inferior Superior Advantage for business Disadvantage for business Not required to make payments to investors Dividends not tax deductible Interest is tax deductible Requires periodic interest payments

12 Common Stock Units of ownership Capital appreciation Dividends Companies issue stock to raise capital Owners entitled to: voting rights (proxy), and receive dividends Preferred Stock Similar to bonds Receive regular payments (dividends) $100 par value Similar to common stock Shareholders not guaranteed dividends No maturity date, perpetuity Preferred Stock Benefits Preferred shareholders rights supersede common shareholders Cumulative preferred Corporation must pay any unpaid preferred dividends from prior years before issuing dividends to common stockholders Learning Outcomes E.33.8 Explain the characteristics, structures, types, and objectives of unit investment trusts and mutual funds. E.33.9 Explain the characteristics and objectives of exchangetraded funds and hedge funds

13 Investment Company Comparison Open-End Closed-End UIT ETF Capitalization Unlimited Fixed Fixed Varies Trading Fund company Exchange Exchange Exchange Pricing NAV + sales charge (if applicable) Current market value NAV + commission NAV + commission* Management Active Active Passive Passive / Active *ETFs generally trade close to NAV; however, supply and demand may cause the price to fluctuate. CFP Exam-Level Question - Unit 3 Preferred stocks are considered a hybrid security because they: 1. offer guaranteed income 2. represent equity ownership 3. pay dividends based on a stated percentage of the par value of the stock 4. are issued for perpetuity A. 1 only B. 1 and 3 C. 2, 3, and 4 D. 1, 2, 3, and CFP Exam-Level Question - Unit 3 Solution Preferred stocks are considered a hybrid security because they: 1. offer guaranteed income 2. represent equity ownership 3. pay dividends based on a stated percentage of the par value of the stock 4. are issued for perpetuity A. 1 only B. 1 and 3 C. 2, 3, and 4 D. 1, 2, 3, and 4 CFP Exam-Level Question - Unit 3 Rationale Preferred stocks possess features of both stocks and bonds. However, they represent equity ownership with no maturity date and pay dividends, though payment may be suspended if earnings are poor. Preferred stocks trade on the exchanges

14 Learning Outcomes Unit 9 What are the main steps in the valuation process process? Describe the main components in each. E.38.4 Explain terminology and concepts associated with fundamental and technical analysis. Stock Valuation Concepts The Valuation Process Learning Outcomes Financial Statement Analysis E.38.5 Calculate the intrinsic value of a stock using various stock valuation techniques or calculate the expected return of a stock. Understand the company, industry, and economy Forecast company performance (Top down or bottom up) Select the appropriate approach (Income, Market, Cost) Estimate value Make an investment decision E.38.6 Evaluate the appropriateness of investment decisions based on stock valuation models. Analysis of Competitive Advantage

15 Valuation Methodologies 1. Income Approach - Free Cash Flow Models 2. Income Approach - Dividend Discount Models 3. Market Approach - Pricing and Transaction Multiples 4. Asset-Based Approach Free cash flow models (FCF) Dividends represent cash actually paid to shareholders. Free cash flow models estimate total cash flows available for distribution to shareholders. Unlike dividends, free cash flow to equity (FCFE) and free cash flow to the firm (FCFF) are not published numbers Free cash flow models (FCF) Definition of FCFF Cash flows available to equity holders and debt holders after all operating expenses have been paid and necessary investments in working capital and capital expenditures have been made. Definition of FCFE Cash flows available to the company s common equity holders after all operating expenses, interest, and principal payments have been paid and necessary investments in working and fixed capital have been made. Analysis of Equity Investments: Valuation. Stowe, Robinson, Pinto, and McLeavey Association for Investment Management and Research. Valuation Basics The value of an asset is the present value of its expected future cash flows: CF t V 0 = t = 1 ( 1 + k ) t CF Cash Flows k Discount rate t time (number of periods)

16 FCFF FCFE Free Cash Flow to the Firm (FCFF) Calculation / Starting with Net Income: Free Cash Flow To Equity (FCFE) Calculation / Starting With CFO: Net Income + Noncash Charges + Interest Expense ( 1 t ) - CAPX - Working Capital Investment = FCFF CFO - CAPX + Net Borrowing = FCFE Valuation Basics You can estimate the discount rate (cost of equity or required return ) using a number of methods including: 1. CAPM 2. APT, or 3. Bond-Yield-Plus-Risk Premium Valuation Basics CAPM = E(R) i = R F + β i [ E(R) M R F ] k i = E(R) i = Expected return on asset i. = Risk free rate of interest. R F β I = Beta of asset i

