IAPM Topic 01 - Slides (Notes) PDF

Investment Analysis and Portfolio Management Introduction: General Concepts and Investment Process 1  Some Practical Information Lecturer: Koen Inghelbrecht Lectures: ‣ Thursdays: 08:30 – 12:30, Auditorium C – Hein Picard ‣ Ques...

Investment Analysis and Portfolio Management Introduction: General Concepts and Investment Process 1  Some Practical Information Lecturer: Koen Inghelbrecht Lectures: ‣ Thursdays: 08:30 – 12:30, Auditorium C – Hein Picard ‣ Questions: Ask before, during or after lectures or use Wooclap (see later) ‣ Exercises: Integrated in the lectures + Self-study Practical Sessions: Video lectures (using Excel) Ufora/Connect: Slides, Articles, Exercises, Multiple-Choice Questions, Data, Groups, Reports, Video Lectures ‣ Ufora: https://ufora.ugent.be/ ‣ Connect: https://connect.mheducation.com/class/iapm-lectures-2024- 2025 2  Course Material Textbook: Bodie, Kane and Marcus, 2024, Essentials of Investments, 12th Edition, McGraw-Hill (ISBN: 978-1-266-88538-9) Additional: Slides, Scientific Articles, News Articles (Ufora) Exercises: Open exercises + Multiple choice (Connect) Video material: Available through Ufora Assignment in groups Exam: Open questions and Multiple-choice questions 3  Connect Connect-platform (practice yourself + e-book + but print copy) URL: https://connect.mheducation.com/class/iapm-lectures-2024-2025 4  Multiple Choice Questions Connect-platform (practice yourself) ‣ URL: https://connect.mheducation.com/class/iapm-lectures-2024- 2025 Wooclap (during lectures) ‣ Using smartphone, tablet or PC ‣ You can answer anonymously! ‣ Also: Messages (Wall) to ask questions ‣ How? - Go to: app.wooclap.com/IAPM1 (for Topic 1) - Go to: app.wooclap.com/IAPM2 (for Topic 2) - Etc. 5 Multiple Choice Questions: Wooclap URL: app.wooclap.com/IAPM1 6  Multiple Choice Question Experience with investing: Question: What is your experience with investing? 1. I actively invest in (individual) stocks. 2. I passively invest in mutual funds, ETFs and/or pension funds. 3. I invest both actively and passively in stock related assets. 4. I have no experience (I keep my money on a savings account). URL: app.wooclap.com/IAPM1 7  Group Assignment Assignment: To analyze different asset classes and to construct, motivate and evaluate optimal risky portfolios using an asset allocation strategy. The report should be no longer than 6 pages (including tables and figures). Details of the assignment: in lecture of 14/11. Deadline of the assignment: 06/12. The assignment is made in teams of 5 students. You can subscribe to the teams. The evaluation of the assignment is based on some criteria and using peer evaluation. Peer evaluation will take place after completing the assignment. 8  Assessment Written Exam (70%) Written Report for Assignment (30%) including Peer evaluation!! The group assignment is evaluated by the lecturer and by fellow students using a peer evaluation Important: The final course grade is a weighted average of the written exam (70%) and the assignment (30%). To pass the course, the student needs to at least pass the written exam. If the student does not have a passing grade for the written exam but does have a weighted average course grade of 10/20 (or more), the final course grade will be reduced to 9/20. Retake exam: Written exam if the student has not passed the written exam during the first term. 9  Questions? VRAGEN? (5’) URL: app.wooclap.com/IAPM1 10  Goals Know how to invest directly and indirectly Never forget that lunches are (hardly) never free! ‣ Risk-Return Trade-Off 100 118 III Understand pricing principles on financial markets PV ‣ How can we determine price and (expected) return and risk of a financial asset? Understand how to construct portfolios MS RBL ‣ How should we allocate our funds? Diversify! ↓ T Be able to evaluate investments (strategies) ‣ How do we know we did a good investment? j A - 11  Why study investments? Most individuals make investment decisions sometime ‣ Need sound framework for managing and increasing wealth ‣ Retirement decisions: importance of making good decisions x = -20 = 100. 