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Lecture 1

Introduction to Portfolio Management and Basic Principles of Finance

Asst. Prof. Dr. Mete Feridun


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Investors make two major steps or decisions in


constructing their own portfolios
Portfolio
The

is simply collection of investment assets

asset allocation decision is the choice among broad asset classes such as stocks, bonds, real estate, commodities, and so on. security selection decision is the choice of which particular securities to hold within each asset class.
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The

Stock Selection Philosophy


Fundamental

analysis Technical analysis

Fundamental Analysis
A

fundamental analyst tries to discern the logical worth of a security based on its anticipated earnings stream
fundamental analyst considers:

The

Financial statements Industry conditions Prospects for the economy


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Technical Analysis
A

technical analyst attempts to predict the supply and demand for a stock by observing the past series of stock prices
statements and market conditions are of secondary importance to the technical analyst
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Financial

Security Analysis

A three-step process
1) The analyst considers prospects for the economy, given the state of the business cycle 2) The analyst determines which industries are likely to fare well in the forecasted economic conditions 3) The analyst chooses particular companies within the favored industries
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An understanding of the risk/return trade-off


Assets with higher expected returns have greater risk. Higher risk assets offer higher expected returns than lower-risk assets. Risk tolerance: The investors willingness to accept higher risk to attain higher expected returns. Risk aversion: The investor is also reluctant to accept risk An investors objectives can be classified as return requirement and risk tolerance

Investors Constraints
Constraints

are the kind of financial circumstances imposed on an investors choice. Five common types of constraints are: 1. Liquidity: refers to how easy an asset can be converted to cash 2. Investment horizon: is the planned liquidation duration of investment. 3. Regulations: Professional and institutional investors are constrained by regulations- investors who manage other peoples money have fiduciary responsibility to restrict investment to assets that would have been approved by a prudent investor. 8

Investors Constraints
4.Tax considerations: special considerations related to tax position of the investor. The performance of any investment strategy are always measured by its rate of return after tax. 5.Unique needs: often centre around the investors stage in the life cycle such as retirement, housing and childrens education.

Portfolio Management

Literature supports the efficient markets paradigm


On a well-developed securities exchange, asset prices accurately reflect the tradeoff between relative risk and potential returns of a security
Efforts to identify undervalued undervalued securities are fruitless Free lunches are difficult to find
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Portfolio Management (contd)

Market efficiency and portfolio management


A properly constructed portfolio achieves a given level of expected return with the least possible risk
Portfolio managers have a duty to create the best possible collection of investments for each customers unique needs and circumstances
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Purpose of Portfolio Management

Portfolio management primarily involves reducing risk rather than increasing return
Consider two $10,000 investments:
1) Earns 10% per year for each of ten years (low risk) 2) Earns 9%, -11%, 10%, 8%, 12%, 46%, 8%, 20%, 12%, and 10% in the ten years, respectively (high risk)

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Low Risk vs. High Risk Investments


$30,000

$25,937 $23,642
$20,000

$10,000

$10,000

Low Risk High Risk

$0 '92 '94 '96 '98 '00 '02


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Low Risk vs. High Risk Investments (contd)


1) Earns 10% per year for each of ten years (low risk)
Terminal value is $25,937

2) Earns 9%, -11%, 10%, 8%, 12%, 46%, 8%, 20%, -12%, and 10% in the ten years, respectively (high risk)

Terminal value is $23,642

The lower the dispersion of returns, the greater the terminal value of equal investments
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Background, Basic Principles, and Investment Policy (contd)


There

is a distinction between good companies and good investments


The stock of a well-managed company may be too expensive The stock of a poorly-run company can be a great investment if it is cheap enough
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Background, Basic Principles, and Investment Policy (contd)

The two key concepts in finance are:


1) A dollar today is worth more than a dollar tomorrow 2) A safe dollar is worth more than a risky dollar

These two ideas form the basis for all aspects of financial management
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Portfolio Management

Passive management has the following characteristics:


Follow a predetermined investment strategy that is invariant to market conditions or Do nothing Let the chips fall where they may
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Portfolio Management (contd)

Active management:
Requires the periodic changing of the portfolio components as the managers outlook for the market changes

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Risk Versus Uncertainty


Uncertainty

involves a doubtful outcome

What you will get for your birthday If a particular horse will win at the track
Risk

involves the chance of loss

If a particular horse will win at the track if you made a bet


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Measuring Risk
Risk

= Probability of incurring harm For investors, risk is the probability of earning an inadequate return.
If investors require a 10% rate of return on a given investment, then any return less than 10% is considered harmful.
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Risk
Probability The range of total possible returns on the stock A runs from -30% to more than +40%. If the required return on the stock is 10%, then those outcomes less than 10% represent risk to the investor.

Outcomes that produce harm

-30% -20%

-10%

0%

10% 20% 30% 40% Possible Returns on the Stock

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Differences in Levels of Risk


Outcomes that produce harm Probability The wider the range of probable outcomes the greater the risk of the investment.