17 Learning Outcomes E.35.1 Calculate the beta coefficient and understand its use and limitations. Beta Coefficient (Beta) Relative measure of systematic risk Measure risk of: diversified portfolios; and securities, as part of diversified portfolios Market beta = 1.0 Beta > 1.0 more volatile than market (aggressive) Beta < 1.0 less volatile than market (defensive) Beta Coefficient (Beta) Example A portfolio has a beta of Therefore, the portfolio is 30% more volatile than the market. If the market was expected to return 10%, the portfolio would be expected to return 13%. If the portfolio had a beta of 0.80, it would be 20% less volatile than the market. If the market was expected to return 10%, the portfolio would be expected to return 8%. Discount Rates The estimated betas for Rambus (RMBS), Sunoco (SUN), and Procter & Gamble (PG) are 1.30, 1.05, and.60, respectively. The risk free rate of return is 4.90%, and the market risk premium is 5%. Calculate the required rates of return for these three stocks using the CAPM

18 Discount Rates Weighted Average Cost of Capital WACC = [MV Debt / (MV Debt + MV Equity)] (r d ) ( 1 t ) + [MV Equity / (MV Debt + MV Equity)] (r) where: MV = Market Value r d = before tax cost of debt r = cost of equity t = tax rate Valuation Basics Example of present value concept: An asset will generate cash flows (or dividends) of $100 in year 1, $150 in year 2, and $200 in year 3. The discount rate is 10%. The value of the asset in year three is projected to be $ V 0 = (1 +.10) 2 (1 +.10) 3 V 0 = $ $ $ V 0 = $ Free cash flow models (FCF) Single-Stage FCFF and FCFE Growth Models: FCFF 0 ( 1 + g ) Firm Value = WACC g FCFE 0 ( 1 + g ) Equity Value = r g Constant Growth Dividend Discount Model Dividends growing at constant rate Assumptions Growth rate < investor s required return Investor s required rate of return constant D V = 1 r g Mature companies

19 Constant Growth Dividend Discount Model Example XYZ stock is currently paying a dividend of $2 per share and the dividend will grow at a constant rate of 6% annually. What should the stock be selling for if the investor s required rate of return is 10%? $2 ( ) $2.12 V = = = $ Expected Return for a Stock Continuing with the previous example, assume that XYZ stock is currently trading at $55 per share. (D 1 is $2.12 and its dividend growth rate is 6%.) We determine the expected return on the stock to be 9.85%. r = $2.12 $55 r = D 1 P + g = = , or 9.85% Market-Based Models Other Common Multiples Relative valuation models Price-to-earnings (P/E) ratio Price-to-free-cash-flow (P/FCF) ratio Price-to-sales (P/S) ratio EV / Revenue EV / EBITDA EV / EBIT EV / Debt-free Net Income EV / Debt-free Cash Flow EV / Total Assets Price / Revenue Price / Book Value of Equity

20 P/S Ratio Example Stock Valuation Question Acme stock Market price per share = $17.83 Sales per share = $2.70 P/S = $17.83 $2.70 = 6.60x DSA stock is currently paying a dividend of $1.50 per share, which is expected to grow at a constant rate of 3% annually. What should the stock be selling for in the secondary market if an investor s required rate of return is 12%? A. $17.17 B. $12.50 C. $15.87 D. $ Stock Valuation Solution DSA stock is currently paying a dividend of $1.50 per share, which is expected to grow at a constant rate of 3% annually. What should the stock be selling for in the secondary market if an investor s required rate of return is 12%? Unit 4 A. $17.17 Using the constant growth dividend discount model: [$1.50 ( )] ( ) = = , or $17.17 Alternative Investments and Derivatives

21 Alternative Investments Real estate (Rentals, REITs, LPs, etc.) Options, Futures Collectibles Precious metals Other commodities Unit 5 Types of Investment Risk and Quantitative Investment Concepts Learning Outcomes E.34.1 Explain terminology related to the analysis of risk and return in portfolio construction and management. Diversification Investor should attempt to realize greatest amount of return per unit of risk by: structuring a portfolio containing assets with low correlation to each other, and/or having a longer investment time horizon Studies have shown that an investor only needs about 15 to 20 assets to fully diversify a portfolio