000 &2 x 3.65 ↓ 40 - 200. 000 Source: Jones, 2010, Investments: Principles and Concepts, p.6 x 14.73 Essential part of a career in the field ‣ Security analyst ‣ Portfolio manager ‣ Stockbrokers ‣ Financial advisors/planners 12  O 1 2 -- 10 % 10 % 121 E100 110 + 10 ↓ 11 1 to  Overview Course Topics 1. Introduction: General Concepts and Investment Process (26/09) 2. Investing Direct and Indirect (03/10) 3. Return and Risk, and Portfolio Theory (10/10) 4. Efficient Diversification (17/10) 5. CAPM and Multifactor Models (24/10) 6. Market Efficiency and Behavioral Finance (31/10) 7. Equity Valuation (07/11) Vs 8. Bond Valuation and Bond Portfolio Management (14/11) Vo 9. Portfolio Performance Evaluation (21/11) 10.Investing using Derivatives (28/12) 11.Applied Portfolio Management (Guest Lecture) (05/12 or 12/12) 13  Agenda Topic 1 Introduction Basis concepts: ‣ Return and risk ‣ Trade-off between return and risk ‣ Efficient markets ‣ Pricing of assets ‣ Diversification Types of Investments Investment Process ‣ Investment Decisions ‣ Investment Management ‣ Factors Affecting Investment Decisions Players in the Financial Markets The Role of Financial Markets (primary versus secondary) Price-Contingent Orders, Buying on Margin and Short Sales 14  References Topic 1 Required reading: Bodie, Kane and Marcus, 2024, Essentials of Investments, Chapter 1, Sections 1.1 to 1.6 Bodie, Kane and Marcus, 2024, Essentials of Investments, Chapter 3, Section 3.1 to 3.9 Background reading: Jones, 2010, Investments: Principles and Concepts, Chapter 1 Additional resources: Refinitiv/LSEG Datastream 15  Multiple Choice Question Investment in financial assets: Question: Which financial asset do you prefer to invest in nowadays? 1. Cash 2. Government bonds 3. Corporate bonds 4. Individual stocks 5. Mutual funds / ETFs 6. Real estate 7. Gold 8. Bitcoins 9. Other URL: app.wooclap.com/IAPM1 16  Introduction: Some Recent Trends Stock market and government/corporate bond market: Return index and return expressed in Euro since 2023 17  Introduction: Some Recent Trends Stock markets worldwide: Returns (based on MSCI return index in Euro) ↓ MINGING 18  Introduction: Some Recent Trends Return per sector (based on MSCI return index in Euro) 19  Introduction: Some Recent Trends Government bond yields (maturity 10 year) Q: What explains the recent decrease in government bond yields? URL: app.wooclap.com/IAPM1 20  Introduction: Some Recent Trends Bond returns for different categories: 21  Introduction: Some Recent Trends Exchange Rates: US 6% st us 22  Introduction: Some Recent Trends US real estate has performed well from a historical perspective, but … - > 23  Introduction: Some Recent Trends FRED Graph 24  Introduction: Historical Perspective Adjusted prices (accounting for stock splits, including dividends) !! Q: What do you conclude? Q: What about currency risk? Y 25  Introduction: Historical Perspective Prices including dividends!! 26  Introduction: Historical Perspective Prices including dividends and coupons!! ↓ ↓ 1 27  Introduction: Historical Perspective Stylized facts: Individual stocks can fluctuate a lot ‣ Great potential for high gains, but also high risk of losing money Stock indices in general do fluctuate less than individual stocks ‣ Less potential for high gains, but also less risk of losing money ‣ Diversification potential Bond indices in general do fluctuate less than stock indices ‣ Less potential for high gains, but also less risk of losing money Basic Concepts: 1. Return and risk 2. Trade-off between risk and return 3. Efficient markets 4. Pricing of assets 5. Diversification of risk 28  Questions? VRAGEN? (5’) URL: app.wooclap.com/IAPM1 29 TIME FOR 10 BREAK! A MIN 30  Two Basic Concepts: Return and Risk t Return: ‣ Why invest? To earn a return 14. # Ore = - Holding cash has an opportunity cost. Which? et +1 = - 4% ‣ Expected return versus Realized return - Expected return: anticipated return for some future period - Realized return: actual return over some past period ‣ Realized return is not always what you expected!! RISK Risk: ‣ Possibility that the realized return will be different than the expected return ‣ Uncertainty about the actual return that will be earned on an investment Hence, investments involves uncertainty about future returns!! 