Building Portfolios with Stocks, Bonds, and Mutual Funds Financial & Retirement Planning

1. Building Portfolioswith Stocks, Bonds, and Mutual Funds Financial & Retirement Planning Jay Taparia, CFA Managing Director, Sanskar Investments, Inc. Lecturer of Finance, University of Illinois @ Chicago

2. The Client Is A Human Being & Is Capable Of Having… • Emotion attached to wealth… • Goals (if…) that are ST, MT or LT • A limited life span… • Uncertainty about the future… • Irrationality associated with decision-making… • A gambling attitude toward the markets… over-confidence • Dreams that could be impossible to reach… • Dreams that are very possible to reach… • An aversion toward risk… whatever that may be • Annoying you at times… • And don’t forget that… Life Happens

3. Because Of This… • Building portfolios is not only a science, but it is an art • Having a nice irrelevant conversation with the client is necessary to build a relationship, but also to discover new “needs” and “objectives” • Client needs & objectives change over time (years even days) • Portfolios are managed with continuously changing objectives

4. Individual Investor Life Cycle Spending Phase Gifting Phase Long-term: Estate Planning Short-term: Lifestyle Needs, Gifts Accumulation Long-term: Retirement, Children’s college Short-term: House, Car Consolidation Long-term: Retirement Short-term: Vacations, Children’s College Phases are Shifting Age

5. Portfolio Management Process • State the Objective – Mission statement of the portfolio, who and what it serves and why: income, and/or capital appreciation. • Identify the Constraints – there are always going to be constraints: taxes, legal, emotions, etc. • Formulate the Investment Policy – develop the “business plan” of the portfolio listing out return, risk and all the other issues associated with the portfolio • Study Market and Economic Conditions to forecast future trends – This is everything that you learned in Economic, Industry, Financial Statements, etc. • Monitor Performance – keep in touch with what is going on in the portfolio, and… • Reevaluate & Modify the Portfolio – rebalance and/or reconfigure according to the policy and markets

6. Role of the Portfolio Manager • Bottom Line? You need someone to manage the whole process of investing – • Minimizing individual security risk (company, industry, or unsystematic risk) • Making sure that the portfolio is well-diversified among industry, country and company • Managing the tax consequences of the portfolio – esp. for expensive people • Most importantly, making sure the portfolio caters to the client needs via an Investment Policy Statement – • Return – capital gain vs.income • Risk Tolerance – varies typically according to age • Tax Issues – maximizing after-tax returns • Time – retirement, college payments • Liquidity – usually driven by time needs • Legal Issues – trust and pensions have special legal issues • Other Unique Needs of the client

7. Realistic Investor Goals • Current income • generate spendable funds • Capital preservation • minimize risk of real loss • strongly risk-averse or cash needs are soon • Capital appreciation • capital gains for real growth for future needs • growth strategy with accepted risk • Total Return • Capital Gains & Income • Desire to have “medium” risk exposure

8. What Is Asset Allocation? Asset allocation is the process of combining asset classes such as stocks, bonds, and cash in a portfolio in order to meet your goals. Stocks Bonds Cash

9. The Need For Asset Allocation • An investment strategy is based on four decisions • What asset classes to consider for investment • What normal or policy weights to assign to each eligible class • The allowable allocation ranges based on policy weights • What specific securities to purchase for the portfolio to satisfy the strategy • 90+% of the overall investment return is due to the first two decisions, not the selection of individual investments (BHB 1991) • 70% of the overall investment return is due to style (Sharpe 1992)

10. Asset Allocation Policy Asset Allocation Policy + Market Timing Asset Allocation Policy + Market Timing + Security Selection Asset Allocation Policy + Market Timing + Security Selection + Other Is Asset Allocation Important? Contributing Factors of Portfolio Performance 91.5% 93.3% 97.9% 100% 20 40 60 80 0 100 Percent

11. Returns & Risk Of Different Asset Classes • Higher returns should compensate for risk • Policy statements must provide risk guidelines • Measuring risk by standard deviation of returns over time indicates stocks are more risky than T-bills • Measuring risk by probability of not meeting your investment return objective indicates risk of equities is small and risk of T-bills is large because of different expected returns • Focusing only on return variability ignores reinvestment risk and many other types of risk

12. HistoricalAsset Performances: A Guide

13. Average Return 12.6% 11.3% 5.2% 3.8% 5.1% Asset Class Returns Highs and Lows: 1926 - 1999 Highest Annual Return 142.9% 150% Lowest Annual Return 100% 54.0% 40.4% 50% 29.1% 14.7% 0% 0.0% -5.1% -9.2% -50% -43.3% -58.0% -100% Small Large Long-Term Int.-Term Treasury Bills Company Company Government Government Stocks Stocks Bonds Bonds Each bar shows the range of annual total returns for each asset class over the period 1926-1999.

