The Practice of Investment

What you’ve done so far?

 Goal setting
 Risk tolerance
 Acquiring Tips in Investing
 Financial Planning & Execution
The Practice of Investment

How prepared are

you?
The Practice of Investment

Consider these 4 factors:

1. How to find and evaluate the information you need
2. The agents and fees involved in trading securities
3. Ethical standards and regulatory requirements of security
industry
4. Special considerations in investing internationally
1. How to find these useful investment
decisions?
Three main kinds of Information:
1. Economic Indicators
2. Market Indices
3. Company performance
Economic Indicators

• Gross Domestic Product

• Inflation
• Unemployment
• Interest rates
The Index of Leading Economic
Indicators:
1. The length of the average workweek(in hrs.)
2. Initial weekly claims for unemployment
compensation
3. New orders placed with manufacturers
4. The percentage of companies receiving
slower deliveries suppliers(vendor
performance)
5. Contracts and orders for new plants and
equipment
The Index of Leading Economic
Indicators:
6. Permits for new housing starts
7. The interest rate spread (difference) between the
10-year Treasury bond and the BSP reserve requirement
rate, the “overnight rate” that banks use to lend each
other
8. The index of consumer expectations
9. Change in the value of the index of stock prices
10. Change in the money supply.
Market Information
- Indexes are used to gauge the movement, direction, and
rate of change as well as nominal value
- PSE stocks Indices
Industry/Company Performance

-check online trade journals and magazines

-check companies specialize in research and analysis
of industry and company data
Portfolio Theory Management

- Describes the resulting risk and return of a

combination of individual assets

- - to identify asset combinations that efficient

- - efficiency means the highest expected rate of
return on an investment for a specific level of risk
Portfolio Theory Management

- Requires an assumption that investors are risk averse

- -investors will not consider a portfolio with more risk
unless it is accompanied by a higher expected rate
of return
Modern Portfolio Theory Management
-integrates the process of efficient portfolio formation
to the pricing of individual assets
-it explains that some sources of risk associated with the
individuals assets can be eliminated, or diversified
away, by holding a proper combination of assets
Figure to Ponder:
Risk-return Trade-off
1. Risks in individual asset returns have two
components: • Systematic risks—common to most
assets • Non-systematic risks—specific to individual
assets.
2. Systematic risks and non-systematic risks are
different: • Non-systematic risks are diversifiable •
Systematic risks are non-diversifiable.
Risk-return Trade-off
3. Forming portfolios can eliminate non-systematic risks.
4. Investors hold diversified portfolios to reduce risk.
5. Investors care only about portfolio risks—systematic
risks.
Modern Portfolio Theory Management
-integrates the process of efficient portfolio formation
to the pricing of individual assets
-it explains that some sources of risk associated with the
individuals assets can be eliminated, or diversified
away, by holding a proper combination of assets
Modern Portfolio Theory Management
-integrates the process of efficient portfolio formation
to the pricing of individual assets
-it explains that some sources of risk associated with the
individuals assets can be eliminated, or diversified
away, by holding a proper combination of assets
Measuring Total(Stand-Alone) Risk:
the Standard Deviation
State of the economy Probability of this Rate of return on Rate of return of
state occurring stocks of Pure Great CEBECO S
Products
Boom 0.2 110% 20%
Normal 0.5 22 16
Recession 0.3 -60 10

Standard deviation 59.3% 3.6%

Note: the larger

standard deviation
indicates a greater
variations
common Methods of Measurement Used
for Risk Management in Investing
Standard deviation
measures the dispersion of data from its expected value.
The standard deviation is used in making an investment
decision to measure the amount of historical
volatility associated with an investment relative to its
annual rate of return

-a stock that has a high standard deviation experiences higher

volatility, and therefore, a higher level of risk is associated with
the stock.
common Methods of Measurement Used
for Risk Management in Investing