31  Multiple Choice Question Risk-return trade-off: Question: In securities markets, there should be a risk-return trade-off with higher-risk assets having _________ expected returns than lower-risk assets. 1. higher 2. lower 3. the same 4. The answer cannot be determined from the information given. URL: app.wooclap.com/IAPM1 32  Trade-off between Risk and Return How to earn return? YGrnu Bones-18 ‣ Financial Markets are competitive Posemou ↑M Yo = 1% - No-free-lunch rule Bones - ANSWER 1: You need to take risk to earn a return (above risk-free rate) ‣ Investors are risk averse - They dislike risk, unless they are compensated for it - ANSWER 2 : Investor only take risk when they expect to earn a return Underlying investment decisions: the trade-off between expected return and risk O 142 20YD How much risk do we want to take? - ‣ Depends on investment horizon and risk tolerance (risk aversion) ‣ Investor risk tolerance affects expected return. Why? 33  Trade-off between Risk and Expected Return Attention: differentiate between ex ante (“before the fact”, expected) and ex post (“after the fact”, realized) (() Gov. Bondf ⑨ Any level of expected return can be attained!! It depends on? O j Source: Jones, 2010, Investments: Principles and Concepts, p.11 34  The Historical Record: 1980 - 2021 Inflation German ST Government Bonds German LT Government Bonds MSCI US Stock Market MSCI Europe Stock Market 14000 > Prices including dividends and coupons!! 12000 10000 8000 6000 4000 2000 YI 100. 0 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Source: Refinitiv Datastream 35  Long-term Realized Risk-Return Trade-Off Past Period: 1980-2021 14,00% MSCI US Stock Market 12,00% 10,00% Realized Returns MSCI Europe Stock Market 8,00% German LT 6,00% Government Bonds German ST 4,00% Government Bonds Inflation 2,00% 0,00% 0,00% 2,00% 4,00% 6,00% 8,00% 10,00% 12,00% 14,00% 16,00% Risk 36  The Historical Record: 1999 - 2011 MSCI US Stock Market MSCI Europe Stock Market German ST Government Bonds German LT Government Bonds Greece LT Goverment Bonds Inflation 250 Prices including dividends and coupons!! 200 I 150 100 50 X 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: Refinitiv Datastream 37  Shorter-term Realized Risk-Return Trade-Off Past Period: 1999-2011 6,00% German LT Government Bonds 5,00% Realized Returns 4,00% German ST 3,00% Government Bonds MSCI US Stock Market Inflation MSCI Europe Stock 2,00% Market 1,00% 0,00% 0,00% 2,00% 4,00% 6,00% 8,00% 10,00% 12,00% 14,00% 16,00% 18,00% Risk 38  Expected vs Realized Risk-Return Trade-Off Stylized fact: In the shorter term the risk-return trade-off between may not always hold (from a historical point of view) ‣ This is essential what risk is about: High risk implies higher returns in the long-term (most of the time), but as risk is high this means in the short-term you could have low even negative returns. BUT Trade-off between risk and expected return still holds!! ‣ WHY? ‣ Higher-risk assets should be priced lower to offer higher expected return than lower-risk assets Recent trend: What used to be safe is not safe anymore!! 39  Questions? VRAGEN? (5’) URL: app.wooclap.com/IAPM1 40  Efficient Markets Two types of expected returns: ‣ E(r): Return you expect based on fundamental information (i.e., forecasted ↓ return) ‣ Required r: Return you expect or require as compensation for risk (i.e., real rate + inflation + risk premium) ⑭ - 6% If markets are efficient 6% 6Y ‣ E(r) = required r => no bargains (no-free-lunch). 150 100 ‣ Market price = fair price V 100 = P v ‣ What happens when E(r) > required r? -P = &544 46 %. 