Week 3 Flashcards
Principles of Investment: Investment objectives
represents the desired outcome in a specified time frame:
people differ in their objectives
people’s objectives can be influenced by many factors (eg. culture, age, attitude to risk)
guiding principle when setting objectives:
understand your client’s needs so you provide investment services they will value and appreciate
Principles of Investment: Investment strategies
is the means used to achieve the investment objectives:
investor allocates funds between asset classes; or
purchases products where this decision is made for them
Examples of Investment Objectives
Access Income Capital Growth Combination of income and capital growth Speculative Tax Driven Investments Philosophical Investing eg/Ethical/Environmental Educational Reasons- Investment Clubs
Principles of investment: Direct vs. Indirect
Direct investment occurs when investors make their own decisions where funds are ultimately placed.
Indirect investment involves investors placing their funds with fund managers.
Direct investment is very popular in Australia.
It is important to appreciate the nature and structure of the relevant markets
The choice of asset classes consists of the following:
cash
interest bearing deposits (domestic and international)
shares (domestic and international)
property
Selection into particular investments can be made directly or indirectly The selection of the appropriate asset class and mix of assets will depend on a number of factors relating to the client’s circumstances
Cash & Interest bearing investments (most familiar)
Commercial banks provide both at call deposit accounts and Term Deposit Accounts to all clients.
Subject to PDS, at call deposit accounts allow you to access your funds at any given time.
Term Deposit Accounts are deposits where if you leave your funds in the account for a fixed term you will earn a fixed rate of interest.
Asset classes: Cash & Interest bearing investments (most familiar)
current brands include:
Trust account, Cheque account, At Call investment account, Term Deposit Account
Asset classes: Non-Cash Payment Services
Online banking (Internet banking & Mobile banking) Rapid Response telephone banking BPAY bill paying service Visa Debit card Personal cheques Regular payments, Direct debit Customer loyalty schemes
Asset Classes: Types of fixed interest investments
Term deposits Treasury notes and bonds Indexed/adjustable rate bonds State/semi/local Government bonds Corporate bonds Bank and non-bank bills Promissory notes Convertible notes and hybrids Debentures Unsecured notes Fixed interest managed investments
Participants in cash and fixed-interest securities
Non ADI- Finance companies insurance companies funds managers private individuals ordinary businesses governments
Asset Classes: Bonds
Corporate bonds are long-term securities that pay regular interest at fixed rates on face value.
Government and semi-government bonds enjoy very good security ratings.
Trading of securities occurs in the primary market initially and later in the secondary market.
There is an inverse relationship between the price of a bond and interest rates.
The difference between selling price and the face value is the interest, hence bonds can be traded at a discount or at a premium.
The Nature of Markets-Fixed Interest
Essential features
Interest rate set at start of loan period
Fixed face value (principal)
All interest rates are based on cash rate which is the interest rate paid on money lent between commercial banks overnight.
Margins added to compensate lenders for increased risk and increased time to maturity.
The cash rate is managed by the RBA by manipulation of the money supply to inject or withdraw funds by buying or selling securities.
Fixed-interest investments can vary from immediate access to up to 20 years.
Two types of fixed-interest markets:
Money market (short term) - Discount
Capital market ( long term) - Bonds
Risks of Bonds
Credit risk
This is the risk that the issuer may not be able to pay back the money they owe on the bonds they have issued (also called ‘default’ risk).
Interest rate risk
This is the risk that the market value of the bonds will go up and down as interest rates go up and down. For example, if interest rates go up, the market value of corporate bonds will generally go down.
Liquidity risk
This is the risk that you won’t be able to sell your bonds when you want to at the price you want to because there aren’t many buyers for the bonds
.
Prepayment (or early redemption) risk
This is the risk that the issuer will redeem the bonds early if interest rates fall and the market price goes up. If this happens, you will be paid the face value of the bonds (you may have paid more for them or they may be worth more on the secondary market)
Example
A security with a face value of $1000 has 180 days to maturity and sells now for $970. What is the discount at which the security is sold and the yield on the investment?
