Prof.-4-Investment-and-Portfolio-Management-PDF

UNIT IV. THE RISK, RETURN, CLASSIC PORTFOLIO COMPOSITION Overview In this unit you will be able to know the composition of classic portfolio, the importance of identifying risk and return on investment using different mathematical formulas to calculate investment returns. Through this unit, you...

UNIT IV. THE RISK, RETURN, CLASSIC PORTFOLIO COMPOSITION Overview In this unit you will be able to know the composition of classic portfolio, the importance of identifying risk and return on investment using different mathematical formulas to calculate investment returns. Through this unit, you will able to analyze the risk and return of investment. Learning Objectives At the end of the unit, the students should be able to: 1. Discuss and Calculate various return measures; and 2. Define and analyze risk-return trade off and its special consideration. Introduction The Risk & Return is similar in concept to a classic efficient frontier image that maps the average return and standard deviation tradeoffs for any combination of assets. But the calculator takes it a few steps further and allows you to not only select your own risk and return measures, but also compare the real-world results of any asset allocation you like alongside every portfolio on the site. The vertical Y-axis maps the return metric and is measured in percent. Lesson Proper I. VARIOUS RETURN MEASURES Financial market assets generate two different streams of return: income through cash dividends or interest payments and capital growth through the price appreciation of the asset. Headline stock market indices typically report on price appreciation only and do not include the dividend income unless the index specifies it is a “total return” series. It is important to be able to compute and compare different measures of return to properly evaluate portfolio performance. 1. Holding Period Return A holding period return is a return earned from holding an asset for a specified period of time. The time period may be as short as a day or many years and is expressed as a total return. This means we look at the return as a composite of the price appreciation and the income stream. Professional 4: Investment and Portfolio Management | 28 The formula for the holding period return computation is as follows: 2. Arithmetic or Mean Return When we have assets for multiple holding periods, it is necessary to aggregate the returns into one overall return. An arithmetic mean is a simple process of finding the average of the holding period returns. For example, if a share has returned 15%, 10%, 12% and 3% over the last four years, then the arithmetic mean is as follows: 3. Geometric Mean Return Computing a geometric mean follows a principle similar to the computation of compound interest. The previous year’s returns are compounded to the beginning value of the investment at the start of the new period in order to earn returns on your returns. A geometric return provides a more accurate representation of the portfolio value growth than an arithmetic return. We note the geometric return is slightly less than the arithmetic return. Arithmetic returns tend to be biased upwards unless the holding period returns are all equal. Using the same annual returns of 15%, 10%, 12% and 3% as above, we compute the geometric mean as follows: 4. Money-weighted or Internal Rate of Return Arithmetic and geometric returns do not take into account the money invested in a portfolio in different time periods. A money-weighted return is similar in computation methodology to an internal rate of return (IRR) or a yield to maturity. We examine the cash Professional 4: Investment and Portfolio Management | 29 flows from the perspective of the investor where amounts invested in the portfolio are seen as cash outflows and amounts withdrawn from the portfolio by the investor are cash inflows. The IRR is the discount rate applied to determining the present value of the cash flows such that the cumulative present value of all the cash flows is zero. The IRR provides the investor with an accurate measure of what was actually earned on the money invested but does not allow for easy comparison between individuals. 5. Annualized Return If the period during which the return is earned is not exactly one year, we can annualize the return to enable an easy comparative return. To annualize a return earned for a period shorter than one year, the return must be compounded by the number of periods in the year. A monthly return must be compounded 12 times, a weekly return 52 times and a daily return 365 times. A weekly return of 2%, when annualized, is as follows: When the holding period is longer than one year, we need to express the year as a fraction of the holding period and compound using this fractional number. For example, a year relative to a 20-month holding period is a fraction of 12/20. If we had a return of 12% for 20 months, then the annualized return is as follows: 6. Portfolio Return When a portfolio is made up of several assets, we may want to find the aggregate return of the portfolio as a whole. In order to compute this, we weight the returns of the underlying assets by the amounts allocated to them. A portfolio that consists of 70% equities which return 10%, 20% bonds which return 4%, and 10% cash which returns 1% would have a portfolio return as follows: II. OTHER MAJOR RETURN MEASURES There are other measures of returns that need to be taken into account when evaluating performance. These are as follows: 1. Gross and net return A gross return is earned prior to the deduction of fees (management fees, custodial fees, and other administrative expenses). A net return is the return post-deduction of fees. Professional 4: Investment and Portfolio Management | 30  2. Pre-tax and after-tax nominal returns In general, returns are presented pre-tax and with no adjustment for the effects of inflation. Tax considerations like capital gains tax and tax on interest or dividend income will need to be deducted from the investment to determine post-tax returns. 