4 "Y -- 108 - Efficient market hypothesis (EMH): Asset prices reflect all relevant information Implications of EMH: ‣ Return you get/expect is compensation for risk ‣ Not possible to do better than the market ‣ Passive management is preferred over active management 41  Multiple Choice Question Pricing of assets: Question: What happens with the market price of a stock, if the stock gets more risky? (assuming that markets are efficient) 1. The market price will increase? 2. The market price will decrease? 3. The market price will not change? URL: app.wooclap.com/IAPM1 42  Pricing of Assets Why does the price of an asset change? Present value model (for stocks): ¥ E(DIVt ) ↑ ↳ V = å DDM Model 0 t =1 (1 + k ) ↑ t required return V0 = fair price ¥ E(DIVt ) Y P0 = å t =1 (1 + E(r)) t A P0 = market price expected return If markets are efficient: P0 = V0 43  Multiple Choice Question Diversification: Question: Diversification (i.e., holding different assets in your portfolio) is likely to _________. 1. increase your portfolio return X 2. decrease (or eliminate) your portfolio risk 3. both 1 and 2 URL: app.wooclap.com/IAPM1 44  Diversification ‘Don’t put all your eggs in one bucket’ Definition: Many assets are held in the portfolio, so that the exposure to any particular asset is limited ‣ Reduction of your portfolio risk ‣ Reduce the fluctuations of your portfolio!! KBL ! Ms ↓ IMBEV I LOCA ↑ 45  Questions? VRAGEN? (5’) URL: app.wooclap.com/IAPM1 46  Types of Investments Nature of Investment: Reduce current consumption for higher future consumption Real assets vs. Financial assets ‣ Real assets Tangible assets ‣ Financial assets Claims on assets Direct vs. Indirect financial investments (focus) ‣ Direct Individual securities (ex. Apple) ‣ Indirect “pools” of assets (ex. Mutual fund) Real Assets Financial Assets: Productive Claims on Real Assets or Capacity Real Asset Income Property, plants and equipment, human capital, etc. 47  Financial Assets STOUTS Common Stock Ownership stake in entity, residual cash flow Asset Classes Derivative Securities Fixed Income Securities BriDS Contract, value derived from underlying market Money market instruments, condition Bonds, Preferred stock DERINATOS 48  Investment Process Definition: Investment process describes how a (individual or institutional) investor should go about making decisions with regard to: BONDS, CASti ‣ what marketable securities to invest in STOCKS , cir ‣ how extensive the investments should be Passive, a ‣ when the investments should be made. Five-step process: 1. Set investment policy 2. Perform security analysis and valuation 3. Construct a portfolio 4. Revise a portfolio Portfolio Management 5. Evaluate performance Take a portfolio perspective!! 49  Investment Process & CoYR Five-step process: -1 x 1. Set investment policy 100 200 00d 000.. ‣ Identify investor’s unique objective ‣ Determine amount of investable wealth r Se E ‣ State objectives in terms of risk and return 120 000 ‣ Identify potential investment categories ~. 1% ‣ Investment policy should address: - mission statement, long-run financial goals - risk tolerance, amount of risk that an investor is willing to bear - policy asset mix, the long-run allocation to broad asset classes (this is by far the most important decision that should be made) - choice for active or passive management 50  y Strate MS D STOCKS BONDS Aut soa R ! ha or It Barbes pe Ja  Investment Process Five-step process: 2. Perform security analysis and valuation ‣ Understand security characteristics and factors affecting them ‣ Next, apply valuation model to estimate their price ‣ Compare current market price to true fair value ‣ Identify undervalued securities ‣ Time consuming and difficult job Necessary? 