Chapter 01 Investment Setting

Investment Management and Asset Allocation Decision

Questions to be answered:
• Why do individuals invest ?
• What is an investment ?
• How do we measure the rate of return on
an investment ?
• How do investors measure risk related to
Chapter 01 Investment Setting and alternative investments ?
Asset Allocation Decision

Chapter 01 Investment Setting Why Do Individuals

and Asset Allocation Decision Invest ?
• What factors contribute to the rates of
return that investors require on
By saving money (instead of
alternative investments ? spending it), individuals tradeoff
present consumption for a larger
future consumption.

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How Do We Measure The Rate Of How Do We Measure The Rate Of
Return On An Investment ? Return On An Investment ?
The pure rate of interest is the People’s willingness to pay the
exchange rate between future difference for borrowing today and
consumption and present their desire to receive a surplus on
consumption. Market forces their savings give rise to an interest
determine this rate. rate referred to as the pure time
value of money.

How Do We Measure The Rate Of How Do We Measure The Rate Of

Return On An Investment ? Return On An Investment ?
If the future payment from the
If the future payment will be investment is not certain, the
diminished in value because of investor will demand an interest
inflation, then the investor will rate that exceeds the pure time
demand an interest rate higher than value of money plus the inflation
the pure time value of money to rate to provide a risk premium to
also cover the expected inflation cover the investment risk.
expense.

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 Measures of
Defining an Investment Historical Rates of Return
Holding Period Return (HPR) 1.1
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.

Measures of
Measures of
Historical Rates of Return Historical Rates of Return
1.1 1.2
Holding Period Return (HPR)
• This HPR value will always be zero or greater—that is, it can
never be a negative value.
Holding Period Yield
• A value greater than 1.0 reflects an increase in your wealth,
which means that you received a positive rate of return during
HPY = HPR - 1
the period.
• A value less than 1.0 means that you suffered a decline in
1.10 - 1 = 0.10 = 10%
wealth, which indicates that you had a negative return during
the period.
• An HPR of zero indicates that you lost all your money
(wealth) invested in this asset.

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 Measures of Measures of
Historical Rates of Return Historical Rates of Return
Annual Holding Period Return
–Annual HPR = HPR 1/n
where n = number of years investment is held

Annual Holding Period Yield

–Annual HPY = Annual HPR - 1

Measures of Measures of
Historical Rates of Return Historical Rates of Return

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 Measures of Measures of
Historical Rates of Return Historical Rates of Return
1.4 1.5
Computing Mean Historical Returns Geometric Mean
Arithmetic Mean

Measures of Measures of
Historical Rates of Return Historical Rates of Return
1.5 1.5
• Investors are typically concerned with long-term
performance when comparing alternative investments.
• Although the arithmetic average provides a good
indication of the expected rate of return for an investment
during a future individual year, it is biased upward if you
are attempting to measure an asset’s long-term
performance.
• GM is considered a superior measure of the long-term
mean rate of return because it indicates the compound
annual rate of return based on the ending value of the
investment versus its beginning value.

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 Measures of
Historical Rates of Return A Portfolio of Investments
1.5

The mean historical rate of return for a

portfolio of investments is measured as
• the weighted average of the HPYs for
the individual investments in the
portfolio or
• the overall percent change in value of
the original portfolio.

Computation of Holding Exhibit 1.1 Mathematical Problem: Exhibit 1.1

Period Yield for a Portfolio Calculate HPY for a Portfolio

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 Computation of Holding Exhibit 1.1
Period Yield for a Portfolio
Expected Rates of Return
• Risk is uncertainty that an
investment will earn its expected
rate of return
• Probability is the likelihood of an
outcome

Expected Rates of Return Expected Rates of Return

1.6 1.6

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Expected Rates of Return Expected Rates of Return
1.6 1.6

Probability Distributions
Risk Aversion Exhibit 1.2

Risk-free Investment
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 Probability Distributions
Exhibit 1.3 Exhibit 1.4

Risky Investment with 3 Possible Returns Risky investment with ten possible rates of return

Measuring the Risk of 1.7

Measuring the Risk of 1.7
Expected Rates of Return Expected Rates of Return

The variance for the perfect-certainty (risk-free) example would be:

The variance for the second example would be:

The larger the variance for an expected rate of return, the greater the
dispersion of expected returns and the greater the uncertainty, or risk, of
the investment.

