Which Investment Option Would You Choose?

Transcription

1 CHAPTER 9 Investment Management: Concepts and Strategies Elements of risk Which Investment Option Would You Choose? FIXED INCOME SECURITIES FIXED-INCOME SECURITY RETURN Where does it come from? FIXED-INCOME SECURITY RISK Inflation Risk Maturity Risk Default Risk Callability Risk Liquidity Risk

2 Values are impacted by inflation changes The longer the life of the investment the greater the uncertainty Chance the firm will default on contractual obligations Chance that the issue will be called by the corporation The ability to covert to cash quickly and at current market value Risk Reduction Strategies Ladder Bond Investments Invest in a portfolio with sequential maturities (ie 20K invested in each level of maturity like 5yr, 6 yr, 15 yr Invest in Tax-exempt Bonds Diversify with Intl. Bonds When one set matures invest in the next maturity ie 15 yr Adopt Dollar Cost Averaging Strategy What is dollar cost averaging? EQUITY RETURN AND RISK EQUITY RETURN Over time, return based on increase in sale price plus dividend payments Should outpace inflation EQUITY RISK Beta Market risk Alpha Estimated return if the stock market earned 0 Standard Deviation

3 The greater the dispersion, the greater the risk Sharpe Ratio (Risk adjusted return) S Return RF Morningstar Risk-adjusted Rating Morningstar Rating for Funds risk premium risk This is a proprietary Morningstar data point. Morningstar rates mutual funds from 1 to 5 stars based on how well they've performed (after adjusting for risk and accounting for sales charges) in comparison to similar funds. Within each Morningstar Category, the top 10% of funds receive 5 stars and the bottom 10% receive 1 star. Funds are rated for up to three time periods-three-, five-, and 10-years and these ratings are combined to produce an overall rating. Funds with less than three years of history are not rated. Ratings are objective, based entirely on a mathematical evaluation of past performance. They're a useful tool for identifying funds worthy of further research, but shouldn't be considered buy or sell signals. Morningstar Rating for Stocks This is a proprietary Morningstar data point. The Morningstar Rating for Stocks is calculated by comparing a stock's current market price with Morningstar's estimate of the stock's fair value. Our rating system also includes an uncertainty adjustment, so that it's more difficult for a company to earn a 5-star rating the more uncertain we are of our fair value estimate. Under our system, 3-star stocks are those that should offer a "fair return," one that adequately compensates for the riskiness of the stock. Three-star stocks should offer investors a return that's roughly comparable to the stock's cost of equity. (The cost of equity is often called a "required return" because it represents the return an investor requires for taking on the risk of owning the stock.) Five-star stocks, of course, should offer an investor a return that's well above the company's cost of equity. Conversely, low-rated stocks have significantly lower expected returns. The Morningstar Rating for Stocks also includes a small buffer around the cutoff between each rating, to reduce the number of rating changes produced by random market "noise." If a $50 stock moves up and down by $0.25 each day over a few days, the buffer will prevent the star rating from changing each day based on this insignificant change.

4 LIMITING EQUITY RISK Dollar Cost Averaging Constant Ratio Plan Maintain a constant ratio of investing As values change the ratio is the same but the number of shares changes Variable Installment Plan Strategy of Covered Calls Purchase options when you own the stock Risky version is to buy options when you do not own the stocks (naked options) Market Volatility and Dollar Cost Averaging

5 THEORY OF PORTFOLIO CONSTRUCTION Most effective strategies are based on: Diversification Asset Allocation THEORY OF EFFICIENT PORTFOLIO Expected return of a portfolio is weighted average of individual assets in the portfolio If assets are not perfectly correlated, risk of the portfolio will be less than the weighted average of the risks of individual assets in the portfolio By diversifying a portfolio with assets that are not perfectly correlated, investor can reduce overall risk of the portfolio without sacrificing the average return This is the essence of modern portfolio theory Maximize return for constant risk Minimize risk for constant returns What is the best goal for risk and return when creating a portfolio CAPITAL ASSET PRICING MODEL Investor expecting to beat the market without assuming additional risk must generate a rate of return that exceeds return of this portfolio If investor assumes higher level of risk than the risk of this efficient portfolio, then a higher level of return must be realized to compensate for the additional risk assumed If the return of a portfolio with similar risk is less than the expected return of the efficient portfolio, then the investor failed to construct an efficient portfolio Overall summary Investors are only paid for market risk Beta measures market risk There is a straight line relationship between market risk and return

6 POWER OF DIVERSIFICATION Domestic Diversification Global Diversification Markowitz model of risk as add stocks risk declines (randomly) Combining asset classes with less than perfect correlation will accelerate the reduction in risk RULES OF SIZING UP A MUTUAL FUND PORTFOLIO How can you determine which mutual fund is the best to buy? 1) First we need to select a fund family. The service of switching funds and the break points for obtaining lower investment costs makes the use of one fund family the best option. a. Many larger fund families have many mutual funds b. Each fund family will have good and bad funds. c. The greater the number to choose from the less likely you would be forced to invest in a poor performer. d. In a 401K this strategy is not important. You will have a mix of fund families. Switching and break points are not important. 2) Classify the mutual family s funds by basic categories a. Aggressive growth b. Growth c. Growth and income d. Income e. Sector f. Time targeted 3) Gather the information you deem important for fund performance for each fund in each group. a. I would first filter the group by life as a fund. b. Eliminate all funds with an inception date sooner than 3 years. 4) Create a checklist to rank the funds.

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