14. Return Risk 9.0% 8.5% Return Risk 10.9% 8.5% DiversifyTo Reduce Risk Or Increase Return Fixed Income Portfolio Cash 10% 1970 - 1999 Higher Return Portfolio Lower Risk Portfolio Bonds 90% Stocks 12% Cash 20% Stocks 39% Cash 35% Bonds 41% Bonds 53% Return Risk 9.0% 6.1% Risk is measured by standard deviation. Risk and return are based on annual data over the period 1970-1999. Portfolios presented are based on Modern Portfolio Theory.

15. 8.0% 2.0% 0.7% Stocks after Inflation Bonds after Inflation Cash after Inflation Return Before & After Inflation 15% 1926 - 1999 11.3% 10% Compound Annual Return 5.1% 5% 3.8% 0% Stocks Bonds Cash Assumes reinvestment of income and no transaction costs or taxes.

16. Monitor Performance • Revise IPS as needed • Modify investment strategy accordingly • Evaluate portfolio performance not only with market return or benchmark portfolio • Consider that relative performance will mean little when relative progress is on track

17. Reevaluate & Modify Portfolio • Asset Allocation – has fixed income/equity balance changed from the design • Style Under/Over-weights – is the portfolio tilted in style? • Industry Selection – based on the economic environment what might the best sectors be, or is the portfolio weighted too much in any 1 sector (i.e. 25%)? • Security Concentrations – usually anything greater than 10% of the portfolio must be reduced in size • Security Selection – sell stocks that have poor fundamental issues in the future – and buy those that have positive changes ahead. • Key point – LT focus – not ST turnarounds. Why? Tax constraints.  

18. Understanding How Stocks Work

19. What is a Stock? • Legal ownership in a company through “shares” – purchase of stock implies you own a “slice” or “share” of the company • Stockholders have 1st right to purchase new shares issued by the company – gives them right to maintain % share of ownership

20. 4 Characteristics of Stocks • Voting Power - Ownership implies “control” having the right to appoint Board of Directors, who in turn, elect management • Residual Claim – you are last on the food chain to collect your investment if the company goes bankrupt • Limited Liability – can only lose the investment you make into the company – not more than that • Stock Market Listing – stocks are traded between buyers and sellers in stock exchange

21. Return & Risk of Stocks • Two Ways to Earn a Return on a Stock • Appreciation in Stock Price – if the investors perceive strong growth in the company’s sales & earnings, then investors will demand to buy more of the stock. As demand increases, the price of the stock increases. • Dividend Payment – if the company pays dividends

22. Caveats of Stock Ownership • No Guarantee of Return – you can lose your investment • % Ownership Can Be Small – you are just 1 of many owners – you have some, but not a whole lot of influence • Mergers & Acquisitions – other companies can offer to “buy your share out” and replace your shares with theirs • Voting Proxy Statements - investors should take an active role in voting for directors and management – they are “owners”

23. Conceptualizing Financial Statements • Financial statements are guided by a set of accounting rules, called GAAP (Generally Accepted Accounting Principles). • Because of flexibility, financial statements can be manipulated to give a “better-than-expected” view of earnings. • Ratio Analysis & Footnotes is one of the key tools to understanding a company.

24. Conceptualizing Companies • Companies are dynamic, financial statements are static • One date of release: summary of 3, 6, 9 or 12-month activity • Lagged: released approximately one month after quarter- or year-end • Past-tense: information possibly already incorporated into the stock price (barring any major surprises) • Dynamic forces on companies are qualitative • The economic cycle • Industry analysis • Management strategy

25. Conceptualizing the 3 Financial Statements • Think of analyzing your own finances… • Financial analysis of companies is similar to personal financial planning • Your balance sheet = a loan application • Income statement = your tax return • Cash & cash flow statement = Your checking account and salary • Footnotes to financial statements =how you would explain what the numbers really mean to an IRS auditor or loan agent