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 Measuring the Risk of 1.7
Measuring the Risk of 1.8
Expected Rates of Return Expected Rates of Return
Standard Deviation is the square
root of the variance

Calculate the variance of return

Measuring the Risk of 1.8

Measuring the Risk of 1.8
Expected Rates of Return Expected Rates of Return
Standard Deviation Standard Deviation

Calculate the standard deviation of return

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 Measuring the Risk of 1.9
Measuring the Risk of 1.9
Expected Rates of Return Expected Rates of Return
Coefficient of variation (CV) a measure of Coefficient of variation (CV)
relative variability that indicates risk per unit
of return
Standard Deviation of Returns
Expected Rate of Returns

Measuring the Risk of 1.9

Measuring the Risk of 1.9
Expected Rates of Return Expected Rates of Return
Coefficient of Variation (CV) Coefficient of variation (CV)

Calculate the Coefficient of variation (CV)

of return

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 Measuring the Risk of
Mathematical Problem 1.9 Historical Rates of Return 1.10

variance of the series

holding period yield during period I
expected value of the HPY that is equal
to the arithmetic mean of the series
Calculate Expected Return, Variance, Standard Deviation, and the number of observations
Coefficient of variation (CV)
of return for Lauren Computer Company.

Determinants of
Required Rates of Return The Real Risk Free Rate
(RRFR)
• Time value of money
• Expected rate of inflation –Assumes no inflation.
• Risk involved –Assumes no uncertainty about
future cash flows.
–Influenced by time preference for
consumption of income and
investment opportunities in the
economy

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 Adjusting For Inflation 1.12
Nominal Risk-Free Rate
Real RFR = Dependent upon
– Conditions in the Capital Markets
– Expected Rate of Inflation

Facets of Fundamental
Adjusting For Inflation 1.11

Risk
Nominal RFR = • Business risk
(1+Real RFR) x (1+Expected Rate of Inflation) - 1
• Financial risk
• Liquidity risk
• Exchange rate risk
• Country risk

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 Business Risk Financial Risk
• Uncertainty caused by the use of debt
• Uncertainty of income flows caused by financing.
the nature of a firm’s business • Borrowing requires fixed payments which
• Sales volatility and operating leverage must be paid ahead of payments to
determine the level of business risk. stockholders.
• The use of debt increases uncertainty of
stockholder income and causes an increase
in the stock’s risk premium.

Liquidity Risk Exchange Rate Risk

• Uncertainty is introduced by the secondary • Uncertainty of return is introduced by
market for an investment. acquiring securities denominated in a
– How long will it take to convert an investment currency different from that of the investor.
into cash?
• Changes in exchange rates affect the
– How certain is the price that will be received?
investors return when converting an
investment back into the “home” currency.

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 Country Risk Risk Premium
• Political risk is the uncertainty of returns f (Business Risk, Financial Risk,
caused by the possibility of a major change Liquidity Risk, Exchange Rate
in the political or economic environment in
Risk, Country Risk)
a country.
• Individuals who invest in countries that or
have unstable political-economic systems f (Systematic Market Risk)
must include a country risk-premium when
determining their required rate of return

Risk Premium Fundamental Risk

and Portfolio Theory versus Systematic Risk
• The relevant risk measure for an • Fundamental risk comprises business risk,
individual asset is its co-movement financial risk, liquidity risk, exchange rate
with the market portfolio risk, and country risk
• Systematic risk relates the variance of • Systematic risk refers to the portion of an
the investment to the variance of the individual asset’s total variance attributable
market to the variability of the total market portfolio
• Beta measures this systematic risk of
an asset

