Investment Analysis and Portfolio Management

1. Investment Analysis and Portfolio Management

2. The Life of every man is a diary in which he means to write one story, and writes another; and his humblest hour is when he compares the volume as it is with what he vowed to make it. - J.M. Barrie

3. Introduction Portfolio Management: The management of a group of investment. Ideally the investment should have different patterns of returns over time. Phases of Portfolio Management: • Security Analysis • Portfolio Analysis • Portfolio Selection • Portfolio revision • Portfolio evaluation

4. The Six Steps of Portfolio Management • Learn the basic principles of finance • Set portfolio objectives • Formulate an investment strategy • Have a game plan for portfolio revision • Evaluate performance • Protect the portfolio when appropriate

5. Portfolio Management (cont’d) • Passive management has the following characteristics: • Follow a predetermined investment strategy that is invariant to market conditions or • Do nothing • Let the chips fall where they may

6. PART THREEPortfolio Management (cont’d) • Active management: • Requires the periodic changing of the portfolio components as the manager’s outlook for the market changes

7. The Investment Decision Process • Two-step process: • Security analysis and valuation • Necessary to understand security characteristics • Portfolio management • Selected securities viewed as a single unit • How efficient are financial markets in processing new information? • How and when should it be revised? • How should portfolio performance be measured?

8. Security Analysis • A three-step process • The analyst considers prospects for the economy, given the state of the business cycle • The analyst determines which industries are likely to fare well in the forecasted economic conditions • The analyst chooses particular companies within the favored industries • EIC analysis (a top-down approach)

9. Why Do Individuals Invest ? By saving money (instead of spending it), individuals tradeoff present consumption for a larger future consumption. Characteristics of Investment: All investments are characterized by certain features which include inter alia: • Return • Risk • Safety • Liquidity

10. Objectives of Investment • Maximization of return • Minimization of risk • Hedge against inflation Investment Vs. Speculation: Investment is distinguished from speculation with respect to three factors, viz. (1) Risk; (2) Capital Gain; (3) Time period. • An investor generally commits his/her funds to low risk investment, whereas a speculator commits funds to a higher risk investment. • The speculator’s motive is to achieve profits through price changes, i.e., he/she is interested in capital gains rather than income from investment. • Investment is long-term in nature, whereas speculation is short-term.

11. Introduction… Investment vs Gambling: Gambling consist in taking high risks not only for high returns, but also for thrill and excitement. It is unplanned and non scientific, undertaken without the knowledge of the nature of the risk involved. Investment is an attempt to carefully plan, evaluate and allocate funds to various investment outlets which offer safety of principal and moderate and continuous return over a long period of time. Gambling is quite opposite of investment.

12. Introduction Investment Avenues: • Corporate securities • Deposits in banks and non-banking companies • Mutual funds schemes • Post office deposits and certificates • Life insurance policies • Provident fund schemes • Government securities

13. How Do We Measure The Rate Of Return On An Investment ? The pure rate of interest is the exchange rate between future consumption and present consumption. Market forces determine this rate.

14. How Do We Measure The Rate Of Return On An Investment ? People’s willingness to pay the difference for borrowing today and their desire to receive a surplus on their savings give rise to an interest rate referred to as the pure time value of money.

15. How Do We Measure The Rate Of Return On An Investment ? If the future payment will be diminished in value because of inflation, then the investor will demand an interest rate higher than the pure time value of money to also cover the expected inflation expense.

16. How Do We Measure The Rate Of Return On An Investment ? If the future payment from the investment is not certain, the investor will demand an interest rate that exceeds the pure time value of money plus the inflation rate to provide a risk premium to cover the investment risk.

17. Defining an Investment A current commitment of $ for a period of time in order to derive future payments that will compensate for: • the time the funds are committed • the expected rate of inflation • uncertainty of future flow of funds.

