Principles & Strategies When Investing for Retirement Flashcards
Investment Policy Purposes
(1) Provides a foundation of goals, time horizons, and constraints on which the client portfolio is constructed. (2) The goals, time horizons, and constraints provide a basis for periodic review by the client and money manager.
Verifying the feasibility of an Investment Policy
(1) Historical Market Data, such as those published by Ibbotson & Associates, are a useful check on how realistic an investment policy is. (2) If client expectations are out of line, these data on past performance can be helpful in educating the client and bringing his or her expectations in line with what can likely be accomplished.
Importance of a clearly defined Investment Policy
A clear definition of the investment policy helps the counselor avoid errors and reduces the chance of disputes between the counselor and the client.
Elements of Investment Policy
(1) Clear statement of goals, (2) Suitable investment vehicles and strategies, (3) Risk tolerance, (4) Rough asset allocation guidelines, (5) a provision for periodic review
Risks of Common Stock
(1) Business Risk, (2) Market Risk
Standard Deviation
(1) The standard deviation is a statistical measure of total risk that considers the dispersion of all data points (observations) around the average (mean). (2) In the investment field, assets whose returns exhibit higher standard deviations have higher volatility (risk)
Coefficient of Variation
(1) The coefficient of variation is calculated by dividing the security’s standard deviation by its mean return. (2) Therefore, it measures risk per unit of return. The lower the number, the better
Beta
(1) Beta is a measure of a security’s volatility relative to a benchmark, such as the market. (2) It is often applied to common stocks. (3) A security with a beta of 1.0 matches the volatility of the market. (4) Beta is a measure of systematic (nondiversifiable) risk. (5) Beta tends to regress toward the mean, or 1, over time.
Duration
(1) Duration is a term used to describe the price sensitivity of a bond or bond portfolio to changes in interest rates. (2) The higher the duration, the grater the price volatility. (3) Long-term bonds with small coupons generally have higher durations.
Calculating change in bond value using change in interest rate
Duration x interest rate change (not decimal but whole) equals the expected change in the value of the bond.
Risk adjusted return measures
(1) Sharpe: a degree of risk as measured by standard deviation used to evaluate performance of a security or a diversified portfolio (2) Treynor: a degree of risk measured by beta used to evaluate performance of a security or portfolio., (3) Alpha: measures the excess return for a given level of risk.
Purpose of Asset Allocation
(1) The purpose of asset allocation is to apportion funds in a way that meets the client’s investment goals, and (2) dampens the effect of periodic market fluctuations.
Risk Measurement
(1) Variability of returns is one of the most common measured of investment risk.
(2) The standard deviation measures the variation of returns over time, around the average return. (3) Thus, standard deviation is the ideal statistical measure of total risk. (4) The more variable these returns (dispersion around an average) the greater the implied risk.
Average Investment Return of Asset Classes
(1) 3.5% T-Bills, (2) 5.4% Intermediate-term government bonds, (3) 5.7% Long-term government bonds, (4) 6.1% Long-term corporate bonds, (5) 9.8% Large company stocks, (6) 11.9% Small company stocks.
Factors alleviating volatility concerns
(1) Two common factors that can alleviate retirement investors’ concerns with security price volatility are time and asset allocation. (2) Longer investment horizons can manage greater volatility than short investment horizons (3) Asset allocation can select asset classes that are aligned with both the investor’s investment horizon and his or her tolerance.
Longevity Risk
(1) Longevity risk is the risk that a retiree will outlive his or her resources. (2) As such, it is a significant risk for a retiree.
Diversification in Portfolio Management
(1) Diversification is the act of acquiring assets with low correlation to each other for the goal of lowering overall portfolio risk. (2) Diversification within stocks can be achieved by selecting 10-15 different stocks representing a variety of industries. (3) Diversification of a portfolio would be accomplished by including different asset classes in the portfolio such as common stock (U.S. and abroad.), bonds, real estate, cash equivalents, precious metals, commodities, etc.
Strategic Asset Allocation
(1) Strategic Asset allocation attempts to identify the asset mix that will provide the optimal balance between expected risk and return for a long investment horizon. (2) Once the asset mix is determined and the weights assigned, the portfolio manager tries to maintain that balance.