3. Construct a portfolio ‣ Identify specific assets (classes) in which to invest ‣ Utilizes the results of security analysis to construct portfolios ‣ Important: portfolio taken as a whole is not equal to sum of its parts cf. Diversification - “Don’t put all your eggs into one basket” 51  Investment Process Five-step process: 4. Revise a portfolio ‣ How and when should the portfolio be revised? ‣ Periodically repeat Step 3 ‣ Revise if necessary - increase/decrease existing securities - delete some securities - add new securities 5. Evaluate performance ‣ How should portfolio performance be measured? ‣ Involves periodic determination of portfolio performance with respect to risk and return ‣ Requires appropriate measures of risk and return 52 TIME FOR 10 BREAK! A MIN 62  Investment Decisions Typical investor faces two steps of investment decisions (in constructing his/her portfolio): 1. Asset allocation: ‣ Choice among broad asset classes ‣ Money, stocks, bonds, real estate, commodities, derivatives etc. ‣ Top-Down Investment Strategies starts with Asset Allocation 2. Security selection: ‣ Choice of particular securities within each asset class (Ex. GM, IBM, etc.) ‣ Requires the valuation process of particular securities, so called, “security analysis” per PCV ‣ Bottom-Up Investment Strategies starts with Security Selection HOW TO MAKE INVESTMENT DECISION? 53  Asset Allocation Source: Norton and Reilly (2006), Investments, Thomson South-Western 100 - AGE 20 GS 54  Investment Management Summarizing Basic Investment Strategies: Asset Allocation versus Security Selection Active versus Passive Management of Portfolio Asset Allocation Security Selection Tab Active Market timing Stock picking 30% 1 Sat 120 % · NVidia APPLE AMSON Maintain pre-determined Try to track a well-known Passive allocation(s) market index Soy 160 % 110%. SapEro SB C Which investment decision is crucial for investment managers to outperform? 55  Course Philosophy: Top-down Approach Asset Allocation Macro-information Security Selection Micro-information Evaluation Portfolio information Alternative: bottom-up approach 56  Multiple Choice Question Efficient markets and investment strategy: Question: In a perfectly efficient market the best investment strategy is probably _____ A. an active strategy. # B. a passive strategy. C. stock picking. D. market timing. URL: app.wooclap.com/IAPM1 57 Efficient markets and investment strategy Choice of Your Belief in Investment- Market Management Efficiency Style Active Management Passive Management Markets are… Inefficient Efficient p No Attempt to Find Actively Seek Security Selection: Undervalued Undervalued Stocks Securities No Attempt to Time Asset Allocation Market Timing Market 58  Factors Affecting Investment Decisions The Great Unknown ‣ “You have to understand that being wrong is part of the process” - Peter Bernstein ‣ Uncertainty in ex post returns dominates decision process ‣ Future is uncertain and must be estimated All investors (individuals and professionals) make investing mistakes Global Investment Area ‣ Adding foreign financial assets: opportunity to enhance return or reduce risk Diversification (Important concept) ‣ Currency risk Why? ‣ Importance of internet and institutional investors Are markets efficient? 59  Foreign Stock Market Foreign financial assets should not be ignored WHY? Stock market returns over the last 6 years (expressed in Euro): Q: Why important to express the returns in Euro? 60  Questions? VRAGEN? (5’) URL: app.wooclap.com/IAPM1 61  Players in the Financial Markets Who Supplies Capital? Households/Retail investors Price of Capital Institutional Investors What Demands Capital? Firms Government Quantity of Capital Role of Financial Intermediaries? Role of Financial Markets? 63  Role of Financial Markets Channel funds from savers to borrowers (with help of financial intermediaries): ‣ Financial markets permit both firms and government to raise needed funds by selling securities ‣ Investors with excess funds are able to invest and earn a return Allow consumption timing Consumption Dollars ‣ Use securities to store wealth Savings ‣ Transfer consumption to the future Dissavings Dissavings Income Help allocate cash to where it is most productive Help lower the cost of exchange 64  Role of Financial Markets Two types of markets: 1. Primary markets: When issuers of securities raise money through selling new securities, often with assistance of investment bankers, these are primary market transactions ‣ Initial public offerings (IPOs) versus seasoned new issues 2. Secondary markets: Investors trade among themselves in secondary markets, often with the assistance of brokers or dealers 65  Initial public offerings (IPOs) Investment opportunities for the investor? Period: 1980 - 2022 66  Initial public offerings (IPOs) Investment opportunities for the investor? 