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 Relationship Between Relationship Between
Risk and Return Exhibit 1.7 Risk and Return Exhibit 1.7

(Expected)

Changes in the Required Rate of Return

Due to Movements Along the SML Changes in the Slope of the SML
Exhibit 1.8 1.13

RPi = E(Ri) - NRFR

where:
RPi = risk premium for asset i
E(Ri) = the expected return for asset i
NRFR = the nominal return on a risk-free asset
A movement along the SML demonstrates a change in the risk characteristics
of a specific investment, such as a change in its business risk, its financial
risk, or its systematic risk (its beta). This change affects only the individual
investment.

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 Change in
Market Portfolio Risk 1.14 Market Risk Premium
Exhibit 1.10
The market risk premium for the market
Expected Return
portfolio (contains all the risky assets in the
market) can be computed:
Rm´
RPm = E(Rm)- NRFR where:
Rm
RPm = risk premium on the market portfolio
E(Rm) = expected return on the market portfolio NRFR
NRFR = expected return on a risk-free asset
A change in the slope of the SML occurs in response to a change in the
attitudes of investors toward risk. Such a change demonstrates that investors
want either higher or lower rates of return for the same intrinsic risk.

Capital Market Conditions,

Expected Inflation, and the SML Individual Investor
Exhibit 1.11 Life Cycle
• Accumulation phase – early to middle
Expected years of working career
Return
• Consolidation phase – past midpoint of
careers. Earnings greater than
NRFR´ expenses
NRF • Spending/Gifting phase – begins after
R
retirement
A shift in the SML reflects a change in expected real growth, a
change in market conditions (such as ease or tightness of
money), or a change in the expected rate of inflation.

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 Individual Investor Life Cycle
Net Worth Exhibit 2.1 Life Cycle Investment Goals
Accumulation Phase Consolidation Phase Spending Phase
Gifting Phase
Long-term:
Retirement Children’s
Long-term: Retirement
Long-term: Estate
• Near-term, high-priority goals
Short-term:
college Planning
Vacations
Short-term:
House Children’s College
Short-term: Lifestyle
Needs Gifts
• Long-term, high-priority goals
Car

• Lower-priority goals

Age

Exhibit 2.2

The Portfolio Management Process The Portfolio Management Process

1. Policy statement - Focus: Investor’s short-term and long-
term needs, familiarity with capital market history, and
expectations 1. Policy statement
2. Examine current and project financial, economic,
political, and social conditions - Focus: Short-term and
– specifies investment goals and
intermediate-term expected conditions to use in acceptable risk levels
constructing a specific portfolio
3. Implement the plan by constructing the portfolio - Focus:
– should be reviewed periodically
Meet the investor’s needs at the minimum risk levels – guides all investment decisions
4. Feedback loop: Monitor and update investor needs,
environmental conditions, portfolio performance

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The Portfolio Management Process The Portfolio Management Process

2. Study current financial and 3. Construct the portfolio

economic conditions and forecast – allocate available funds to minimize
future trends investor’s risks and meet investment
– determine strategies to meet goals goals
– requires monitoring and updating

The Portfolio Management Process

The Need For A Policy Statement
• Helps investors understand their own
4. Monitor and update needs, objectives, and investment
– evaluate portfolio performance constraints
– Monitor investor’s needs and market
• Sets standards for evaluating portfolio
conditions
performance
– revise policy statement as needed
• Reduces the possibility of
– modify investment strategy
accordingly inappropriate behavior on the part of
the portfolio manager

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 Constructing A Policy Statement Constructing A Policy Statement
• What other capital or income sources do I
Questions to be answered: have? How important is this particular
• What are the real risks of an adverse financial portfolio to my overall financial position?
outcome, especially in the short run? • What, if any, legal restrictions may affect
• What probable emotional reactions will I have to my investment needs?
an adverse financial outcome? • What, if any, unanticipated consequences of
• How knowledgeable am I about investments and interim fluctuations in portfolio value might
the financial markets?
affect my investment policy?