A is a much riskier investment than B

-30% -20%

-10%

0%

10% 20% 30% 40% Possible Returns on the Stock

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Risk and Return


Risk and return are the two most important attributes of an investment.
Research has shown that the two are linked in the capital markets and that generally, higher returns can only be achieved by taking on greater risk. Risk isnt just the potential loss of return, it is the potential loss of the entire investment itself (loss of both principal and interest).
Return %
Risk Premium

RF

Real Return Expected Inflation Rate

Risk

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Relationship Between Risk and Return


The

more risk someone bears, the higher the expected return The appropriate discount rate depends on the risk level of the investment The risk-less rate of interest can be earned without bearing any risk

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Expected return

Rf 0 Risk
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Returns and Risk of Different Asset Classes


Historically,

small company stocks have generated the highest returns. But the volatility of returns have been the highest too Inflation and taxes have a major impact on returns Returns on Treasury Bills have barely kept pace with inflation
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Historical Returns on Different Asset Classes


Next

figure illustrates the volatility in annual returns on three different assets classes from 1938 2005. Note:
Treasury bills always yielded returns greater than 0% Long Canadian bond returns have been less than 0% in some years (when prices fall because of rising interest rates), and the range of returns has been greater than Tbills but less than stocks Common stock returns have experienced the greatest 27 range of returns

Measuring Risk
Annual Returns by Asset Class, 1938 - 2005

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Portfolio Size and Total Risk

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Investment Choices
The Concept of Dominance Illustrated
Return %
10% A B

A dominates B because it offers the same return but for less risk. A dominates C because it offers a higher return but for the same risk.

5%

5%

20%

Risk
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To the risk-averse wealth maximizer, the choices are clear, A dominates B, A dominates C.

Risk Aversion
Most

investors are risk averse

People will take a risk only if they expect to be adequately rewarded for taking it
People

have different degrees of risk aversion


Some people are more willing to take a chance than others
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Dispersion and Chance of Loss


There

are two material factors we use in judging risk:


The average outcome The scattering of the other possibilities around the average

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Dispersion and Chance of Loss (contd)


Investment value

Investment A Investment B

Time
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Dispersion and Chance of Loss (contd)


Investments

A and B have the same arithmetic mean B is riskier than Investment A

Investment

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Types of Risk
Total

risk refers to the overall variability of the returns of financial assets risk is risk that must be borne by virtue of being in the market
Arises from systematic factors that affect all securities of a particular type
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Undiversifiable

Types of Risk (contd)


Diversifiable

risk can be removed by proper portfolio diversification


The ups and down of individual securities due to company-specific events will cancel each other out The only return variability that remains will be due to economic events affecting all stocks

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Growth of Income

Benefits from time value of money


Sacrifices some current return for some purchasing power protection

Differs from income objective


Income lower in earlier years Income higher in later years
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Growth of Income (contd)

Often seek to have the annual income increase by at least the rate of inflation Requires some investment in equity securities

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Growth of Income (contd)


Example
Two portfolios have an initial value of $50,000. Interest rates are expected to remain at a constant 10% per year for the next ten years. Portfolio A has an income objective and seeks to provide maximum income each year. The portfolio is invested 100% in debt securities. Thus, Portfolio A generates $5,000 in income each year.
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Growth of Income (contd)


Example (contd)
Portfolio B seeks growth of income and contains both debt and equity securities. Portfolio B has an annual total return of 13%. In the first year, Portfolio B provides $3,500 in income (a 7% income yield) and experiences capital appreciation of 5%. The income generated by both portfolios over the next ten years is shown graphically on the following slide.
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Growth of Income (contd)


Example (contd)
$7,000 $6,000 $5,000 $4,000 $3,000 $2,000 $1,000 $0 1999 2001 2003 2005 2007 2009
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$6,180 $5,000 Portfolio A Portfolio B

Categories of Stock
Blue

chip stock Income stocks Cyclical stocks Defensive stocks Growth stocks Speculative stocks Penny stocks
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Blue Chip Stock


Blue

chip has become a colloquial term meaning high quality


Some define blue chips as firms with a long, uninterrupted history of dividend payments The term blue chip lacks precise meaning, but some examples are:
Coca-Cola Union Pacific General Mills
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Income Stocks
Income

stocks are those that historically have paid a larger-than-average percentage of their net income as dividends
The proportion of net income paid out as dividends is the payout ratio The proportion of net income retained is the retention ratio

Examples

include Consolidated Edison and Allegheny Energy


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Cyclical Stocks
Cyclical

stocks are stocks whose fortunes are directly tied to the state of the overall national economy
include steel companies, industrial chemical firms, and automobile producers
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Examples

Defensive Stocks
Defensive

stocks are the opposite of cyclical stocks


They are largely immune to changes in the macroeconomy and have low betas

Examples

include retail food chains, tobacco and alcohol firms, and utilities
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Growth Stocks
Growth

stocks do not pay out a high percentage of their earnings as dividends


They reinvest most of their earnings into investment opportunities Many growth stocks do pay dividends