Tactical Asset Allocation
(1) Tactical asset allocation is an active approach that tries to position a portfolio into those assets, sectors, and individual securities showing the most promise of above-average gains. (2) Tactical asset allocation can incorporate sector rotation, market timing, or momentum investing, whereby money is moved from area with below-average performance to areas performing above average. (3) Tactical can also be seen as the opposite of momentum investing in some cases.
Asset Allocation Process
(1) Determine asset classes that should be represented in the portfolio. No specific securities are identified at this stage; only general classes of assets. (2) Next, the percentage allocation to each asset class is determined. (3) Security selection, (4) Review of portfolio performance and investment climate.
Advantages and Disadvantages of Target Funds
(1) The strategy used by target funds is also called glide path. (2) Advantages is ease of investing. (3) Disadvantages are the “one size fit all” may not be optimal for the investor.
Benefits of Buy-And-Hold
(1) Evidence has generally concluded that a buy-and-hold strategy of a diversified stock portfolio has produced returns at least as good as strategies based on market timing and trading. (2) It also results in lower transaction costs and the deferral of capital gains taxes on profits.
Contrarian Technical indicators
(1) Short selling, (2) Specialists’ Sentiment, (3) Mutual Fund Cash Position, and (4) Put-call ratio.
Short selling
(1) Increasing short selling in a stock indicated a growing herd consensus that the market will decline; when this happens, the contrarian expects the market to increase.
Specialist’s Sentiment
Specialists are considered to be the “smart money,” and their increased bullishness in a stock makes contrarians bullish as well, and vice versa.
Mutual Fund cash positions
(1) Mutual fund managers are viewed by contrarians as herd animals; (2) when mutual funds have low and decreasing cash positions (indicating managers’ bullishess), contrarians take this as a sell signal; the reverse is true as well.
Put-call ratio
(1) High and increasing put-call ratios suggest buying opportunities to the contrarian; (2) low or decreasing put-call ratios suggest the opposite.
General guidelines for value investing
(1) Select stocks with low P/Es, but only if the companies have solid performances. Many stocks deserve low P/Es because the companies they represent are truly inferior companies. (2) Diversify: a portfolio of low P/E stocks should have an equal weighting in 15-20 different stocks representing 10-12 industries. (3) Only buy shares of medium to larger companies that are listed on the NYSE or AMEX or that are actively traded over the counter.
Benjamin Graham’s Value Investing Rules of Thumb
(1) Buy stocks for 2/3 or less of their net current assets, (2) The earnings-price ratio (earnings yield) should be twice the current AAA bond yield. (3) The dividend yield should be no less than two-thirds of the AAA bond yield. (4) Avoid companies that are currently losing money or that have more than 60% debt-to-total assets. (5) Ben Graham maintained that safety of principal was the first requirement of investing.
Small-firm effect
The small-firm effect is a market anomaly that enables investors in small capitalized companies to reap returns greater than the associated risks explain.
Elements of Small-stock strategy
An investor following small-stock strategy should: (1) be prepared to live with volatility, (2) have a long time horizon (3-5 yrs), (3) diversify to 20-30 different issues, acquires shares over time and on weakness, (4) Avoid turning over more than 30% of a portfolio, (5) look for firms where management has a tangible ownership stake, (6) sell not only if fundamentals change adversely, but also if and when 40% of the company’s shares become owned by institutional investors.
Ladder strategy
(1) The ladder strategy, also known as the staggered maturity strategy, spreads equal amounts of the bond holding along different maturities; (2) This strategy avoids large commitments at one maturity, and is intended to help offset interest rate risk. (3) A 10-year ladder strategy entails buying 10-year bonds with staggered maturities.
Barbell strategy
(1) The barbell strategy splits the bond portion of the portfolio between a short-term bond series and a long-term bond series; both ends then stagger maturities similar to the ladder approach. (2) The essence of this strategy is to blend short-term and long-term bonds to provide an overall income stream that is acceptable to the client.
Negative correlation
Indicated that two investments move in exactly opposite directions, but they do not have to move by the same magnitude.
Portfolio Rebalancing
Portfolio rebalancing tightens the range of returns in a portfolio by selling assets that have appreciated the most and buying those that have appreciated the least.
Price of a Bond
(1) Present value of income stream and maturity value.