3. Real returns Returns are typically presented in nominal terms which consist of three components: the real risk-free return as compensation for postponing consumption, inflation as compensation for the loss of purchasing power and a risk premium. Real returns are useful for comparing returns over different time periods as inflation rates vary over time. 4. Leverage returns If an investor makes use of derivative instruments within a portfolio or borrows money to invest, then leverage is introduced into the portfolio. The leverage amplifies the returns on the investor’s capital, both upwards and downwards. III. RISK MEASURES Risk measures are statistical measures that are historical predictors of investment risk and volatility, and they are also major components in modern portfolio theory (MPT). MPT is a standard financial and academic methodology for assessing the performance of a stock or a stock fund as compared to its benchmark index. There are five principal risk measures, and each measure provides a unique way to assess the risk present in investments that are under consideration. The five measures include the alpha, beta, R-squared, standard deviation, and Sharpe ratio. Risk measures can be used individually or together to perform a risk assessment. When comparing two potential investments, it is wise to compare like for like to determine which investment holds the most risk. Understanding Risk Measures  Alpha Alpha measures risk relative to the market or a selected benchmark index. For example, if the S&P 500 has been deemed the benchmark for a particular fund, the activity of the fund would be compared to that experienced by the selected index. If the fund outperforms the benchmark, it is said to have a positive alpha. If the fund falls below the performance of the benchmark, it is considered to have a negative alpha.  Beta Beta measures the volatility or systemic risk of a fund in comparison to the market or the selected benchmark index. A beta of one indicates the fund is expected to move in conjunction with the benchmark. Betas below one are considered less volatile than the benchmark, while those over one are considered more volatile than the benchmark.  R-Squared R-Squared measures the percentage of an investment's movement attributable to movements in its benchmark index. An R-squared value represents the correlation between Professional 4: Investment and Portfolio Management | 31 the examined investment and its associated benchmark. For example, an R- squared value of 95 would be considered to have a high correlation, while an R-squared value of 50 may be considered low. The U.S. Treasury Bill functions as a benchmark for fixed-income securities, while the S&P 500 Index functions as a benchmark for equities.  Standard Deviation Standard deviation is a method of measuring data dispersion in regards to the mean value of the dataset and provides a measurement regarding an investment’s volatility. As it relates to investments, the standard deviation measures how much return on investment is deviating from the expected normal or average returns.  Sharpe Ratio The Sharpe ratio measures performance as adjusted by the associated risks. This is done by removing the rate of return on a risk-free investment, such as a U.S. Treasury Bond, from the experienced rate of return. This is then divided by the associated investment’s standard deviation and serves as an indicator of whether an investment's return is due to wise investing or due to the assumption of excess risk. IV. RISK-RETURN TRADEOFF The risk-return tradeoff is the trading principle that links high risk with high reward. The appropriate risk-return tradeoff depends on a variety of factors including an investor’s risk tolerance, the investor’s years to retirement and the potential to replace lost funds. Time also plays an essential role in determining a portfolio with the appropriate levels of risk and reward. For example, if an investor has the ability to invest in equities over the long term, that provides the investor with the potential to recover from the risks of bear markets and participate in bull markets, while if an investor can only invest in a short time frame, the same equities have a higher risk proposition. Investors use the risk-return tradeoff as one of the essential components of each investment decision, as well as to assess their portfolios as a whole. At the portfolio level, the risk-return tradeoff can include assessments of the concentration or the diversity of holdings and whether the mix presents too much risk or a lower-than-desired potential for returns. V. Special Considerations in Risk Returns  Measuring Singular Risk in Context When an investor considers high-risk-high-return investments, the investor can apply the risk-return tradeoff to the vehicle on a singular basis as well as within the context of the portfolio as a whole. Examples of high-risk-high return investments include options, penny stocks and leveraged exchange-traded funds (ETFs). Generally speaking, a diversified portfolio reduces the risks presented by individual investment positions. For example, a penny stock position may have a high risk on a singular basis, but if it is the only position of its kind in a larger portfolio, the risk incurred by holding the stock is minimal.  Risk-Return Tradeoff at the Portfolio Level That said, the risk-return tradeoff also exists at the portfolio level. For example, a portfolio composed of all equities presents both higher risk and higher potential returns. Within an all-equity portfolio, risk and reward can be increased by concentrating investments in specific sectors or by taking on single positions that represent a large Professional 4: Investment and Portfolio Management | 32 percentage of holdings. For investors, assessing the cumulative risk-return tradeoff of all positions can provide insight on whether a portfolio assumes enough risk to achieve long- term return objectives or if the risk levels are too high with the existing mix of holdings. Supplemental Readings/Videos  Return Measures https://www.youtube.com/watch?v=1wv6MqpV0MM References  https://www.investopedia.com/  https://portfoliocharts.com/portfolio/risk-and-return/ Assessing Learning Name:_______________________________________ Date:____________________ Section: Score:___________________ ACTIVITY 4.1 IDENTIFICATION. Identify what words or terms being described in the following statement. Write your answer on the space provided before each number. ________________1. It is a return earned from holding an asset for a specified period of time. ________________2. It is a simple process of finding the average of the holding period returns. ________________3. It provides a more accurate representation of the portfolio value growth than an arithmetic return. ________________4. It is similar in computation methodology to an internal rate of return (IRR) or a yield to maturity. ________________5. It is return earned for a period shorter than one year, the return must be compounded by the number of periods in the year. ________________6. It is made up of several assets, we may want to find the aggregate return of the portfolio as a whole ________________7. It is made up of several assets, we may want to find the aggregate return of the portfolio as a whole. ________________8. It is earned prior to the deduction of fees (management fees, custodial fees, and other administrative expenses). A net return is the return post- deduction of fees. ________________9. If an investor makes use of derivative instruments within a portfolio or borrows money to invest, then it is introduced into the portfolio. _______________10. If are statistical measures that are historical predictors of investment risk and volatility, and they are also major components in modern portfolio theory (MPT) _______________11. It is a risk measures relative to the market or a selected benchmark index. _______________12. It measures the volatility or systemic risk of a fund in comparison to the market or the selected benchmark index. _______________13.It measures the percentage of an investment's movement attributable to movements in its benchmark index. _______________14. It measures performance as adjusted by the associated risks. _______________15. It is a method of measuring data dispersion in regards to the mean value of the dataset and provides a measurement regarding an investment’s volatility. Professional 4: Investment and Portfolio Management | 33 _______________16.It states that the potential return rises with an increase in risk. ESSAY:17-20 Explain the difference of Arithmetic Mean and Geometric Mean return. _________________________________________________________________________________________________________ _________________________________________________________________________________________________________ _________________________________________________________________________________________________________ _________________________________________________________________________________________________________ _________________________________________________________________________________________________________ _________________________________________________________________________________________________________ _________________________________________________________________________________________________________ _________________________________________________________________________________________________________ _________________________________________________________________________________________________________ _________________________________________________________________________________________________________ _________________________________________________________________________________________________________ _________________________________________________________________________________________________________ Name:_______________________________________ Date:____________________ Section: Score:___________________ ACTIVITY 4.2 INSTRUCTION: Compute the following problems given below: Problem Solving: Mr. Smith has returned 25%, 15%, 12% and 5% over the last four years, compute the arithmetic and geometric mean. 1. Arithmetic Mean Return 2. Geometric Mean Return Professional 4: Investment and Portfolio Management | 34 UNIT V. PORTFOLIO MANAGEMENT Overview In this unit you will be able to know the composition of classic portfolio, the importance of identifying risk and return on investment using different mathematical formulas to calculate investment returns. Through this unit, you will able to analyze the risk and return of investment. Learning Objectives At the end of the unit, the students should be able to: 1. Compare Active and Passive Portfolio Management; 2. Discuss Private Wealth Management; 3. Discuss and classify types of private wealth manager and its functions; and 4. Discuss Treynor Black model, its history and the dual portfolio. Introduction Investors have two main investment strategies that can be used to generate a return on their investment accounts: active portfolio management and passive portfolio management. Active portfolio management focuses on outperforming the market in comparison to a specific benchmark such as the Standard & Poor's 500 Index. Passive portfolio management mimics the investment holdings of a particular index in order to achieve similar results. As the names imply, active portfolio management usually involves more frequent trades than passive management. An investor may use a portfolio manager to carry out either strategy, or may adopt either approach as an independent investor. Lesson Proper I. ACTIVE PORTFOLIO MANAGEMENT The investor who follows an active portfolio management strategy buys and sells stocks in an attempt to outperform a specific index, such as the Standard & Poor's 500 Index or the Russell 1000 Index An actively managed investment fund has an individual portfolio manager, co- managers, or a team of managers all making investment decisions for the fund. The success of the fund depends on in-depth research, market forecasting, and the expertise of the management team.Portfolio managers engaged in active investing follow market trends, shifts in the economy, changes to the political landscape, and any other factors that may affect specific companies. This data is used to time the purchase or sale of assets. Proponents of active management claim that