22 Risk vs. Number of Securities Portfolio Diversification Reduces unsystematic risk and enhances returns Asset classes Cash and cash equivalents Fixed-income investments Equities Real assets Asset allocation Consist of securities in each class to offer broad diversification Learning Outcomes E.34.2 Differentiate among the various sources of risk in investments, both systematic and unsystematic. Total Risk Total risk = unsystematic risk + systematic risk Standard deviation Components Unsystematic, or diversifiable, risk Systematic, or nondiversifiable, risk Beta

23 Unsystematic Risk Affects a particular company, country, or sector Business risk Financial risk Liquidity risk Marketability risk Default risk Political risk Tax risk Investment manager risk Diversifying may greatly reduce unsystematic risk Systematic Risk Reflects uncertainty of returns (PRIME) Purchasing power (inflation) risk Reinvestment rate risk Interest rate risk Market risk Exchange rate risk Learning Outcomes E.35.2 Explain the use of stochastic modeling in projecting future portfolio performance. Standard Deviation Measures variability of actual investment returns around average, or mean, of those returns Most accepted measure of total, or absolute, risk Tells how far from mean investment s actual return varies

24 Normal Probability Distribution Normal Probability Distribution Perfectly symmetrical Bell-shaped curve Normal curve is symmetrical Interpreting and analyzing standard deviation 68% chance of return falling within 1 standard deviation of the mean 95% chance of return falling within 2 standard deviations of the mean Mean, median, and mode are equal 99% chance of return falling within 3 standard deviations of the mean Probability Distribution Question Probability Distribution Solution ABC stock has a mean return of 7.5% and a standard deviation of 5%. Which statement is CORRECT? A. Approximately 68% of ABC stock s returns will fall between 2.5% and 12.5%. B. Five percent of ABC stock s returns will be greater than 17.5%. C. Half of ABC stock s returns will fall below 2.5%. D. ABC stock is highly unlikely to experience a negative return. ABC stock has a mean return of 7.5% and a standard deviation of 5%. Which statement is CORRECT? A. Approximately 68% of ABC stock s returns will fall between 2.5% and 12.5%. With a normal probability distribution, 68% of the returns fall within 1 standard deviation of the mean (2.5% 12.5%), 95% within 2 standard deviations ( 2.5% 17.5%), and 99% within 3 standard deviations ( 7.5% 22.5%)

25 Standard Deviation Example Learning Outcomes E.35.5 Identify covariance and correlation coefficient, know how to calculate one given the other, and understand their application and relevance when calculating the standard deviation of a portfolio Covariance (COV) Extent to which two variables move together either: positively (together), or negatively (opposite) COV = ρσσ ij ij i j Covariance Example ABC and XYZ stocks have standard deviations of 7.18% and 12%, respectively, and a correlation coefficient of Covariance between the two stocks is ( ). Direct relationship with correlation coefficient

26 Correlation Coefficient (R) Covariance Example Measures strength of straight-line relationship between two variables Range: 1.0 to +1.0 R (or ρ) = COV ij σσ x i j Correlation Summary Correlation Coefficient Example Perfectly positively correlated: ρ = +1.0 Asset returns move exactly together No reduction in total risk Perfectly negatively correlated: ρ = 1.0 Asset returns move exactly opposite of one another Total risk can be completely eliminated ρ = 0.0 No relationship between the returns ρ < +1.0 Farther from +1.0, greater diversification benefits Covariance between ABC and XYZ stocks = ABC s standard deviation = 7.18% XYZ s standard deviation = 12% R (or ρ) = = =

27 Standard Deviation of a Two-Asset Portfolio Standard Deviation of a Two-Asset Portfolio Example W = weighting of each asset σ = standard deviation of those respective assets COV ij = covariance between security i and j Learning Outcomes Unit 6 E.36.1 Explain terminology related to investment return computations and calculate returns. (See Investor Cash Flow Handout) Explain the difference between required and expected rates of return. (See IPS Example) Measures of Investment Returns