26. Balance Sheet (or ... what have you got?) Assets Current assets Cash and temporary investments Accounts receivable Inventory Prepaid expenses Total current assets Long-term assets Property, plant and equipment Less: Depreciation Net property, plant, and equipment Deferred tax assets Intangible assets and goodwill Total long-term assets Total assets Liabilities + Owners' Equity Current liabilities Accounts payable Taxes Payable Short-term notes payable Current portion of long term debt Total current liabilities Long-term liabilities Long-term debt less current portion Deferred tax liability Total long-term liabilities Owners' equity Common stock par Capital surplus Retained earnings Less treasury stock at cost Total owners' equity Total liabilities + Owners' equity Income Statement Statement of Cash Flows (or ... what do you tell the Government you made?) (or ... what REALLY happened this year) Cash flows from operations Sales Income from operations - Cost of sales (including depreciation expense) Net income (Profits) Depreciation + Restructuring charge not spent + Gross profit on sales = - or Gains or losses + or - Deferred income taxes + - Selling and administrative expenses Cash provided by (used for) working capital - Restructuring expense or - Accounts receivable + Gains or losses +/- or - Inventory + or - Accounts Payable + = Net Operating Income = Net cash provided by operating activities (Cash Flows From Operations)(CFFO or CFO) + Other revenues - Other expenses = Earnings before tax Cash from investing activities - Income tax expense Sale of assets + Net income (Profits) = Purchase of assets - Net cash provided by investing = activities Dividends on preferred stock - = Net income available to common stock Cash from financing activities Issue of debt + Dividends on common stock - Retirement of debt - Sale of common stock = Net income transferred to surplus or retained earnings + Dividends paid - Net cash provided by financing = activities The sum of the last line in each box above = the change in cash balances

27. Public Filings You Need to Know • Form 10-K (due 90 days after fiscal year close) • Income statement (aka Statement of Operations) • Balance Sheet • Cash Flow Statement • Footnotes to the Financial Statements • Management Discussion and Analysis • Auditor’s Report • Liquidity Position and Capital Expenditures

28. Stock Market Indices (i.e., Indexes) • Price-Weighted Index - each company represented by 1 share in index. Gives higher-priced shares more weight in determining performance of the index (e.g., Dow Jones Industrial Average) • Market Value-Weighted Index - weight of companies in index based on its market capitalization (stock price x # shares outstanding) – the higher the market value, the higher the weight in the index (e.g., S&P 500, NASDAQ) • Comparing your portfolio’s performance to the “market” depends on which index you are using and whether you are really comparing “apples to apples” or “ apples to oranges”

29. Costs of Investing • Commissions – Costs from the broker to implement trades one-way – must remember that you incur the cost when selling also • Bid-Ask Spread – brokers who “make a market” in the stock make the spread as their profit (or your cost) • Market Impact Costs - if you are institutional (mutual or pension fund), your purchases/sales are large enough to move the stock price against you while buying or selling

30. Buying Stock on Margin • Definition - Borrowing Funds to Buy Stock - initially up to 50% of the equity purchase – called the Initial Margin Requirement • After the Purchase - must maintain at least 30% equity of the total account value – called the Maintenance Margin Requirement – to guard against default • Primary Objective - Usually done to make higher returns on your equity via “using someone else’s funds” – but can also lose more than if you did not borrow the funds • High Risk Strategy – only meant in cases where client has high amounts of liquidity (cash reserves) or has the risk tolerance (i.e., loves risk and has nerves of steel)

31. Buying Stock on Margin • Example of Margin Trading • $10,000 of GE desired to be purchased with $5,000 personal funds and a $5,000 Margin Loan from broker • GE’s stock price is $50 per share = # of shares = 200 • Interest Rate on Loan is 10% Bottom Line? Margin increases gain and loss returns substantially!

32. Short Selling • Definition – Instead of “Buying Low 1st, And Selling High 2nd,” you are doing this in reverse (Selling High, Buying Low) - You do this, when you think the stock price is overvalued and you decided to “short” or sell first, in expectation that the stock is going to fall • High Risk Strategy – only meant in cases where client has high amounts of liquidity (cash reserves) or has the risk tolerance (i.e., loves risk and has nerves of steel)

33. Procedure to Short Selling • Borrow the Stock from Broker – as if you were taking a loan • Sell the Stock in the Market – collecting the proceeds • When Stock Price Declines – buy the stock back at lower price • Return the Stock to the Broker – keep leftover funds as profit • Similar Margin Requirements – as in Margin Trading

34. Basics on Portfolio Management • Always make sure that your portfolio is diversified – not just 8-10 securities, but 20-30 minimum – across industries and countries • Caveat emptor – there are 7,000 stocks and 10,000 mutual funds at a minimum to choose from in the USA – should you be picky about what you buy? YES!! • Be “street smart” – make sure that what you are buying makes sense and you know the reasons why you are buying it – not just a “hot stock tip” – in other words, squeeze the tomatoes

35. Basics on Portfolio Management • Make sure your portfolio does not become too concentrated in 1 name or 1 sector. Be receptive to sell if any 1 stock becomes greater than 10% of the portfolio – it may drive future performance, including downward • Just because you made good money on 1 stock or sector, please be aware that you might get “emotionally attached” to it – but keep in mind, stocks and money never were born with a “heart”

