Ch 1 Diversification

1. Ch 1 Diversification • More Stocks , Less Risk As the number of stocks in a portfolio increases, the total risk or volatility of that portfolio decreases.

2. Benefits of Diversification • Diversification is the act of combining assets with dissimilar behavior for the purpose of producing a portfolio with an optimal risk/return tradeoff. “NOT PUTTING ALL YOUR EGGS IN ONE BASKET” By diversifying, a deep loss in one asset class may be offset by gains in another. The net result is a more stable portfolio.

3. Diversification Helps Manage Risk • In an ideal world, investors would find securities that offer consistently high return with little risk. However in the real world there is no such thing.

4. International Securities International stocks and bonds are another major asset class to consider. There have been some instances when foreign securities have outperformed their U.S. counterparts. The diversification benefits of international securities, have generated high interest in global markets. To reduce the total volatility risk of some portfolios, it would be wise to invest internationally as well.

5. Asset Allocation The most important investment decision is the asset mix of a portfolio. The five major asset classes investors are concerned with their investment needs are: Day-to-Day, Emergencies, Saving for a Near-Term Purchase, Long-Term Savings, and Retirement. The understanding of five major investment fundamentals aids in a assembling a portfolio are: • Tradeoff between risk and return • Diversification Benefits • Long-Term Investing and Compounding Returns • Liquidity and Marketability Considerations • Tax Deferral Benefits However the most important decision is the Asset Allocation choice

6. Ch 2Modern Portfolio Theory (MPT) Prepared by Alex Au

7. Introduction • MPT: takes into account of different possible outcomes, project results with a high degree of certainty, have the ability to be fine tuned on a regular basis, stay within selected parameter and reduce your overall risk. • MPT let investors choose their own risk level. • MPT work with proper diversification to reduce risk and increase return.

8. The Need for Asset Allocation • Diversification can reduce a portfolio’s risk and improve return. • Since each asset class have a different uncertainty it is necessary to consider the range of possible outcome for each asset class.

9. Portfolio Risk and Return • Investors want a high expected return, but at the same time they want an asset with low standard deviation. • Expected return and standard deviation are estimated from historical data. • Investors are not concern with holding a asset in isolation, but rather with the risk of the entire portfolio.

10. (cont’d) • Portfolio risk not only depend on the riskiness of its component assets, but also on how the return are related to one another. • Risk that can be eliminated by diversification does not command a risk premium. • A portfolio’s expected rate of return should be easy to determine using the weighted average return of the individual assets.

11. (cont’d) • Correlation coefficient is the measure of the relationship between the rate of return behavior of each asset versus every other asset. • First-order autocorrelations of a return series, is the return in one period that is related to the return in the next period. • Cross correlations show how much one series’ returns are related to another.

12. (cont’d) • The portfolio’s risk is a function of the the individual assets and their correlation to each other.

13. Portfolio Optimization • Efficient portfolio have a mixture of assets, whereas inefficient portfolio has assets that make higher risk-adjusted incremental contributions to portfolio return than other assets. • Efficient frontier refers to the collection of all efficient portfolios corresponding to the full range of portfolio risk possibilities.

14. Optimizing the Portfolio • Once the expected return, standard deviation, and cross-correlation have been estimated for the asset classes than mathematical calculation to derive the asset allocations for portfolios on the efficient frontier. • Optimal portfolio will always have a subjective dimension because there is no way to directly measure a client’s risk tolerance.

15. (cont’d) • Managers’ expectation of return on asset class may not be in line with the benchmark return, therefore it is not recommended that the manager’s returns be used in place of benchmark estimates.

16. Symmetrical vs. Asymmetrical Risk Distribution • Symmetrical risk distribution uses all the optimization software to minimize risk, whereas asymmetrical is where the investors are more concerned with losses.

17. Why MPT Hasn’t Been More Widely Used • The software is expensive (from $50,000 to $200,000 per year). • Index funds and foreign funds were not widely accessible. • Most planners do not have the theoretical and practical education to implement MPT. • Asset allocation and MPT did not receive mainstream press coverage.

18. (cont’d) • MPT calculates different combinations of assets that yield the maximum expected return at each level of risk, as measured by standard deviation. • It is important to understand that the expected return, standard deviation and correlation of the assets in the portfolio are merely forecasts based on past performance.

19. Ch 3Structuring A Portfolio By Yihui Yu

20. Diversification • Objective: to add investments to the client’s portfolio that are not closely related to his other investments • Measurement: correlation coefficients. - coefficient = 0 (no direct relationship) - coefficient = 1 (perfect positive relation) - coefficient = -1 (perfect negative relation)

21. The Correlation Matrix • Concept: compare one investment o another and report the correlation coefficient • Investment categories for the matrix: - domestic stock - foreign stock - bonds - cash equivalents - real assets

22. Selecting Assets For a Portfolio • The assets that the client refuses to get rid of should be included. • Several investment categories are represented. • Each category should comprise at least 5% of the portfolio. • Recommended weightings should be rounded off to the nearest whole number.

23. Other Factors The type of mutual fund or annuity chosen should depend on the following factors: • Client’s time horizon • Any existing investment the client already owns • Client’s goals and objectives • Client’s risk tolerance level

24. Ch 4 Asset Allocation

25. Definition • Asset allocation is the process of distributing portfolio investments among the various available investment categories. • Process involves three decisions: 1. Which types of investments should be included or excluded? 2. How much weight should be given to each asset? 3. Which vehicles should be used?

26. Importance of Asset Allocation • If you should have x% of a portfolio’s holdings in growth and income funds versus some other percentage figure is much more important than trying to gauge if ht investment should be made now or in six months.

