Chapter 7 - Portfolio Management

Question 1

what does portfolio management entail

Answer 1

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)

Question 2

The most important concepts for portfolio management are

Answer 2

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

Question 3

asset classes and investment instruments

Answer 3

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

Question 4

financial vs. real investments

Answer 4

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

Question 5

risk in portfolio management

Answer 5

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

Question 6

return in portfolio management

Answer 6

Investors want a return, either
continuous (dividends, i)
end of period (capital growth)

Question 7

what is a desired portfolio

Answer 7

diversified

Negative performance in one investment cancelled out by positive performance of another investment

Question 8

What is the philosophy of portfolio management

Answer 8

Compile combination of investment alternatives to achieve a realistic & acceptable level of risk within the investment objectives

Question 9

what are the investment objects that the investor needs to decide on

Answer 9

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.

Question 10

What are the 3 general measures used to determine risk

Answer 10

variance or stdefv of expected returns

range of returns

returns lower than the expected returns

Question 11

calculation of the variance and stdev

Answer 11

(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.

Question 12

Determination of the rate of return

Answer 12

– 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.

Question 13

only the returns lower than expected should be viewed

Answer 13

Implies the calculation of the semi-variance.

Question 14

Risk increases when

Answer 14

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

Question 15

portfolio management

Answer 15

Portfolio management = combination of a healthy balance of investment instruments that will suite the investor’s specific profile of risk/return.

Question 16

The investment life cycle of an individual

Answer 16

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.

Question 17

4 phases of the investment life cycle

Answer 17

accumulation
consolidation
spending
gifting

Question 18

accumulation phase

Answer 18

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

Question 19

consolidation phase

Answer 19

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

Question 20

spending/ gifting phase

Answer 20

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

Question 21

The portfolio management process

Answer 21

1. determine investment policy (investment objectives and constraints)
2. study all economic and financial circumstances ( try forecast future trends) - regularly monitor and adapt when necessary
3. compile portfolio (Spread across countries, asset classes & investment instruments
   Satisfy return expectations & within limits of risks
   Use Top-Down or Bottom-Up Process)
4. monitor investment needs as well as the state of the financial markets (Adapted & change when necessary
   Evaluate the performance regularly & compare with expected returns)

Question 22

constraints of a portfolio

Answer 22

availability of funds 
liquidity 
time horizon
tax considerations 
legal aspects
investment costs 
unique needs and preferences

Question 23

availability of funds

Answer 23

Sensible investor – use discretionary funds
Large amounts – wider range – sufficient diversification
Smaller amounts – provide sufficient diversification- Unit Trusts & Satrix products

Question 24

Liquidity

Answer 24

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

Question 25

Time horizon

Answer 25

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

Question 26

Tax considerations

Answer 26

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

Question 27

Legal aspects

Answer 27

Law prohibits insider trading share transactions

Certain investments have a min investment term (e.g. policies & participation bonds)

Question 28

Investment costs

Answer 28

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

Question 29

Unique needs and preferences

Answer 29

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.

Question 30

Passive portfolio management

Answer 30

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)

Question 31

Passive portfolio management

Answer 31

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)

Question 32

Active portfolio management

Answer 32

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

Question 33

top down investment process

Answer 33

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.

Question 34

bottom up investment process

Answer 34

Use technical analysis to buy a number of shares & other investments that have good growth potential according to their graphs.