(43).---PORTFOLIO MANAGEMENT.

Portfolio Theory.

(1). Introduction.

The analysis of risk and uncertainty concentrates in some way on altering future returns to allow for uncertainty of outcome (e.g. using probability distributions of returns). An alternative approach is to allow for uncertainty by increasing our required rate of return on risky projects.

This latter approach is commonly taken by investments. For example, if we were comparing a building society investment with one in equities we would normally require higher return form equities to compensate us for their extra risk. In a similar way if we were appraising equity investment in a food retailing company against a similar investment in a computer electronics firm we would usually demand higher returns from the electronics investment to reflect its higher risk.

Clearly use of a risk adjusted discount rate can be employed in almost any situation involving risk. The practical problem is how much return we should demand for a given level of risk. To solve this problem we can turn to the stock exchange-a place where risk and return combinations (securities) are bought and sold every day. If for example, we can better the return earned by investors on the stock market by investing in a physical asset offering the some level of risk, we can increase investor wealth and the investment should be adopted.

Unfortunately the required approach is not as simple as this. Investors seldom hold securities in isolation. They usually attempt to reduce their risks by ‘not putting all their eggs into one basket” and therefore hold portfolios of securities. Before we can deduce a risk-adjusted discount rate from stock exchange returns we need to identify the risks investors in their diversified investment portfolios.

(2). The portfolio effect.

A portfolio is simply a combination of investments. If an investor puts half of this funds into an engineering company and half into a retail ships firm then it is possible that any misfortunes in the engineering company (e.g. A strike) may by to some extent offset by the performance of the retail investment. It would be unlikely that both would suffer a strike in the same period.

(3). Correlation.

Correlation is a statistical measure of how strong the connection is between two variables. In portfolio theory the two variables are the returns of two investments. High positive correlation means that both investments tend to show increase (or decrease) in return at the same time.

The degree of risk reduction possible by combining the investments depends on the carrel between them.
The more negative the correlation the greater the possibilities for risk reduction.

(4). Portfolio theory- the two-security portfolio.

A formal analysis of the combination of two investments is now presented. Because portfolio theory has its roots in the management of stock exchange investments, this is referred to as the two security portfolio.

The analysis is usually presented in terms of rates of return over a single time period is simply:

(End of period value – start of period value) + dividend paid /Start of period value.

(5). Covariance and correlation.

The risk reduction in the last example was made possible by low correlation between the investments. Jest looking at the possible reruns of A and B shows that there is no consistent positive or negative relationship between them. The correlation coefficient will probably be jest higher then zero.

The covariance will be positive for positive correlation and negative for negative correlation, but its size depends on the size of the figures in the original data and is difficult to interpret.

(6). Formulae for the two – security portfolio.

In general, the risk of a two –security portfolio will depend on:
a. The risk of the constituent investments in isolation;
b. The correlation between them ; and
c. The proportion in which the investments are mixed.

(7). Two – security portfolios-Effect of the correlation coefficient.

Maximum risk reduction is possible with a correlation of -1. In this case, risk can be (but is not always) reduced to zero. If correlation is +1, the portfolio risk is simple a weighted average of the investment risks.

(8). Combining a risky security and a risk-free security.

There is a special case of the two-security portfolio which is particularly important for our later studies. This is the case of combining a risk-free security with a risky security.

A risk-free security is one which shows no variability in its predicated returns. In other words its return is known with certainty. In practice it can be approximated by an investment in government stocks or bank deposit accounts at fixed interest (although varying rates of inflation would mean the real on these investments becomes uncertainty.

A risk free security has a zero variance and a zero covariance with any other security.
In the other words the portfolio standard deviation is simply the standard deviation of the riskily investment times the proportion of that investment in the portfolio.

The expected returns of the portfolio will still be weighted average of the expected returns of the two investments.

(42).---PORTFOLIO MANAGEMENT.

INTRODUCTION.

(1).Definition .
Asset allocation is the process of deciding how to distribute an investor’s wealth among different countries and asset classes for investment purposes.
This process will be guided by the investor’s policy statement which will specify;

• The types of risks the investor is willing to take; and
• His or her investment goals and constraints.
  For an individual investor, needs change over the investor’s life cycle. The policy statement will be related to an investor’s;
• Age;
• Financial status;
• Future plans; and
• Needs.

(2).Phases of wealth assimilation-investor’s life cycle.