170 % Period: 1980 - 2022 67  Initial public offerings (IPOs) Always positive first-day returns and what in the long term? What is the long-term performance of an average IPO? Source: Prof. Jay Ritter, University of Florida, April 2012 68  Secondary Markets Markets where investors trade previously issued securities ‣ Necessary to let investors view securities as attractive opportunities Listed securities versus non-listed securities ‣ Listed: listing requirements, listing fee ‣ Non-listed: over-the-counter (OTC), pink sheets Examples: NYSE, Nasdaq, Euronext, LSE, TSE Trading: Rise of electronic trading Trading costs: broker’s commission (explicit) + bid-ask spread (implicit) Types of Orders: ‣ Market orders (importance of bid-ask spread and market depth) ‣ Price-contingent orders 69  Trading Costs Commission: Fee paid to broker for making transaction. Spread: Cost of trading with dealer. Bid: Price at which dealer will buy from you. Ask: Price at which dealer will sell to you. Spread = Price Ask − Price Bid Combination: On some trades both are paid. 70  How Securities Are Traded? Market Order Market order: ‣ Execute immediately at best price. ‣ Bid price: price at which dealer will buy security. ‣ Ask price: price at which dealer will sell security. Note: This is a portion of the limit order book for shares in Microsoft taken from the CBOE electronic exchange, October 14, 2022. 71  Market Depth Market depth = total number of shares offered for trading at the best bid/ask prices Figure 3.3 Market Orders: Average Market Depth What does the difference in market depth for large versus small firms imply? 72 How Securities Are Traded? Price-Contingent Orders So Pf = BOUGH AT 32 47 47 55 Limit orders: Order to buy or sell at a specified (or better) price Stop orders: Order specifying certain price at which market order takes effect 73  Buying on Margin Margin = Describes securities purchased with money borrowed in part from DiTYS& broker a Initial Margin Requirement (IMR) = Minimum % initial investor equity ‣ Minimum set by Federal Reserve under Regulation, currently 50% for stocks Maintenance Margin Requirement (MMR) = Minimum amount equity before additional funds must be put into account ‣ MMR = Exchanges mandate minimum 25% Margin Call = Notification from broker that you must put up additional funds or have position liquidated 74  Buying on Margin Example: 75  ↳ A I & #- too Lon 4000 4000 ↳000 so to 300o ↓ 1008 t 1808 2 CASH 100d too Scor. Murair - Assets Mar Gir - Margin & 20% Ma Morn I 2008 33 % = Goo  Buying on Margin & 100 - 130 80 Why? # = Coo - 200 % 130 ~ 2001 100 - Cory 70 * 10000 / A = 20000 & 10 0000, 9% 900. Return -ro 200 , 51 % Return- 10. 000 76  Short Sales Po = 10 Data Pit 12 3 Return - 30% 12 X + - 10 Po = 10 Pr 8 = Dj = 1 - = 10 = 8 - 2 Return 1 77  Short Sales # 1000 = p = 100 P = 120 Example: 50% margin requirement P = 168 160. 000 & 120800 4 j the 30 dir - 10 -80d Maintenance margin of 30% -> What does this mean? 100 800. ~ So % “Short-selling periodically comes under attack, particularly during times of financial stress when share prices fall” -> Why? Macsir - 30808 URL: app.wooclap.com/IAPM1 - 120 000. P = 80 = 25% V= fa 78  Questions? VRAGEN? (5’) URL: app.wooclap.com/IAPM1 79  Overview Course Topics 1. Introduction: General Concepts and Investment Process (26/09) 2. Investing Direct and Indirect (03/10) 3. Return and Risk, and Portfolio Theory (10/10) 4. Efficient Diversification (17/10) 5. CAPM and Multifactor Models (24/10) 6. Market Efficiency and Behavioral Finance (31/10) 7. Equity Valuation (07/11) 8. Bond Valuation and Bond Portfolio Management (14/11) 9. Portfolio Performance Evaluation (21/11) 10.Investing using Derivatives (28/12) 11.Applied Portfolio Management (Guest Lecture) (05/12 or 12/12) 80