28 Arithmetic Mean Sum of periodic returns total periods Average, or mean, return Noncompounded return No reinvestment of returns Arithmetic Mean Example An investor has earned the following series of returns on an investment: Year 1: 15.20% Year 2: 9.10% Year 3: 6.50% Year 4: 18.30% Year 5: 16.80% 65.90% Arithmetic mean = 13.18% (65.90% 5) Geometric Mean Assumes compounding of returns Continuing with previous example (15.2%, 9.1%, 6.5%, 18.3%, 16.8%): GM = ( )( )( )( ) ( ) 1/5 = /5-1 = , or 13.09% Geometric Mean Question What is the geometric mean of the following series of annual returns? Year 1: 25% Year 2: 10% Year 3: 8% Year 4: 33% A. 10% B % C. 14% D. 17.5%

29 Geometric Mean Solution What is the geometric mean of the following series of annual returns? B % GM = ( )(1 0.10)( )( ) 1/4 1 = /4-1 Nominal Rate of Return Stated rate of return for a given period Does not account for: inflation, taxation, and compounding 12.75% Real Rate of Return Real Return Example Rate of return adjusted for inflation Inflation-adjusted rate of return ( n ) ( 1+I) 1+R R n = absolute return I = inflation rate Renee owns a corporate bond with a coupon rate of 6%. If the annual inflation rate is 3.5%, her real rate of return on the bond is 2.42%, calculated as follows: = ( ) 100 = 2.42%

30 After-Tax Inflation-Adjusted Rate of Return Renee is in a 15% federal marginal income tax bracket (no state income tax) After-tax rate of return = 5.1% [0.06 (1 0.15)] After-tax inflation-adjusted rate of return = 1.55% = ( ) 100 = 1.55% After-Tax Rate of Return Question Jackie earned a before-tax rate of return of 12.65% on a recently purchased investment. She is in the 35% federal and the 5% state marginal income tax brackets. What is the after-tax rate of return on this investment? A. 4.55% B. 5.19% C. 7.59% D. 8.10% After-Tax Rate of Return Solution Taxable Equivalent Yield Jackie earned a before-tax rate of return of 12.65% on a recently purchased investment. She is in the 35% federal and the 5% state marginal income tax brackets. What is the after-tax rate of return on this investment? C. 7.59% [1 ( )] = = , or 7.59% Compares yields on municipal bonds with fully taxable bonds TEY = tax-exempt yield 1 marginal tax rate Example Lucy s municipal bond, trading at par 5% coupon rate 28% federal income tax bracket TEY = 0.05 (1 0.28) = , or 6.94%

31 Learning Outcomes Unit 10 E.37.4 Evaluate investment alternatives to select investment portfolios based on modern portfolio theory principles. Asset Allocation, Portfolio Development, and Investment Strategies Strategic Allocation In strategic asset allocation, an investor s return objectives, risk tolerance, and investment constraints are integrated with long-run capital market expectations to establish exposures to IPS permissible constraints. Specification of asset classes Assets within an asset class should be relatively homogeneous. Asset classes should be mutually exclusive. Asset classes should be diversifying. The asset classes as a group should make up a preponderance of world investable wealth. The asset class should have the capacity to absorb a significant fraction of the investor s portfolio without seriously affecting the portfolio s liquidity

32 Optimization Methodologies Mean-variance analysis Black-Litterman Monte Carlo simulation Experience-based techniques Mean-Variance Analysis Efficient portfolios make efficient use of risk; they offer the maximum expected return for their level of variance or standard deviation. Once we have identified an efficient portfolio with the desired combination of expected return and variance, we must determine the asset class weights in that portfolio Black-Litterman Seeks to avoid the difficulties of estimating expected returns in MVO analysis by using asset returns implied by a value-weighted global market index. Implied returns are then incorporated into standard MVO. Monte Carlo Simulation Computer simulation that incorporates the effects of various assumed capital market factors (yields, inflation, recessions, etc.) in the next period as well as their compounding effects over several future periods. Includes thousands of potential outcomes. Garbage in = garbage out

33 Experience-Based Approach Based on rules of thumb, including, but not limited to: 60/40 stock/bond asset allocation 100 minus age Tactical Asset Allocation Tactical asset allocation involves making shortterm adjustments to asset class weights based on short-term relative performance among asset classes Learning Outcomes E.40.3 Explain investment strategies such as market timing, buy-and-hold, and sector rotation. Types of Common Stock (1 of 3) Blue chip stocks Issued by highly regarded, well-capitalized companies Pay regular dividends Growth stocks Issued by companies whose sales and earnings growth rates exceed industry average Typically do not pay dividends