The investor’s life cycle stage can have an impact on his or her risk and return preferences.
a) Accumulation phase
Individuals are in the early-to-middle years of their working careers. The features of this phase are;
Net worth small relative to liabilities;
Priorities will include:

• Saving for fairly immediate needs;
• Life and disability insurances; and
• Investments for future financial independence;
  Very long time horizon and growing income stream and hence can undertake more high Return, high-risk investment.

a) Consolidation phase.Individuals are in the mid-to-late career stage. The features of this phase are:
-Income exceeds expenses;
-Investment portfolio is accumulating (including equity and retirement programs):
Shorter time to retirement leads to some risk control and capital preservation and hence high capital gain investments are balanced with some lower risk assets.

a) Spending phase,
This generally starts with retirement. The features are:
-Individuals are financially independent;
-No earned income and therefore reliant on capital;
-Focus on assets with relatively secure values and high income streams.

a) Gifting phase,
This generally coincides with the spending phase and the features are:
-Assets exceed needs:
-Risk & return preferences are unchanged but the purpose of the investments changes.
The above analysis is oversimplified. The basic personality that each investor brings to his stage in the life cycle greatly influences where he falls on the risk and return continuum.

(3).Goal setting.

All individual investor must be investing to achieve a goal, either tangible or intangible. These goals can be categorized as follows,
Near-term high priority goals, for example, a house down-payment-
Low risk investment chosen.Long term high priority goals-More aggressive investment approaches but diversified to avoid unnecessary risk.Lower priority goals -Speculative kinds of investmentsEntrepreneurial or money-making goals-All investor in one stock (often own company or employee)

(4).The policy statement.

The process of formulating a policy statement serves several purposes:
(a).It helps investors understand their own needs, objectives & investment constraints by learning about financial markets & the risks of investing.
(b).It will assist the advisor or portfolio manager in managing client’s funds.
(c).It crates a standard by which the performance of the portfolio manager can be judged.

The construction of the statement is mainly the responsibility of the investor. The investor has to be in a position where he or she can articulate & communicate his or her needs & goals to the portfolio manager.

(5).Investment objectives.

These are the investors investment goals expressed in terms of both risk & return. A careful analysis of the investors risk tolerance should precede any discussion of return objectives & this will be influenced by the following:
(a).The inventors psychological make up current insurance coverage & cash reserves.
(b).The investor’s family situation number of dependents & age.
(c).The investor’s current net worth & expectation of future income & salary.

The return objective may be stated as a general goal or in terms of & absolute or relative percentage return.

Capital preservation
Minimize the risk of loss appropriate objective for very risk-averse investors.
Capital appreciation
Want the portfolio to grow in real terms over time. Very aggressive strategy. Appropriate objective for investors willing to take on risk to meet their objective.
Current income
Minimize income generation rather than capital gins. Low risk strategy appropriate for investors who want to suppliant their earnings.
Total return
Increase portfolio value by both capital gains & reinvesting current income. Risk exposure lies between that of the current income & capital appreciation strategies.

(6).Investment constraints.

The policy statement, in addition to stating the investors risk & return objectives, will specify certain constraints which will have an impact on the investment plan.
In outline the constraints are as follows

(a).Liquidity needs.
1. Emergency cash.
2. Near term goal spending.
3. Income taxes.
4. Investment flexibility.

(b).Time horizon.
The discussion of an investor’s life cycle phases highlighted the time horizon as an investment constraint. In addition, an investor’s time horizon, liquidity needs and ability to handle risk are all related.

(c).Tax concerns.
In general terms the objective is to,

• Defer tax
• Avoid tax or
• Pay tax at the lowest rate possible
  It is important to appreciate the different tax treatment of income versus capital gains.

(d).Legal and regulatory factors.
There can be divided into three categories
(a).investment specific regulations.
(b).Fiduciary duties.
(c).Trading laws.

(e).Unique needs and preferences.
There are certain investments which an investor may want to include or exclude form his or here portfolio for personal or social consciousness reasons.

(f).The portfolio construction process.The portfolio management process consists of the following steps

1. Identification and evaluation of the investor’s objectives, preferences and constraints as a basis for constructing the investor’s policy statement.
2. Formulation of appropriate investment strategies (asset allocation) & hence the selection of optimal combinations of financial & real assets.
3. Monitoring of market conditions, relative asset values, and the investors circumstances.
4. Adjustments of the portfolio as are appropriate to reflect significant changes in any of the relevant variables.