Module 2- Principles and Strategies When Investing for Retirement Flashcards
Chapter 1: Investment Policy
- Coherent set of guidelines for managing financial assets and in line with a client’s goals and realities of investment markets
- Guidelines for asset allocation, portfolio management and investment strategy
- Should cover risk tolerance and a realistic target ROR
- Provides direction in times when market is in turmoil
- Investment policy reduces the tendency to overreact to short-term events
Purpose Twofold
1. Provide foundation of goals, time horizons and constraints on which the client portfolio is constructed
- Provide basis for review, performance evaluation and adaptation to changing conditions
Attributes of Sound Investment Policy
- Realistic- Should not be advisor if return expectations are not realistic
- Long-term perspective- Stocks, bonds, money market funds, real estate, typically produce positive returns long-term
Most retirees should have a long-term perspective (men life is 82.6, women 85.3) - Policy must be clearly defined- Should be able to follow if not competent, and written out
Essential Elements of an Investment Policy
- Clear statement of the client’s investment goal in relative terms (comparative) or absolute
- Statement identifying the investment vehicles and strategies deemed suitable (and unsuitable)
- Statement of risk level acceptable to the client and how risk is controlled
- How a clients assets should be allocated among suitable classes of investments and a statement of how they should be managed. Should provide percentage ranges and target within ranges
- Provision for periodic review
Chapter 1 Questions and Answers
1.What are the two purposes of investment policy?
- ID one approach to checking whether investment policy is realistic
- Why is a long term perspective essential?
- Why is it important that investment policy is clearly defined?
- What 5 elements should every investment policy contain?
- Provide foundational goals, time horizons and constraints on how portfolio is constructed
1B. Provide basis for review and performance evaluation - Reviewing performance expectations based on long term rates of return and standard deviation
- Essential as average life expectancy continues to grow longer and short term fluctuations in the market can cause errors in decision making
- Can help ease conversations and reduce room for dispute
- Should contain 1. investment goals 2. investment strategies available 3. statement of risk acceptance 4. Allocation levels 5. period between reviews
Chapter 2: Asset Classes, Characteristics and Performance
Common Stocks
Advantages: -Outperform all financial instruments
- 9.8% compounded return from 1926-2012 for large caps, 11.9% for small
- Dividends
- Return higher than inflation in most cases
Disadvantages: More volatile (small caps especially), can go through periods of underperformance compared to historical returns
Both US and International
International typically measured against EAFE or Europe, Australasia, Far east
Small cap typically provide better diversification INTL
Real Return
Actual performance - Inflation = Real Return
Should take into account tax in this calculation
Types of Risk Stocks Undergo
Business risk- unsystematic risk attributed to individual companies going bankrupt
Unsystematic risk- Mitigated by diversification
Systematic- Risk attributed to overall market performance, not able to be reduced by diversification
Dividends
Stocks pay dividends based on profitability
Most are qualified (15% tax rate or 20% for most wealthy)
Interest is taxed at rate of the individual
Reinvestment of dividends allows for better growth
Strategies to offset volatility in retirement
- Set aside 3-5 years of living expenses in safe investments and eat away at those during bear markets
- Use low-cost, fixed annuities as part of fixed income component to be used like a pension
Fixed Income Securities
Most bonds/notes pay interest on a semiannual basis
Market value increases when prevailing interest rates decrease
Taxation of federal debt is only taxable at federal level
Bond Risks
Reinvestment and call risk- The risk of not being able to reinvest at same rate
Bond maturity- Some investors overlook when thinking about interest rates
Interest Rate risk- The degree to which bond prices can fall if interest rates increase
Longer time period till maturity, more volatile the bond price will be
Credit risk- Standard and Poors- AAA, AA, A, and BBB
Moodys Aaa, Aa, A, Baa
BBB or Baa= investment grade
Below= High-yield or Junk bonds
Coupon Rate- Lower coupon rate will have more volatility in price
Duration- Measures interest rate risk
Change in duration X Interest rate change = Price change
Duration of a zero-coupon is 0
Inflation risk- Risk that purchasing power will decrease over life of bond
Bond yields
Current Yield- Annual dividend / Price
Yield to Maturity- Interest +/- (Premium/ years to maturity) / Avg price
T-bills produced an avg return of 3.5%
Long term corps and government 6.1%, 5.1%
STRIPS are a type of zero coupon, have to pay taxes on appreciation
TIPS
Fixed interest rate
Principal increases every 6 months based on movement of CPI
Multiple of $100, with 5, 10 or 30 year maturities
Receive greater of face value or inflation adjusted return
Best used in IRAs
Inflation for specific aspects of economy can move quicker so important to watch
JC Penny was first to issue a zero coupon
Cash Equivalents
Bank Accounts/money market instruments
Taxed at all 3 levels except bills
TBills- $100 face, zero coupon
Negotiable CDs- 100k, mature within a year, insured up to 250k per depositor by FDIC
Commercial paper- Short term debt of a corporation, typically under 270 days
Banker acceptances- time drafts of cash, usually in 25k or 500k increments
Real estate
50% of Americans own a home
Land, Residential, Commerical and industrial
Historically has been a good hedge against inflation
Illiquid historically
Mortgage and equity REITs
Historicl\al return of 12.9%
Historical average returns and standard deviations
Large cap- 9.8% avg return, 20.2% standard deviation
Small cap- 11.9% avg, 32.% SD
LT Corp- 6.1% avg, 8.3% SD
LT US Gov- 5.7% avg, 9.7% SD
Mid US Gov- 5.4% avg, 5.6% SD
T Bills- 3.5%, 3.1% SD
Inflation- 3.0% avg, 4.1 SD
Chapter 2 Review
- Advantages/Disadvantages of Stocks, why should be in retirement portfolio?