34 Types of Common Stock (2 of 3) Income stocks Issued by companies consistently paying dividends, provide income to investors Value stocks Currently trading below value based on historical earnings and asset values Types of Common Stock (3 of 3) Cyclical stocks Issued by companies that prosper in growing economies and suffer in economic declines Defensive stocks Issued by companies relatively unaffected by the business cycle Common Stock Question Leslie wants to buy the stock of a well-capitalized company that pays steady dividends regardless of the condition of the economy. What type of stock should he buy? A. Growth stock B. Cyclical stock C. Value stock D. Blue-chip stock Common Stock Solution Leslie wants to buy the stock of a well-capitalized company that pays steady dividends regardless of the condition of the economy. What type of stock should he buy? D. Blue-chip stock Blue-chip stocks are stocks issued by highly regarded, well-capitalized companies that have historically paid dividends no matter the condition of the broader economy. Growth stocks typically do not pay dividends; instead, they invest their earnings back into the company. Cyclical stocks are stocks of companies that tend to prosper in a growing economy but do poorly during declining economic conditions. Value stocks are stocks currently trading at prices that are low, given the issuing company s historical earnings and asset values

35 Sector Rotation Active portfolio management Emphasizing or over-allocating certain economic sectors or industries Investors must time entry and exit of specific sectors based on business cycles Value vs. Growth Investing (1 of 2) Value investing Concentrates on numerator of P/E ratio (price) Assumes P/E ratio is below natural level Efficient market will soon recognize this pattern and drive stock price upward Value vs. Growth Investing (2 of 2) Growth investing Focuses on denominator of P/E ratio (earnings) Investors look for stocks having superior ability to develop products with minimum competition Superior earnings growth Low dividend payouts Performance Review and Rebalancing

36 Learning Outcomes E.36.3 Calculate one or more stock performance measurements for a given portfolio. Total Return Total return includes the income from dividends or interest plus any capital appreciation over a given time period, usually one year Total Return Example A common stock purchased for $20 with an annual dividend of $1, which was paid in cash, is sold after one year for $24. Total return is $5 $1 in cash dividends + $4 in capital appreciation Total return = 25% ($5 $20) Holding Period Rate of Return (HPR) Single period return Fails to consider timing of cash flows If holding period > one year HPR overstates return If holding period < one year HPR understates return HPR = ending value beginning value + cash flows beginning value

37 HPR Example Holding Period Return Question Michael purchases a Treasury bond for $1,050 and sells the bond later for $980. While he owned the bond, he received interest payments of $160. Therefore, Michael s holding period rate of return (HPR) is 8.57%. HPR = $980 $1,050 + $160 = $90 $1,050 $1,050 = , or 8.57% Jack purchased 500 shares of ABC stock for $45 per share. The stock paid a $.25 dividend per share at the end of the year. During the same year, there was a 2- for-1 stock split. If the value of Jack s investment at the end of the year was $36,000, what was his holding period rate of return (HPR)? A. 30.3% B. 60.6% C. 61.1% D. 62.5% Holding Period Return Solution Alternative HPR Formula Jack purchased 500 shares of ABC stock for $45 per share. The stock paid a $.25 dividend per share at the end of the year. During the same year, there was a 2- for-1 stock split. If the value of Jack s investment at the end of the year was $36,000, what was his holding period rate of return (HPR)? C. 61.1% HPR = holding period return r = rate of return for given period n = number of periods HPR = $36,000 $22,500 + ($ ) = $13,750 $22,500 $22,500 = , or 61.1%

38 Alternative HPR Formula Example (1 of 2) Jim owns an investment with the following returns over the past 5-year period: Year 1: 12% Year 2: 9% Year 3: 3% Year 4: 5% Year 5: 7% What is Jim s HPR over the 5-year period? Alternative HPR Formula Example (2 of 2) What is Jim s HPR over the 5-year period? HPR = [( ) (1 0.09) ( ) ( ) (1 0.07)] 1 HPR = [ ] 1 HPR = = , or 2.51% Jensen s Alpha Measures risk-adjusted value added by portfolio manager Portfolio s actual return in excess of (or deficient to) CAPM return Positive alpha portfolio manager added value, portfolio plots above the SML Negative alpha portfolio manager has underperformed, portfolio plots below the SML Absolute performance measure Jensen s Alpha Formula ( ) α =r r + r r β p p f m f p where α =alpha p p β = beta, measures systematic or market risk p r =the average rate of return for portfolio p r =the return on the market m r = the risk- free rate of return f 38

