Lecture 1

Introduction to Portfolio
Management and Basic Principles
of Finance

Asst. Prof. Dr. Mete Feridun

1

Investors make two major steps or decisions in

constructing their own portfolios
Portfolio

is simply collection of investment assets

The

asset allocation decision is the choice among

broad asset classes such as stocks, bonds, real
estate, commodities, and so on.

The

security selection decision is the choice of

which particular securities to hold within each asset
class.
2

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

The

fundamental analyst considers:

Financial statements
Industry conditions
Prospects for the economy
4

Technical Analysis
A

technical analyst attempts to predict the

supply and demand for a stock by observing
the past series of stock prices

Financial

statements and market conditions

are of secondary importance to the technical
analyst
5

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
6

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
10

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
11

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)

12

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
13

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
14

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
15

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
16

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

17

Portfolio Management (contd)

Active management:

Requires the periodic changing of the

portfolio components as the managers
outlook for the market changes

18

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
19

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.
20

Risk
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.

Probability

Outcomes that produce harm

-30% -20%

-10%

0%

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

21

Differences in Levels of Risk

The wider the range of probable
outcomes the greater the risk of the
investment.

Outcomes that produce harm

Probability

A is a much riskier investment than B

-30% -20%

-10%

0%

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

22

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

23

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

24

Expected return

Rf
0

Risk

25

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
26

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

28

Portfolio Size and Total Risk

29

Investment Choices
The Concept of Dominance Illustrated
Return
%
10%

5%

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

5%

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

20%

Risk

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

A dominates C.

30

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
31

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

32

Dispersion and Chance of Loss

(contd)
Investment value

Investment A
Investment B

Time
33

Dispersion and Chance of Loss

(contd)
Investments

A and B have the same

arithmetic mean

Investment

B is riskier than Investment A

34

Types of Risk
Total

risk refers to the overall variability of

the returns of financial assets

Undiversifiable

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
35

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

36

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
37

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

38

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.
39

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.
40

Growth of Income (contd)

Example (contd)
$7,000
$6,180

$6,000

$5,000

$5,000
$4,000

Portfolio A
Portfolio B

$3,000
$2,000
$1,000
$0
1999 2001 2003 2005 2007 2009

41

Categories of Stock
Blue

chip stock
Income stocks
Cyclical stocks
Defensive stocks
Growth stocks
Speculative stocks
Penny stocks
42

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
43

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
44

Cyclical Stocks
Cyclical

stocks are stocks whose fortunes

are directly tied to the state of the overall
national economy

Examples

include steel companies,

industrial chemical firms, and automobile
producers
45

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
46

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

47

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
48

Penny Stocks
Penny

stocks are inexpensive shares

Penny

stocks sell for $1 per share or less

49

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
50

Capitalization
Capitalization

refers to the aggregate value

of a companys common stock

Typical

divisions (for U.S.) are:

Large cap ($1 billion or more)

Mid-cap (between $500 million and $1 billion)
Small cap (less than $500 million)
Micro cap
51

Investment Styles
1-Value

investing

2-Growth

investing

52

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

53

Price/Earnings Ratio
The

PE ratio is stock price divided by EPS

forward-looking PE uses earnings

forecasts

trailing PE uses historical earnings

54

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

ratios
55

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
56

Why Do Individuals
Invest ?
By saving money (instead of
spending it), individuals tradeoff
present consumption for a larger
future consumption.
57

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

58

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.
59

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.
60

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.
61

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.
62

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
63

Probability Distributions
Risk-free Investment
1.00
0.80
0.60
0.40
0.20
0.00

-5%

0%

5%

10% 15%

64

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%

66

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%
67

Remember, When You Invest Your $s

Risk
Higher Potential
Returns
But...

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

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

68

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
69

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
70

FINAL QUESTION
Which of these three do you want?
PROTECTION
GROWTH

LIQUIDITY
The market only allows you two out of three!
71