Chapter 7 - Portfolio Management Flashcards
what does portfolio management entail
at this stage the investor is aware of the various instruments that can be used and that investment instruments provide different levels of return.
Some investments – provide an income on continuous basis (dividends, i, rent)
Other investments – provide capital growth (gain)
The most important concepts for portfolio management are
Investor should realize that, when combining certain investments → he should have greater certainty over his income & the risk of all investments together.
Key to success - Diversification over different asset classes during construction of portfolio.
risk differs from investment to investment
asset classes and investment instruments
Key Success Factor – Build a diversified portfolio of investments - Spread available funds across as many asset classes as possible within the constraints of the investment objectives
Investment Instruments – subdivided into 2 groups/asset classes – Real & Financial
financial vs. real investments
F: represented by a piece of paper, easy to safeguard, liquidity is high
R: physical products, difficult to safeguard, require a lot of admin., not very liquid
risk in portfolio management
Possibility – investment will not produce desired return (income)
Uncertainty associated with return = Risk - actual future return will vary from expected return
Actual Return < Expected Return
Actual Return > Expected Retur
return in portfolio management
Investors want a return, either
continuous (dividends, i)
end of period (capital growth)
what is a desired portfolio
diversified
Negative performance in one investment cancelled out by positive performance of another investment
What is the philosophy of portfolio management
Compile combination of investment alternatives to achieve a realistic & acceptable level of risk within the investment objectives
what are the investment objects that the investor needs to decide on
level of return that he will be satisfied with, &
certain risk profile (amount of risk he is willing to accept to achieve this desired return).
To determine return is reasonably simple. Even if there is uncertainty about the future income, one can apply probabilities to calculate an expected future return.
What are the 3 general measures used to determine risk
variance or stdefv of expected returns
range of returns
returns lower than the expected returns
calculation of the variance and stdev
(statistically determine the spread of the returns around the expected value).
The greater the variance/standard deviation, the greater the uncertainty that the expected return will be realised, & thus the greater the risk. Problem = based on historical data.
Determination of the rate of return
– difference between the highest & lowest expected return.
The larger the range, the greater the uncertainty of what the expected return will be & therefore the greater the risk.
only the returns lower than expected should be viewed
Implies the calculation of the semi-variance.
Risk increases when
Risks increases as the return of the various asset classes increase.
Risk attached to treasury bills (money market instrument of government), is very low & therefore the accompanying return is also low.
Property, with a much higher risk, will have a much higher expected return.
graph 7.1
portfolio management
Portfolio management = combination of a healthy balance of investment instruments that will suite the investor’s specific profile of risk/return.
The investment life cycle of an individual
Investment needs change as you get older
Manner in which you will structure your financial plans will be influenced by age, financial ability, future plans & needs.
Before investment can be considered, other needs must be met:
income –cover daily expenses (food, clothing, house)
reserve – unexpected events (accident, unemployment)
Then develop investment plan which is influenced
Investment objectives will be influenced by what stage of your life you are in.
4 phases of the investment life cycle
accumulation
consolidation
spending
gifting
accumulation phase
people in their initial to middle working years
accumulate as many assets for their intermediate need satisfaction as possible.
Start making provision for LT objectives (retirement, children studies)
Net asset value = small
Debt = substantial
Long investment period ahead
Income will increase
Willing to make high-risk investments that promise above aver returns
consolidation phase
past the midpoint of their careers
Debt = Repaid most
Children’s studies = probably sufficient resources
Income exceeds expenses – therefore discretionary funds available to start making provision for retirement & planning their estate
Investment period still long – therefore willing to make medium-risk investments
Avoid high risks investments
spending/ gifting phase
usually when a person retires
Living expenses covered by pension & income from investments
Concerned about (1) protection of capital (2) to find a hedge against the negative impact of inflation on capital
Require risky growth investments to battle effects of inflation
More wealthy = sufficient income to cover living expenses & make provision for unplanned
Surplus to financially support friends, family, contributions to welfare societies & conduct estate planning to minimize their estate duties
The portfolio management process
- determine investment policy (investment objectives and constraints)
- study all economic and financial circumstances ( try forecast future trends) - regularly monitor and adapt when necessary
- compile portfolio (Spread across countries, asset classes & investment instruments
Satisfy return expectations & within limits of risks
Use Top-Down or Bottom-Up Process) - monitor investment needs as well as the state of the financial markets (Adapted & change when necessary
Evaluate the performance regularly & compare with expected returns)
constraints of a portfolio
availability of funds liquidity time horizon tax considerations legal aspects investment costs unique needs and preferences
availability of funds
Sensible investor – use discretionary funds
Large amounts – wider range – sufficient diversification
Smaller amounts – provide sufficient diversification- Unit Trusts & Satrix products
Liquidity
Speed to convert to cash. Treasury bills → Property
Older you get, the more you prefer certainty about income, lower risk, more liquid instruments with certain cash flow
Time horizon
Long investment period can afford to make more risky investments with higher return potential.
Liquidity requirements will be smaller.
Sufficient time to recuperate any losses
Tax considerations
Dividend income = taxed @ 20%
Interest earned above certain amount = taxed in hands of the indiv
Consider capital gains tax (profit of selling an asset). Avoid/minimize
Legal aspects
Law prohibits insider trading share transactions
Certain investments have a min investment term (e.g. policies & participation bonds)
Investment costs
Cost to acquire certain investments are astronomical
Ordinary share investment = broker fee is R150 and more. If investment is only R1000, can take years to recuperate the cost. Admin cost to maintain investment could place number of investment possibilities beyond the reach of small investor
Unique needs and preferences
Based on investor interest, can invest in veteran motors or antique furniture.
Religion – Due to religion, can consider certain options as gambling.
Social consciousness may not want to invest in liquor, cigarettes or gambling companies.
Passive portfolio management
Not continuously busy with management of portfolio:
intention is to keep investment for a long period
e.g. beach cottage & couple of shares to be kept for 10 years
Purchases investment instruments that are actively managed by other individuals / institutions, e.g. unit trusts (management company decides when, how much to buy / sell) property, freight containers (agents do admin & letting)
Passive portfolio management
Not continuously busy with management of portfolio:
intention is to keep investment for a long period
e.g. beach cottage & couple of shares to be kept for 10 years
Purchases investment instruments that are actively managed by other individuals / institutions, e.g. unit trusts (management company decides when, how much to buy / sell) property, freight containers (agents do admin & letting)
Active portfolio management
The investor consistently monitors his own investments and the economic climate to determine which investments to buy or sell what.
The investor actively attempts to improve the portfolio’s return by including undervalued securities in the portfolio.
Evaluates & changes the composition of his portfolio to adapt to changing economic circumstances.
e.g. at the beginning of bull market, he will increase his exposure to shares
top down investment process
1.Determine the state of the general economy & future trends of the economy
2.Determine which sectors will experience growth in the near future.
3.Explore the expected growth rates & risks of each sector to identify those with biggest growth potential.
.Allocate funds to respective asset classes (diversification), e.g. 50% shares, 20% property, 20% money market, 10% non-monetary investment.
4.Decide which specific shares / property / vintage cars to buy.
5.By applying fundamental analysis, he can decide which company will provide the best growth potential given a specific risk level.
Choose shares within the predetermined sectors that will best fit into its portfolio, take into account its investment policy.
Acquisition of the investments.
6. Apply technical analysis to determine the state of the financial markets & thus achieve the correct timing.
In this way he will hopefully obtain or discard the correct investments at the right time.
bottom up investment process
Use technical analysis to buy a number of shares & other investments that have good growth potential according to their graphs.