39 Jensen s Alpha Example Realized portfolio P mean return = 10% Portfolio P beta = 0.50 Market portfolio mean return = 12% Risk-free rate = 4% Jensen s alpha = 0.10 [ ( )0.5] = = 0.02, or 2% Treynor Ratio Uses beta Compares performance of diversified portfolios or stocks constituting diversified portfolios Relative performance measure Higher ratio, better risk-adjusted performance r -r p f T p = β p Treynor Ratio Example Portfolio B s actual return = 12% Beta = 0.60 Risk-free rate of return = 3% Treynor ratio = 0.15 [( ) 0.60] Sharpe Ratio Uses standard deviation Compares performance of all portfolios Relative performance measure Higher ratio, better risk-adjusted performance r p r S p = σ p f

40 Sharpe Ratio Example Portfolio B s actual return = 12% Standard deviation = 6.5% Risk-free rate of return = 3% Sharpe ratio = 1.38 [( ) 0.065] Information Ratio Measures portfolio s average rate of return in excess of a comparison portfolio divided by standard deviation of the excess return Alpha divided by standard deviation R P R IR = σ A B Coefficient of Variation Coefficient of Variation Question Relative measure of total risk per unit of expected return Compares investments with varying rates of return and standard deviations CV = standard deviation of asset expected return of asset An investor is deciding whether to make an investment in ABC stock, which has a standard deviation of 5.4% and an expected return of 9.5%, or XYZ stock, which has a standard deviation of 6.4% and an expected return of 12.5%. Using the coefficient of variation (CV), which of these stocks is the preferable investment choice? A. ABC, with a CV of B. XYZ, with a CV of C. XYZ, with a CV of D. ABC, with a CV of

41 Coefficient of Variation Solution CFP Exam-Level Question - Unit 7 An investor is deciding whether to make an investment in ABC stock, which has a standard deviation of 5.4% and an expected return of 9.5%, or XYZ stock, which has a standard deviation of 6.4% and an expected return of 12.5%. Using the coefficient of variation (CV), which of these stocks is the preferable investment choice? B. XYZ, with a CV of For ABC, the CV is ( ). For XYZ, the CV is ( ). Using this information, the investor may choose to select the asset with the lower CV. Your client, Tiffany, owns a portfolio that earned 12% during the current year. Her portfolio had a beta of 1.3 and a standard deviation of 14%. During the current year, the market (S&P 500) returned 9%. The risk-free rate of return was 5%. Which of the following statements is(are) CORRECT? 1. The Treynor ratio for the market is The Treynor ratio for Tiffany's portfolio is The Treynor ratio for Tiffany's portfolio is Tiffany's portfolio outperformed the market on a risk adjusted basis. A. 1 and 2 B. 2 and 3 C. 1, 2, and 4 D. 1, 3, and CFP Exam-Level Question - Unit 7 Solution Your client, Tiffany, owns a portfolio that earned 12% during the current year. Her portfolio had a beta of 1.3 and a standard deviation of 14%. During the current year, the market (S&P 500) returned 9%. The risk-free rate of return was 5%. Which of the following statements is(are) CORRECT? 1. The Treynor ratio for the market is The Treynor ratio for Tiffany's portfolio is Tiffany's portfolio outperformed the market on a risk adjusted basis. D. 1, 3, and 4 CFP Exam-Level Question - Unit 7 Rationale Market Treynor: ( ) 1.0 = Tiffany s portfolio Treynor: ( ) 1.3 = With a higher Treynor ratio, Tiffany's portfolio outperformed the market on a risk adjusted basis

42 Learning Outcomes Discuss calendar and percentage of assets rebalancing methods. Monitoring and rebalancing Changes in circumstances and wealth (more wealth = more risk). Changing liquidity requirements (unemployment, illness, court judgments, retirement, divorce, death of a spouse, building a new home, etc.) Changing time horizons (as one moves through life cycle, time horizon shortens and risk should be reduced) Changes in laws and regulations Monitoring and rebalancing Monitoring and rebalancing

43 Monitoring and rebalancing Review: The Investment Management Process Client Due Diligence Planning Execution Performance Rebalancing Financials Goals Risk Tolerance Asset Classes Stock/Bond Basics Expected Risk and Return Asset Allocation Investment Strategy Return Analysis Attribution Types of Rebalancing Thank You! Check out courses 101, 102, 104, 105, and