36. Understanding How Bonds Work

37. Definition of a Bond • Contractual loan that pays interest over a fixed term • Upon its maturity, the principal or the investment amount is returned to the lender of the bond • Interest rate (called Coupon Rate) is typically fixed – hence, the alternative name for bonds as “fixed income” securities • An Income-Based Investment – focus on generating income and less so on capital appreciation <> stocks • Bond Contract is called an Indenture Agreement – which has all of the structure details about the bond and disclosures about the company issuing the bonds • Usually denominated in $1,000 units – $50,000 in Bonds = 50 Bonds

38. Bond Classifications • Registered vs. Bearer Forms • Security • Collateral – secured by financial securities • Mortgage – secured by real property, normally land or buildings • Debentures – unsecured • Notes – unsecured debt with original maturity less than 10 years • Seniority

39. Major Classes of Bonds • U.S. Treasury Bonds – issued by the U.S. Government and considered the safest type of bond • Corporate Bonds – issued by corporations to fund their projects and assets – carry higher risk than the U.S. Treasury bonds due to high risk of default (or non-payment of interest and/or principal) • Municipal Bonds – issued by cities, counties, quasi-government agencies (like the Illinois State Tollway) and states to fund projects and general municipal funding.

40. Major Classes of Bonds • Foreign Bonds – issued by foreign governments as well as foreign corporations – can be denominated either in US Dollars or in foreign currency – considered to have multiple layers of risk, both in terms of the foreign entities willingness to pay as well as in currency risk terms • Securitized Certificates – issued by taking a group of assets such as mortgages, auto loans or credit cards and packaging them for issuance as a security. Considered to have higher quality than a single asset due to diversification. Cash flow is usually less predictable and dependent on changing levels of interest rates

41. Key Characteristics of Bonds • Par Value – stated value of a bond – usually $1000 par value per bond. $50,000 par is = to 50 bonds to buy. • Coupon Interest Rate – the amount that is paid each period to a bondholder by the issuer. Rate is usually quoted as an annual rate, but payments are made usually semi-annually. • Coupon Payment = Coupon Interest Rate x Par Value • Maturity Date – when the bond matures – principal and last coupon payment paid on this day. • Price (Market Value) – what the value of the bond is worth. Better yet, what the market is valuing this Annuity Stream.

42. Bond Value ($) kd = 7%. 1,372 1,211 kd = 10%. M 1,000 837 kd = 13%. 775 30 25 20 15 10 5 0 Years remaining to Maturity

43. Bond Risks • Default Risk – Risk that you are not going to get your original principal back due to the company going bankrupt. • Interest Rate Risk – as interest rates rise, the price (and value) of the bond falls. Capital Loss!! • Reinvestment Rate Risk – has to do with the reinvestment of interest and principal payments. • Interest Payments – what do you do with the interest payments (beside spend it) – if rates decline, your return is lower as you reinvest these at a lower rate. • Principal Payments – what do you do when you get your money (principal) back – if rates decline, your principal gets reinvested at a lower rate. • Keep in mind that Callable Bonds also have reinvestment rate risk. The company will only call the bonds when rates decline. You have both interest and principal payment reinvestment rate risk.

44. What is Interest Rate Risk? Also, called Price Risk… Interest rate risk: Rising kd causes bond’s price to fall. Which bond has more risk? 1-year or 10-year? 1-year 10-year Change Change kd $1,048 $1,386 5% +4.8% -4.4% +38.6% -25.1% 1,000 1,000 10% 956 749 15%

45. Prices and Yield / Interest Rates Price Yield

46. Default Risk Premium (Credit Risk) Investment Grade Junk Bonds Moody’s Aaa Aa A Baa Ba B Caa C S&P AAA AA A BBB BB B CCC D

47. Corporate Bond Spreads – AA & BB

48. Benefits of Bonds in Portfolios • Historically Lower Risk • Diversification Benefits • Income Generation • Expand Efficient Opportunities • Potential Growth

49. Average Rise in Price during Declining Interest Rate Periods Average Decline in Price during Rising Interest Rate Periods Fixed Income Maturity (Interest Rate) Risk 1970 - 1999 Long-TermGov’t Bond 15% Intermediate-TermGov’t Bond 9.8% 10% 5.9% Short-TermGov’t Bond 5% 1.5% 0% -1.3% -5% -4.5% -10% -8.7%

50. Return Risk 10.8% 8.0% Return Risk 10.8% 7.6% Using Bonds to Diversify 1970 - 1999 Original Portfolio Lower Risk Portfolio Cash 19% Stocks 50% Stocks 38% Cash 50% Bonds 43% Risk is measured by standard deviation. Risk and return are based on annual data over the period 1970-1999. Portfolios presented are based on Modern Portfolio Theory.