27. Approaches to Asset Allocation • Strategic asset allocation is a passive approach that focuses on long-range policy decisions to determine the appropriate asset mix. It does not attempt to predict or time the market. The portfolio is fully invested at all times. Risk is reduced by using several different investment categories.

28. Approaches to Asset Allocation • Tactical asset allocation is an active approach that generally uses market predictions to change the asset mix in order to exploit superior predictive ability through such techniques. This strategy believes that market inefficiencies can constantly be found and that short-term trading can take advantage of such inefficiencies.

29. Approaches to Asset Allocation • Dynamic asset allocation is an active technique that reacts to changing market conditions by making relatively frequent changes in the asset mix with the goal of providing downside protection in addition to upside participation.

30. Ch 5Market Timing

31. Introduction • Essence of market timing in any investment is to buy low and sell high • Use of leading indicators • A blending of business analysis with technical projections • Reaction to leading indicators sometimes opposite of expectations • Investors take advantage of market inefficiencies • Switching of portfolios of high/low betas according to market conditions

32. Methodology: Moving Averages • Straight or simple moving average is the sum of a data series divided by the total units involved • Commonly used: 30 and 60 day moving averages • Exponential moving average is a weighted moving average • Smoothes out minor fluctuations in trends • More reliable

33. Moving Averages (Continued) • Two basic rules: • Buy signals rendered whenever price of fund rises above level of moving averages employed • Sell signals rendered when price level falls below level of moving averages employed

34. Methodology: Cash Flow Indicator • Based on the concept of contrary thinking • Buy at peak pessimism; sell at peak optimism of market • Example: Mutual fund cash position • Large increase/decrease may indicate bear/bull market expectations • Historically, rise above 10% leads to major upward market move; converse at 8%; normal at 9%

35. Drawbacks to Short-term Trading • Market timers have to be right twice: when they are getting in and again when they are exiting the market • The more moves, the greater the chance for mistakes • May lose advantage of deferred taxation

36. Studies: Trinity Study • Observations on nine peak-to-peak cycles since WWII: May 29, 1946 through Aug. 25, 1987 • About 1.7 times more up months than down: 309 vs. 187 • Average bull market up 104.8% vs. Average bear market drop of 28% • Bull markets last three times as long as bear markets: 41 up months vs. 14 down months • Even in bear markets, on average 3 to 4 months out of 10 are up months • On average, 8 of 41-month bull market duration accounted for 60% of total returns

37. Charles D. Ellis Study • All 100 pension funds engaged in some market timing • Not one improved rate of return • 89 of 100 lost as a result of “timing”

38. William F. Sharpe Study • Market study from 1934 to 1972 • Market timer with 2% in trading costs, choosing once a year between stocks and cash, would have to be right at least 82% of the time to do as well as a buy-and-hold stock investor

39. Chua and Woodward Study • To be successful at market timing, investors require forecast accuracy for at least: • 80% of all bull markets, 50 % of all bear markets; • 70% of all bull markets, 80% of all bear markets; or • 60% of all bull markets, 90% of all bear markets

40. Robert H. Jeffrey Study • If market timing is only accurate 50% of the time, probable outcomes: • Best-case real dollar return, only two times greater than from continuous investment in S&P • Worst-case produces 100 times less.

41. Roy D. Henrikson Study • Study on 116 mutual funds from 1968 to 1980 • Virtually all fund managers showed no significant ability to time purchases for superior performance

42. Ibbotson Study • Study on security returns from 1949 to 1998 • If investor missed 5 best years for common stocks and invested in T-bills instead, $1 in stocks at end of 1925 would only become $127, instead of $578 if invested continuously in S&P 500 • Point: market timer has tremendous natural odds to overcome; odds increase geometrically with length of timeframe and frequency of timing interval

43. Timing Services • Many investors rely on newsletters or timing services for timing signals • Timing services also track fund performance and recommend specific funds to buy • Minimum account: $25,000 • Plus 2% annual management fee

44. Timing vs. Buy-and-Hold • Q: Which does better? • A: It depends • Performance measurements strongly influenced by period of comparison • Buy-and-hold is better in upward trend markets • Timing is better in declining markets • In good markets, all can do well. Therefore, timing services may help cut losses

45. Ch 6FORMULA TIMING INDICATORS Introduction- • Offers a mechanical timing approach • Commonly used substitutes for subjective buy-and-sell timing decisions. • Requires investor input

46. 3 Types of formula plans includes: • Constant Dollar Plans- requires investor to set the dollar value of the aggressive portfolio. • Constant Ratio Plan- maintains the value of the aggressive portfolio relative to the value of the conservative portfolio. • Variable Ratio Plan- mechanical portfolio management plan that requires extensive forecasting.

47. TIMING INDICATORS Bear Market Endings 6 indicators that tell investors when it is time to start buying stocks again: • Investment Sentiment • Market P/E • Dividend Yield • Interest Rates • Market Volume • Advances and Declines

48. Stocks in a recession 1973-1975 • In 1973-75 during the beginning of the recession, there was a 7.8% growth in the S & P 500. • In 1980 there was a 14.6% growth • In 1981-82 there was a 16.5% growth.

49. Markets in a recession 1948-1991 • There have been 9 business recessions since the end of World War II. • First Postwar Recession 1948-1949 • Second Postwar Recession 1953-1954 • Third Postwar Recession 1957-1958 • Fourth Postwar Recession 1960-1961 • Fifth Postwar Recession 1969-1970 • Sixth Postwar Recession 1973-1975 • Seventh Postwar Recession Jan 1980-June 1980 • Eighth Postwar Recession 1981-1982 • Ninth Postwar Recession 1990-1991

50. PREDICTABILITY • Businesses tend to occur in most major nations about twice in each 10-year period. • National Bureau of Economic Research is one of the most respected economic organizations to study business cycles.