18. Measures of Historical Rates of Return 1.1 Holding Period Return

20. Measures of Historical Rates of Return 1.2 Holding Period Yield HPY = HPR - 1 1.10 - 1 = 0.10 = 10%

21. Measures of Historical Rates of Return Annual Holding Period Return • Annual HPR = HPR 1/n where n = number of years investment is held Annual Holding Period Yield • Annual HPY = Annual HPR - 1

22. Measures of Historical Rates of Return 1.4 Arithmetic Mean

23. Measures of Historical Rates of Return 1.5 Geometric Mean

24. Arithmetic vs. Geometric Averages • When rates of return are the same for all years, the AM and the GM will be equal. • When rates of return are not the same for all years, the AM will always be higher than the GM. • While the AM is best used as an “expected value” for an individual year, while the GM is the best measure of an asset’s long-term performance.

25. A Portfolio of Investments The mean historical rate of return for a portfolio of investments is measured as the weighted average of the HPYs for the individual investments in the portfolio.

26. Computation of HoldingPeriod Yield for a Portfolio Exhibit 1.1

27. Arithmetic Average: An Example

28. Geometric Average: An Example

29. Arithmetic vs. Geometric Averages • When rates of return are the same for all years, the AM and the GM will be equal. • When rates of return are not the same for all years, the AM will always be higher than the GM. • While the AM is best used as an “expected value” for an individual year, while the GM is the best measure of an asset’s long-term performance.

30. Expected Rates of Return • Risk is uncertainty that an investment will earn its expected rate of return • Probability is the likelihood of an outcome

31. Expected Rates of Return 1.6

32. Risk Aversion The assumption that most investors will choose the least risky alternative, all else being equal and that they will not accept additional risk unless they are compensated in the form of higher return

33. Measuring the Risk of Expected Rates of Return 1.7

34. Measuring the Risk of Expected Rates of Return 1.8 Standard Deviation is the square root of the variance

35. Measuring the Risk of Expected Rates of Return 1.9 Coefficient of variation (CV) a measure of relative variability that indicates risk per unit of return Standard Deviation of Returns Expected Rate of Returns

36. Measuring the Risk of Historical Rates of Return 1.10 variance of the series holding period yield during period I expected value of the HPY that is equal to the arithmetic mean of the series the number of observations

37. Determinants of Required Rates of Return • Time value of money • Expected rate of inflation • Risk involved

38. The Real Risk Free Rate (RRFR) • Assumes no inflation. • Assumes no uncertainty about future cash flows. • Influenced by time preference for consumption of income and investment opportunities in the economy

39. Adjusting For Inflation 1.12 Real RFR =

40. Nominal Risk-Free Rate Dependent upon • Conditions in the Capital Markets • Expected Rate of Inflation

41. Adjusting For Inflation 1.11 Nominal RFR = (1+Real RFR) x (1+Expected Rate of Inflation) - 1

42. Facets of Fundamental Risk • Business risk • Financial risk • Liquidity risk • Exchange rate risk • Country risk

43. Business Risk • Uncertainty of income flows caused by the nature of a firm’s business • Sales volatility and operating leverage determine the level of business risk.

44. Financial Risk • Uncertainty caused by the use of debt financing. • Borrowing requires fixed payments which must be paid ahead of payments to stockholders. • The use of debt increases uncertainty of stockholder income and causes an increase in the stock’s risk premium.

45. Liquidity Risk • Uncertainty is introduced by the secondary market for an investment. • How long will it take to convert an investment into cash? • How certain is the price that will be received?

46. Exchange Rate Risk • Uncertainty of return is introduced by acquiring securities denominated in a currency different from that of the investor. • Changes in exchange rates affect the investors return when converting an investment back into the “home” currency.

47. Country Risk • Political risk is the uncertainty of returns caused by the possibility of a major change in the political or economic environment in a country. • Individuals who invest in countries that have unstable political-economic systems must include a country risk-premium when determining their required rate of return

48. Risk Premium f (Business Risk, Financial Risk, Liquidity Risk, Exchange Rate Risk, Country Risk) or f (Systematic Market Risk)

49. Risk Premium and Portfolio Theory • The relevant risk measure for an individual asset is its co-movement with the market portfolio • Systematic risk relates the variance of the investment to the variance of the market • Beta measures this systematic risk of an asset

50. Fundamental Risk versus Systematic Risk • Fundamental risk comprises business risk, financial risk, liquidity risk, exchange rate risk, and country risk • Systematic risk refers to the portion of an individual asset’s total variance attributable to the variability of the total market portfolio