Lecture 5 Introduction to Portfolio Management (1).pptx

VALUATION & INVESTMENTS (FINC 412) Lecture 5: Introduction to Portfolio Management Muhammad M. Ma’aji, PhD, A C C A , F M VA  Lesson Plan Lesson Topic Introduction to Portfolio Management, Portfolio management process and construction Learning Outcomes At the end...

VALUATION & INVESTMENTS (FINC 412) Lecture 5: Introduction to Portfolio Management Muhammad M. Ma’aji, PhD, A C C A , F M VA  Lesson Plan Lesson Topic Introduction to Portfolio Management, Portfolio management process and construction Learning Outcomes At the end of this lesson, students will be able to: Explain the portfolio approach to investing Calculate the correlation coefficient between two securities Outline the steps in the portfolio management process. Explain risk aversion and its implications for portfolio selection. Show the reasons for a written investment policy statement (IPS). Describe risk and return objectives and how they may be developed for a client. Discuss the principles of portfolio construction and the role of asset allocation in relation to the IPS. Activities/Methods Lecture, discussion, group exercise and excel practice Reading and References Main textbook Reading: CFA Material, Equity: Part I; CFA Material, Portfolio Management: Part I Main textbook Reading: Bodie, Kane & Marcus (2019) Investments, 11th Edition, McGraw Hill Practice: KAPLAN Schweser Notes 2018 Exam Preparation, Equity and Portfolio Agenda  A portfolio perspective on investing Principles of portfolio management & construction Portfolio perspective Individuals and institutions faced challenges deciding how to invest for future needs. One important question is: Should we invest in individual securities, evaluating each in isolation, or should we take a portfolio approach? Who faces the highest risk? And Why ◦ Mr Casey invest 100% of his wealth in Acleda bank shares, while ◦ Ms Zarima invest 60% of her with in PPAP shares and 40% in PWSA shares. What  is portfolio approach? By “portfolio approach,” we mean evaluating individual securities in relation to their contribution to the investment characteristics of the whole portfolio. An investor who holds all his wealth in a single stock – his portfolio is very risky compared to holding a diversified portfolio of stocks. Modern portfolio theory (by Professor Harry Markowitz, 1952) concludes that the extra risk from holding only a single security is not rewarded with higher expected investment returns. Diversification Portfolio diversification helps investors avoid disastrous investment outcomes. A key reason for this diversification is the desire to manage risk, which is consistent with the saying, “Don’t put all your eggs in one basket.” Diversification allows an investor to reduce portfolio risk without necessarily reducing the portfolio's expected return. Enron vs. S&P 500 Index Diversification Correlation between two securities ◦ Correlation: a statistical measure of the relationship between two series of numbers. ◦ The covariance of the returns of two securities can be standardized by dividing by the product of the standard deviations of the two securities to give correlation. ◦ Positively correlated: two series tend to move in the same direction. ◦ Negatively correlated: two series tend to move in opposite directions. ◦ Uncorrelated: two series bear no relationship to each other. Diversification Correlation and Diversification ◦Correlation ◦Correlation coefficient: measures the degree of correlation, whether positive or negative ◦ Perfectly positively correlated: series with a correlation coefficient of +1.0 ◦ Perfectly negatively correlated: series with a correlation coefficient of -1.0 Diversification Diversification Correlation and Diversification ◦ As a general rule, the lower the correlation between any two assets, the greater the risk reduction that investors can achieve by combining those assets in a portfolio: ◦ Assets with +1 correlation eliminate no risk ◦ Assets with less than +1 correlation eliminate some risk ◦ Assets with less than 0 correlation eliminate more risk ◦ Assets with -1 correlation eliminate all risk ◦ Assets that are less than perfectly positively correlated tend to offset each others movements, thus reducing the overall risk in a portfolio. Diversification  Combining Negatively Correlated Assets to Diversify Risk  Practice 1 The following are the monthly rates of return for Madison