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Speculative Stocks
Speculative

stocks are those that have the potential to make their owners rich quickly Speculative stocks carry an above-average level of risk Most speculative stocks are relatively new companies with representation in the technology, bioresearch, and pharmaceutical industries
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Penny Stocks
Penny

stocks are inexpensive shares


stocks sell for $1 per share or less

Penny

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Categories Are Not Mutually Exclusive


An

income stock or a growth stock can also be a blue chip


E.g., Potomac Electric Power

Defensive

or cyclical stocks can be growth

stocks
E.g., Dow Chemical is a cyclical growth stock
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Capitalization
Capitalization

refers to the aggregate value of a companys common stock divisions (for U.S.) are:

Typical

Large cap ($1 billion or more) Mid-cap (between $500 million and $1 billion) Small cap (less than $500 million) Micro cap
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Investment Styles
1-Value

investing
investing

2-Growth

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1-Value Investing
Value

investors look for undervalued stock

Utilize

the firms earnings history and balance sheet


PE ratio, price/book ratio

Place

much emphasis on known facts


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Price/Earnings Ratio
The

PE ratio is stock price divided by EPS

forward-looking PE uses earnings forecasts

trailing PE uses historical earnings


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Price/Book Ratio
The

price/book ratio is the stock price divided by book value per share
Book value is the firms assets minus its liabilities Book value is different from market value

Value

investors look for low price/book


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ratios

2-Growth Investing
Growth

investors look for price momentum

Look for stocks that are in favor and have been advancing Look for stocks that are likely to be propelled even higher
The

market moves in cycles

Many investors own both growth and value stocks


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Why Do Individuals Invest ?


By saving money (instead of spending it), individuals tradeoff present consumption for a larger future consumption.
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How Do We Measure The Rate of Return on An Investment ?


The pure rate of interest is the exchange rate between future consumption and present consumption. Market forces determine this rate.

$1.00 4% $1.04

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Peoples willingness to pay the difference for borrowing today and their desire to receive a surplus on their savings give rise to an interest rate referred to as the pure time value of money.
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If the future payment will be diminished in value because of inflation, then the investor will demand an interest rate higher than the pure time value of money to also cover the expected inflation expense.
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If the future payment from the investment is not certain, the investor will demand an interest rate that exceeds the pure time value of money plus the inflation rate to provide a risk premium to cover the investment risk.
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Defining an Investment
A current commitment of $ for a period of time in order to derive future payments that will compensate for:
the time the funds are committed the expected rate of inflation uncertainty of future flow of funds.
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Risk Aversion
The assumption that most investors will choose the least risky alternative, all else being equal and that they will not accept additional risk unless they are compensated in the form of higher return
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Probability Distributions
Risk-free Investment
1.00 0.80 0.60 0.40 0.20 0.00

-5%

0%

5%

10% 15%

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Probability Distributions
Risky Investment with 3 Possible Returns
1.00 0.80 0.60 0.40 0.20 0.00

-30%

-10%

10%

30% 65

Probability Distributions
Risky investment with ten possible rates of return

1.00 0.80 0.60 0.40 0.20 0.00 -40% -20% 0%

20% 40%

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ALL INVESTING INVOLVES TWO CONCEPTS

Risk

vs

Safety

Question: What percentage of my assets should be in At-Risk Investments? Answer: Age 100 Your Age = Percentage of Risk Example: 100 60 = 40%
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Remember, When You Invest Your $s


Risk
Higher Potential Returns But...

vs

Safety
1) As we go down the Safety list, your potential return increases No Loss due to Principal decline
Various Investment Options Substantial Track Record

1) As we go down the Risk list, your return will decrease

Daily Fluctuations 2) As we go down the Risk list, your risk of in the market loss declines And... Decreased Safety

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First Lets Review the Risk Investments


Risk vs Safety 1) Stocks a) Company risk b) Market risk c) Macro risk d) Historic 11.1% return 2) Mutual Funds a) Diminished company risk b) Still has market & macro risk c) Could return 8-10% 3) Variable Annuities a) Uses sub-accounts b) Can be more expensive c) Returns of 6-9% 4) Long-Term Bonds a) Subject to interest rate risk
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Risk 1) Stocks a) Company risk b) Market risk c) Macro risk d) Historic 11.1% return 2) Mutual Funds a) Diminished company risk b) Still has market & macro risk c) Could return 8-10% 3) Variable Annuities a) Uses sub-accounts b) Can be more expensive c) Returns of 6-9% 4) Long-Term Bonds a) Subject to interest rate risk

vs

Safety

1) CDs a) Temporary parking spot 4 - 5% b) After tax and inflation, results in minimal returns 2) Short Term Medium Term U.S. Government Bonds 3) Fixed Annuities a) Tax-deferred b) Earnings add up c) Higher interest rates paid 4) Equity Indexed Annuities 5 8 a) Over Time - No Market Risk b) Links to major indexes Usually S&P 500 c) With No Risk of Loss of Principal due to market decline
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FINAL QUESTION
Which of these three do you want? PROTECTION GROWTH

LIQUIDITY
The market only allows you two out of three!
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