- FI?
- Cash Equivalents?
- Real Estate?
- Historically have a higher return than all other asset classes, but also have the most volatility. Produce a higher rate than inflation in a typical period.
- Advantage is that they are a safer asset and most produce a revenue stream, but could potentially default and produce 0. Interest and Principal
- Very liquid, typically need reinvesting due to short term holding periods.
- Move in-line with inflation typically, but need maintaining
Chapter 3: Portfolio Management Principles
Systematic risk
Systematic- No control, non-diversifiable
Can be attributed to individual asset classes
PRIME Risks
Purchasing power risk- Inflation eating away at return, bonds and preferred stock most affected
Reinvestment risk- Risk that market interest rates will drop
Interest rate risk- Bonds and possibly even stocks falling due to rising rates
Market Risk- Downside of a cycle
Exchange rate risk- Changes in value of currencies
Unsystematic risk
Business risk- Ability of company to operate profitably, and execute on plans
Financial Risk- Debt obligations of a company, can reduce dividends, hurt credit of company and cause short term operating issues
Credit Risk- Risk of downgrading due to excess business or financial risk, usually causes selling if moving from BBB to BB
Default risk- Not able to meet debt obligations
Liquidity Risk- Risk of not being able to convert investment into cash at or near original invested value
Marketability risk- Cannot be converted to cash at or near current market price (real estate)
Event risk- Affected by unanticipated and damaging event
Correlation Coefficient
90% of benefit of diversification accomplished through 12-18 unrelated stocks
Correlation of 1 is perfectly correlated
Perfect negative correlation (opposite) is -1
Most major assets are positively correlated to some extent
Impossible to find a perfect opposite unless its a derivative
0-0.6 is very weak
Constantly changing
Measuring risk
Mean (X)- Develops an expected return based on possible returns
Standard Deviation- How far returns are likely to vary. Risk averse clients prefer lower standard deviation
1 Standard deviation= 68%, 2= 95%
Coefficient of Variation= Standard deviation/ mean
Lower CV, less risk
Risk per percent of return basically
Beta- Volatility of an asset related to a benchmark (measures systematic risk)
Readily available on Value Line Investment Survey, typically related assets will regress to mean of 1
Uses linear regression (past) to determine future performance
Growth vs Value
- Value investing- Graham (founder), quantitative strategy, compares intrinsic value to market price, value only once in a 24 yr period did worse than S&P between 1976-99
- Strictly bottom up fundamental analysis
- Buy stocks 2/3rds or less of net current assets
- Earnings/price should be twice value of AAA bond yield
- Dividend yield no less than two thirds of AAA bond yield
•Growth Investing- Typically have earning per share growth of 15%+, small dividends, above avg PE, high beta
Often shape the future
Stick with company until earnings growth begins to slow
T Rowe Price one of the greats, wanted to find higher peaks
Small stock investing
Rolf Banz
Small firm effect- Got more return for the amount of risk taken
3-5 year time horizon clients
Volatility expected
Dollar cost averaging
Chapter 6 Review questions
- Low trading fees and usually outperforms active management and hugs the benchmark
- Idea that all information is known
- 6000 invested, 400 shares
- 1800
- Buy. M,
- Three general guidelines of P/E investing: 1. Only buy low PE if solid company 2. Diversify 3. Medium to large only
- Four rules of value investing by Benjamin Graham: 1. 2/3rds of current asset value 2. Earnings price ratio twice current AAA bond yield 3. Dividend 2/3rd bond yield 4. No companies losing money
Chapter 7: Bond Valuation
Bond valuation basics are on straight bonds
Present value of future cash flows and lump sum end payment
Assumed that there will be two payments so N must be double and P/Yr set to 2 and use end mode
End mode used due to interest payments being paid at end of period
FV is 1,000
Solving bonds on a financial calculator
Press shift to multiply by payments per year
Set Future value to 1000 and solve for PV in END MODE
There is no payment if it is a zero coupon bond
Use YTM for interest payment, not coupon yield
Coupon yield helps with interest payment
Bond Price Volatility
-duration X Interest rate move
Bond Strategies
- Ladder Strategy- Equal amounts at different maturities
Maturing part of ladder reinvests in longest maturity date
- Barbell Strategy- Two different ladders: one starting at 5 years and working down to maturity
The other starting at 20 years and working down to 15 befor being sold
Offsets interest rate risk with reinvestment risk
Chapter 7 Questions
2. 7% coupon, 20 years till maturity, 1000 face, 9% YTM
2. 20 Shift N 9 I 35 PMT 1000 FV PV End = 815.98
- 171.93
The lower the coupon rate
The greater the price volatility of a bond
Bond price volatility is inversely related