Cookies and for Sophie Electric during a six-month period. Months Madison Cookies Sophie Electric Nestle Jan -0.04 0.07 -0.05 Feb 0.06 -0.02 -0.24 Mar -0.07 -0.10 0.48 Apr 0.12 0.15 -0.05 May -0.02 -0.06 0.65 Jun 0.05 0.02 -0.25 Jul 0.04 -0.03 -0.24 Aug 0.11 0.12 -0.09 Compute the following 1.Average monthly rate of return for each stock 2.Standard deviation of returns for each stock 3.The correlation coefficient between the rates of return Answer  Practice 2 Mr Eddie has the following summary of his six years of percentage returns from GTI and PAS investment. Of his total investment, 60% were invested is in PAS will the remaining 40% in PPAP. Calculate the covariance, and correlation for the two returns series. Year PPAP Return PAS Return 2014 10% 20% 2015 -15% -20% 2016 20% -10% 2017 25% 30% 2018 -30% -20% 2019 20% 60% 2020 -20% -15% 2021 -10% 20% Answer Agenda  A portfolio perspective on investing Principles of portfolio management & construction Portfolio Management Process and Construction To build a suitable portfolio for a client, investment advisers should first seek to understand the client’s investment goals, resources, circumstances, and constraints. Investors can be categorized into broad groups based on shared characteristics with respect to these factors (e.g., various types of individual investors and institutional investors).  Even investors within a given type, however, will invariably have a number of distinctive requirements. Portfolio Management Process and Construction Step One: The Planning Stage - Understand the clients’ needs - Preparation of an investment policy statement (IPS) Step Two: The Execution Stage - Asset allocation - Security analysis - Portfolio construction Step Three: The Feedback Stage - Portfolio monitoring and rebalancing - Performance measurement and reporting The Planning Step Investment policy statement (IPS) ◦ IPS is a written document governing the process of constructing a portfolio to meet the client’s investment objectives. ◦ Why IPS? (1) Pension Schemes required statement of investment principles; (2) Governance arrangement within the investment company; (3) Suitability of an investment ◦ Help understand client's needs, knowledge about investments and the financial markets. Content of IPS ◦ Should contains client investment objectives (risk and return) and constraints (Liquidity, time horizon, tax factors, legal and regulatory constraints, and unique needs and preferences) ◦ Benchmark – such as the rate of return or the performance of a particular market index The Execution Step Strategic Asset Allocation: is the long-term mix of assets that is expected to meet the investor’s objectives. ◦ What asset classes to consider for investment ◦ What policy weights to assign to each eligible class ◦ What allocation ranges are allowed based on policy weights Security analysis ◦ The top-down view can be combined with the bottom-up insights of security analysts who are responsible for identifying attractive investments in particular market sectors. Portfolio construction ◦ The portfolio manager will then construct the portfolio, taking account of the target asset allocation, security analysis, and the client’s requirements as set out in the IPS. ◦ A key objective will be to achieve the benefits of diversification Stock Market and Business Cycle The Feedback Step ◦ Portfolio monitoring and rebalancing ◦ Monitored and reviewed and revised the composition as the security analysis changes because of changes in security prices and changes in fundamental factors. ◦ When security and asset weightings have drifted from the intended levels as a result of market movements, some rebalancing may be required. ◦ Performance evaluation and reporting ◦ The performance of the portfolio must be evaluated, which will include assessing whether the client’s objectives have been met. ◦ Assess how the portfolio has performed relative to any benchmark that has been set. ◦ Analysis of performance may suggest that the client’s objectives need to be reviewed and perhaps changes made to the IPS. Investment useful links https://www.investopedia.com/terms/r/risk.asp https://www.investopedia.com/terms/b/beta.asp https://www.investopedia.com/terms/v/variance.asp https://www.investopedia.com/terms/s/standarddeviation.asp https://www.investopedia.com/terms/s/sharperatio.asp Click icon to add picture Thank you for listening Q&A Appendix 1: Major components of an IPS