BETA measures the amount of systematic risk an individual

security or an industrial sector has relative to the whole stock
market

A security with a beta greater than 1 indicates that it is more

volatile than the market

For example, suppose a security's beta is 1.5. In theory, the

security is 50 percent more volatile than the market.
common Methods of Measurement Used
for Risk Management in Investing
 SHARPE INDEX

The higher the ratio, the greater the investment return relative
to the amount of risk taken, and thus the better the investment
TREYNOR RATIO
When using the Treynor Ratio, keep in mind:
• For negative values of Beta, the Ratio does not give
meaningful values.
• When comparing two portfolios, the Ratio does not
extract the economic significance on the difference
of the values, as they are ordinal. For example, a
Treynor Ratio of 0.5 is better than one of 0.25, but
not necessarily twice as good.
• The numerator is the excess return to the risk-free
rate, and the denominator is the Beta of the
portfolio, or, in other words, a measure of systematic
risk of a portfolio.
ACTIVITY NO.2: COMPUTE AND DECIDE
WHERE TO INVEST
Average risk free rate 6%
Average return for Camila 15%
Stock
Average return for Landers 14%
Stock
Standard Deviation of Camila 2%
Stock
Standard Deviation of 4%
Landers stock
Beta of Camila Stock .8
Beta of Landers Stock 1.1
Some Calculations: Rate of Return for
a Single Period Investment

In what follows, we implement several return computations,

starting with a simple single-period example.
Suppose you invested in AIG’s stock at Php25 per share. After
one year, the stock price increases to Php35, you originally
bought 450 shares. For each AIG stock, you also receive Php1
cash dividend during the year. a. How much is the total
investment? b. What is your investment rate of return in
% and in peso?
Some Calculations: Rate of Return for
a Single Period Investment

In what follows, we implement several return computations,

starting with a simple single-period example.
Suppose you invested Php10,000 in AIG’s stock at Php25 per
share. After one year, the stock price increases to Php35. For
each AIG stock, you also receive Php1 cash dividend during
the year. a. How many shares did you buy? b. What is your
investment rate of return in % and in peso?
HOLDING PERIOD RETURN

HPR=(Ending price-Beginning price + Cash dividend) /

Beg. Price
HOLDING PERIOD RETURN

the price of a share of a stock is currently Php100, and your

time horizon is one year. You expect the cash dividend during the
year to be Php4. Your HPR will depend on the price one year
from now. Suppose your best guess is that it will be Php110 per share. If you
are right, the HPR will be?
Calculating Investment Return: Dividend Yield vs.
Capital Gain
Obviously, you bought 400 stocks. Dividend Yield
= Php1/Php25 = 4%
Capital Gain = (Php35 - Php25)/Php25 = 40% Total
Percentage Return = 4% + 40% = 44% Total PESO
Return = 44% of Php10,000 = Php4,400 At the end of
the year, the value of your Php10,000 investment
becomes Php4,400, from which Phh4,400 is the value
of the Php 4000 AIG stocks and Php400 is cash due
to dividend payment.
RISK & RETURN CONSIDERATIONS
Key Points
• The general progression in the risk – return spectrum is: short-
term debt, long-term debt, property, high-yield debt, and
equity.
• When a firm makes a capital budgeting decision, they will
wish, as a bare minimum, to recover enough to pay the
increased cost of goods due to inflation.
• Risk aversion is a concept based on the behavior of firms
and investors while exposed to uncertainty to attempt to
reduce that uncertainty.
• Beta is a measure firms can use in order to determine an
investment ‘s return sensitivity in relation to overall market
risk.
RISK & RETURN CONSIDERATIONS
systematic risk: The risk associated with an
asset that is correlated with the risk of asset
markets generally, often measured as its beta.
inflation: An increase in the general level of
prices or in the cost of living.
political risk: the potential loss for a company
due to nonmarket factors such as
macroeconomic and social policies
RISK & RETURN CONSIDERATIONS
systematic risk: The risk associated with an
asset that is correlated with the risk of asset
markets generally, often measured as its beta.
inflation: An increase in the general level of
prices or in the cost of living.
political risk: the potential loss for a company
due to nonmarket factors such as
macroeconomic and social policies
Moreover, the importance of a loss of X
amount of value can be greater than the
importance of a gain of X amount of value, so
a riskier investment will attract a higher risk
premium even if the forecast return is the
same as upon a less risky investment. Risk is
therefore something that must be
compensated for, and the more risk the more
compensation is required.
• Risk aversion is the reluctance to accept a bargain with an uncertain payoff
rather than another bargain with a more certain, but possibly lower, expected
payoff.
• For example, a risk-averse investor might choose to put his or her money into a
bank account with a low but guaranteed interest rate, rather than into a stock
that may have high expected returns, but also involves a chance of losing value.
Risk aversion can be thought of as having three levels:

• Risk-averse or risk-avoiding
• Risk-neutral
• Risk-loving or risk-seeking
• Suppose you buy Php10,000 face value of treasury bill maturing in 6 months for
Php9,900. On the bill’s maturity date you collect the face value. Because there
are no other interest payments, the holding period return for this six- month
investment is?
• Suppose you buy Php10,000 face value of treasury bill maturing in 6 months for
Php9,900. On the bill’s maturity date you collect the face value. Because there
are no other interest payments, the holding period return for this six- month
investment is?

• HPR=( cash income + price change) / initial price

=( 0+Php100) / Php9,900 = .0101 or 1.01%

The APR on this investment is therefore 1.01% x 2= 2.02%

The Effective Annual Rate is a bit higher

1 + EAR= ( 1.0101)^2 = 1.0203

which implies that EAR= 2.03%

Example:
 One year ago you deposited Php1,000 in a 1 year bank deposit guaranteeing a
rate of interest of 10%. Suppose the inflation rate is running at i=6%. A candy
that cost Php1.00 last year might cost Php1.06 this year. So now, determine the
nominal rate and the real rate of return?
 If the interest rate on a one-year CD is 8%, and you expect inflation
to be 5% over the coming year, what is the real rate of interest?
Approximation rule

R real=(1+ R nom )/ (1 + i)

 more accurate for small inflation rates and is perfectly exact for
continuously compounded rates
Key terms:

 Risk-free rate- the rate of return that can be earned with CERTAINTY,
often measured by the rate on Treasury bills

 Risk premium- an expected return in excess of that risk-free

securities

 Excess return- rate of return in excess of the risk-free rate

 Risk aversion- reluctance to accept risk

seatwork

The stock of Business Adventures sells for Php40 a share. Its likely
dividend payout and end-of –year price depend on the state of the
economy bye the end of the year as follows:
Dividend Stock Price

Boom Php2.00 Php50

Normal Economy 1.00 43

Recession .50 34

A. Calculate the expected HPR per state of the economy.

MEASURING RISK
WHAT HOLDING-PERIOD
RETURNS ARE POSSIBLE, AND
HOW likely are they?
Scenario analysis

-process of devising a list of possible economic scenarios and

specifying the likelihood of each one ( probability ), as well as the HPR
that will be realized in each case.
 The current value of a stock portfolio is Php23 million. A financial analyst summarizes the
uncertainty about next year’s holding period return using the scenario analysis in the
following spreadsheet. What are the holding-period returns of the portfolio in each
scenario? Calculate the expected holding-period return and standard deviation of
returns.

END-OF-
YEAR ANNUAL
VALUE IN DIVIDEND
BUSINESS CONDITIONS SCENARIO PROBABILITY MILLION IN MILLION
HIGH GROWTH 1 0.3 35 4.40
NORMAL GROWTH 2 0.45 27 4.00
NO GROWTH 3 0.2 15 4.00
RECESSION 4 0.05 8 2.00