Investment Objectives Investment Objectives

• Risk Tolerance General Goals
• Capital preservation
• Absolute or relative percentage
– minimize risk of real loss
return
• Capital appreciation
• General goals – Growth of the portfolio in real terms to meet
future need
• Current income
– Focus is in generating income rather than
capital gains

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 Investment Objectives Investment Constraints
General Goals • Liquidity needs
– Vary between investors depending upon age,
• Total return
employment, tax status, etc.
– Increase portfolio value by capital gains and by
reinvesting current income • Time horizon
– Maintain moderate risk exposure – Influences liquidity needs and risk tolerance

Investment Constraints Investment Constraints

• Tax concerns • Tax concerns (continued)
– Capital gains or losses – taxed differently from – interest on municipal bonds exempt from
income federal income tax and from state of issue
– Unrealized capital gain – reflect price – interest on federal securities exempt from state
appreciation of currently held assets that have
not yet been sold income tax
– Realized capital gain – when the asset has been – contributions to an IRA may qualify as
sold at a profit deductible from taxable income
– Trade-off between taxes and diversification – – tax deferral considerations - compounding
tax consequences of selling company stock for
diversification purposes

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 Effect of Tax Deferral on
Equivalent Taxable Yield Investor Wealth over Time
Exhibit 2.6
Investment $10,062.66
Value

$5,365.91

$1,000

Time

Methods of Tax Deferral Legal and Regulatory Factors

• Regular IRA - tax deductible • Limitations or penalties on withdrawals
– Tax on returns deferred until withdrawal
• Fiduciary responsibilities -
• Roth IRA - not tax deductible
“prudent man” rule
– tax-free withdrawals possible
• Cash value life insurance – funds accumulate tax- • Investment laws prohibit insider trading
free until they are withdrawn
• Tax Sheltered Annuities
• Employer’s 401(k) and 403(b) plans – tax-
deferred investments

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Unique Needs and Preferences Constructing the Policy Statement
• Personal preferences such as socially conscious
investments could influence investment choice
• Objectives - risk and return
• Time constraints or lack of expertise for managing • Constraints - liquidity, time horizon, tax
the portfolio may require professional factors, legal and regulatory constraints, and
management unique needs and preferences
• Large investment in employer’s stock may require • Developing a plan depends on
consideration of diversification needs understanding the relationship between risk
• Institutional investors needs
and return and the the importance of
diversification

The Importance The Importance

of Asset Allocation of Asset Allocation
• An investment strategy is based on four
decisions • According to research studies, most (85% to
– What asset classes to consider for investment 95%) of the overall investment return is due
– What normal or policy weights to assign to each to the first two decisions, not the selection
eligible class of individual investments
– Determining the allowable allocation ranges
based on policy weights
– What specific securities to purchase for the
portfolio

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Returns and Risk of Different Returns and Risk of Different
Asset Classes Asset Classes
• Historically, small company stocks have
generated the highest returns. But the • Measuring risk by probability of not
volatility of returns have been the highest meeting your investment return objective
too indicates risk of equities is small and that
of T-bills is large because of their
• Inflation and taxes have a major impact on
returns differences in expected returns
• Focusing only on return variability as a
• Returns on Treasury Bills have barely kept
pace with inflation measure of risk ignores reinvestment risk

Asset Allocation and

Asset Allocation Summary
Cultural Differences
• Policy statement determines types of assets
• Social, political, and tax environments influence
to include in portfolio
the asset allocation decision
• Asset allocation determines portfolio return • Equity allocations of U.S. pension funds average
more than stock selection 58%
• Over long time periods, sizable allocation to • In the United Kingdom, equities make up 78% of
equity will improve results assets
• Risk of a strategy depends on the investor’s • In Germany, equity allocation averages 8%
goals and time horizon • In Japan, equities are 37% of assets

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