Discount= % below face value = 30/1000 x 365/180 = 6.08%
Yield= % return from an investment = 30/970 x 365/180 = 6.27%
Note : Fixed-term investments appeal to more risk-averse people because:
There are guaranteed interest payments at a given level.
The level of capital remains fixed which means there is a low risk of loss.
Asset Classes: Property
In Australia the rate of home ownership is one of the highest in the world.
As an investment, property can offer:
A stable income stream
Capital growth in excess of inflation over the long term.
Participants in the property market include: Investors as owners Residential tenants Commercial tenants Valuers, brokers and agents
Qualities and characteristics of property
solid form of investment land is scarce generally illiquid form of investment returns comprise both income and capital entry and exit costs may be high management and maintenance costs can be expensive high level of gearing possible taxation advantages prices less volatile property market cycles do not necessarily coincide with the share market — can offer diversification.
There are number of classes of property:
residential, commercial, industrial and rural
property Returns are dependent on
Type of property
Position of property
Continuity of rental stream
Cost of upkeep
TAXATION OF PROPERTY
Rental income is assessable income Legitimate expenses are deductible Investment in property has both CGT implications, and GST implications
Asset Classes: Shares or Equity
Represents an interest in / ownership of a firm.
Can share in a company’s successes and failures.
No guarantee of return on capital.
Payment by companies of dividends is optional.
Normally ranks last in event of liquidation.
Shares
Shares have historically offered higher returns than other asset classes, over the long term.
They can offer regular income.
They can provide strong capital growth.
Australian shares can offer the added tax benefit of dividend imputation.
Shares offer an investment of with limited liability.
Participants in the equities market include
Listed corporations Investors Brokers Hedgers Speculators Arbitrageurs
Nature of the Equities Market
Bulk of trading occurs on stock exchanges, with the ASX having a monopoly in Australia.
Market price is determined by interaction of supply and demand.
There are various classes of shares. Ordinary & Preference
Ordinary- most common, share of business, receive dividends
Preference- more like a fixed interest product, return is fixed, but more guaranteed.
Advantages
Shares
May provide income. May provide capital growth. May be tax effective. Generally liquid. Can provide diversification benefits.
Disadvantages
Shares
Involves risk.
Income and cash flow are not assured.
Ranks behind all creditors in event of liquidation.
Business risk
the risk that a company may not be well run resulting in poor outcomes for shareholders in terms of income and capital growth.
Credit risk
the risk that a company may not be able to meet its financial commitments (e.g. OneTel, Enron).
Reputation risk
where a major incident involving a company causes a loss of faith by the market, devaluing its shares.
Market risk
loss of confidence in the sector or overall market can have a drop in share value.
Political risk
stability of the present or future Government policies can affect the capability of companies to perform.
Liquidity risk
the shareholder may be unable to find a buyer at the desired price.
Inflation risk
increases in overheads, costs and margins could adversely affect company performance and shareholder outcomes.
Income risk
there is no certainty of dividend payments.
Information risk
Information risk
a case of poor/lack of information can cause a wrong investment decision or is incorrectly interpreted.
Fundamental Analysis
Fundamental analysis uses objective measures to analyse a company’s current financial position. It involves studying three main factors in an attempt to determining the best time to invest:
Fundamental analysis uses objective measures to analyse a company’s current financial position. It involves studying three main factors in an attempt to determining the best time to invest:
- Firm specific factors ,(i.e. its performance, level of debt, dividends, management, future direction, asset base and competitive advantage).
- Industry wide factors,– (quotas, tariffs ).
- Economy wide factors , (unemployment, inflation, movements in interest rates, exchange rates, )
Fundamental Analysis can be usually divided into 2 levels:
bottom up approach
focuses on the firm level predominantly and then moves towards analysing the economy level (use of ratios)
top-down approach
looks predominantly at general economic trends before moving towards analysing the firm level
Fundamental Analysis: Common ratios
Earnings per share (EPS)
Price / Earnings ratio (P/E ratio)
Earnings per share (EPS)
provides an indication of company profitability
calculated as:
Operating profit after tax
divided by
No. of ordinary shares
Price / Earnings ratio (P/E ratio)
shows how much the market is prepared to pay for shares in relation to reported profits
calculated as:
Current market price
divided by
EPS
Dividends per share (DPS)
provides an indication of company profitability and payout of dividends
calculated as:
Dividends to ord. shareholders
divided by
No. of ordinary shares
Dividend yield ( DY)
relates the dividends paid to the current market price
provides an insight into the return on investment
calculated as:
DPS
Divided by
Market price
Value investment characterised by:
finding undervalued shares (low P/E ratio)
Shares may have high dividend yield
Considers some shares to be overvalued
Waits for market to correctly price the shares
Growth investment characterised by:
select shares which exhibit high growth (high P/E ratio)
Shares may have low dividend yield
Contrarian or “picking the dogs”
Contrarians believe that investors tend to overreact to recent news causing the price to vary from its fair value
Fads may also cause investors to overreact
Price variations will correct themselves
By going against the trend, contrarians hope to profit when investors realise they have oversold out-of-favour companies
Ratios to consider
Low P/E ratios, high dividend yield , low ratio of price / net tangible assets
Technical analysis
Attempts to predict future share prices by studying past behaviour of markets as a guide to their possible behaviour
Analysts believe that investors are moved by market psychology
ie herd mentality enables some sort of predictability in movements
Tools for technical analysis include the following:
charting historical prices and volume
trend and cycle studies
investor sentiment - behavioural studies
looking at technical indicators (moving averages,momentum oscillators
Investment approaches
Buy and hold
Timing the market
Dollar cost averaging
Dollar cost averaging
Is a strategy of investing fixed amounts at regular intervals regardless of market trends
Avoids the need to pick the highs and lows of the market
Smooths out the average cost of an investment because the fixed amount of money buys more units of the investment when the price is low and less when the price is high
Provides a saving discipline
Investment Consideration
Whatever be the choice of assets classes, there are a number of factors that investors must take into consideration.
Client objectives whether it’s financial or lifestyle is your prime focus
Investment Consideration
- Liquidity
how easily the asset can be converted into cash to pay short term debts
the greater the liquidity, the lower the yield
Investment Consideration
- Investment horizon
the selection of investments must be tailored to the investor’s time frames
generally investors with a longer time frame can usually accept greater risk / volatility as a trade-off for higher returns
investors with a short time frame will be concerned with protection of capital
what sort of asset allocation would be required for a 2 year time horizon as compared to a 7 year time horizon?
- Taxation
each investment has its own taxation attributes and impact upon the investor’s tax position
need to ascertain how important tax is in constructing a portfolio
- Diversification
achieving optimal return for the given level of risk
diversification is insurance
it reduces risk, BUT AT A COST
- Transaction costs
entry, exit, broker fees, estate agents, solicitors, accountants
- Timing
how important is it to time the market? consider efficient market hypothesis Strategies to eliminate timing problems long term investing dollar cost averaging
- Return
need to determine the reason for investing
major role of financial planners task is to find right balance between income and growth. Will need to consider taxation also
choice between investing in assets that yield regular income and those that have better potential for capital gain or combination of both
income only
income and growth
growth only
- Risk analysis
What is risk analysis
a framework for understanding risk, comparing the risks of different investments, and analysing the relationship between risk and return
Principle of risk - reward trade-off
generally, investors seek the best return from investments with the lowest level of risk
Different investors have different risk profiles and it is important to know the level of risk the investor is willing to accept
an investors tolerance to risk can be measured to an extent by risk tolerance
Establish efficient frontier