these processes will result in higher returns than can be achieved by simply mimicking the stocks listed on an index.1 Professional 4: Investment and Portfolio Management | 35 Since the objective of a portfolio manager in an actively managed fund is to beat the market, this strategy requires taking on greater market risk than is required for passive portfolio management. II. PASSIVE PORTFOLIO MANAGEMENT Passive portfolio management is also referred to as index fund management. The portfolio is designed to parallel the returns of a particular market index or benchmark as closely as possible. For example, each stock listed on an index is weighted. That is, it represents a percentage of the index that is commensurate with its size and influence in the real world. The creator of an index portfolio will use the same weights. The purpose of passive portfolio management is to generate a return that is the same as the chosen index. A passive strategy does not have a management team making investment decisions and can be structured as an exchange-traded fund (ETF), a mutual fund, or a unit investment trust. Index funds are branded as passively managed rather than unmanaged because each has a portfolio manager who is in charge of replicating the index.Because this investment strategy is not proactive, the management fees assessed on passive portfolios or funds are often far lower than active management strategies. Index mutual funds are easy to understand and offer a relatively safe approach to investing in broad segments of the market. Private wealth management is an investment advisory practice that incorporates financial planning, portfolio management, and other aggregated financial services for individuals, as opposed to corporations, trusts, funds, or other institutional investors. From the client's perspective, private wealth management is the practice of solving or enhancing their financial situation and achieving short-, medium-, and long- term financial goals with the help of a financial adviser.From the financial adviser's perspective, private wealth management is the practice of delivering a full range of financial products and services to clients, so that those clients can achieve specific financial goals. III. UNDERSTANDING PRIVATE WEALTH MANAGEMENT Some private individuals of means may lack the time, effort, or knowledge to manage their own finances. So they seek the counsel of wealth managers who specialize in managing the finances of private, often high-net-worth individuals (HNWI). HNWIs have unique financial situations that require greater diligence and a higher degree of active management HNWIs require a more holistic approach to investment management than many financial advisers are capable of providing. HNWIs can have issues with income taxes, estate planning, investment management, and other legal issues that need more attention and specific expertise than traditional investment advisers are qualified to give. Types of Private Wealth Managers Private wealth management services can be provided by banks and large brokerage houses, independent financial advisers, or multi-licensed portfolio managers who focus on high-net-worth individuals, and family offices. Many private wealth management firms are smaller groups within larger financial institutions focused on providing personalized service to their clients. Their main objective is to manage and grow the assets of their clients to provide for future generations. Professional 4: Investment and Portfolio Management | 36  These groups often have a variety of advisers and expertise that provide guidance across a wide spectrum of investments including cash, fixed-income, equities, and alternative investments. They can create a portfolio of assets that meets the investor's risk tolerance while also offering the opportunity for growth. Some HNWIs may want to consider opening a family office. A family office provides a wider range of services tailored to meet the needs of HNWIs. From investment management to charitable giving advice, family offices offer a total financial solution to high net worth individuals. There are two types of family offices: A single-family office supports one affluent individual or family, while the more common multifamily office supports multiple families and individuals. Multifamily offices are more prevalent due to economies of scale that allow for cost-sharing among the clientele. How Private Wealth Management Works Most private wealth management firms are fee-based. They charge their clients a percentage of the assets under management. HNWIs may believe that fee-based financial advisors have fewer conflicts of interest than traditional commission-based advisers.Commissioned advisors can push investors towards front-end and back-end load mutual funds that charge significant commissions, in many cases without offering any better performance than no-load funds. Technological advances have allowed many larger financial adviser companies to provide services online at reduced costs. Despite many investors gravitating to these types of services, many HNWIs still want a more personalized approach to their finances, even with the additional associated costs. IV. TREYNOR-BLACK MODEL The Treynor-Black model is a portfolio-optimization model that seeks to maximize a portfolio's Sharpe ratio by combining an actively managed portfolio built with a few mispriced securities and a passively managed market index fund. The Sharpe ratio evaluates the performance of a portfolio or a single investment against the risk-free rate of return. The standard risk-free return rate is the U.S. Treasury. History of the Treynor-Black Model The Treynor-Black model, published in 1973 by Jack Treynor and Fischer Black, assumes that the market is highly—but not perfectly—efficient. Following the model, an investor who agrees with the market pricing of an asset may also believe that they have additional information that can be used to generate abnormal returns—known as alpha— from a few mispriced securities. The investor using the Treynor-Black model will select a mix of securities to create a dual-partitioned portfolio. One portion of the portfolio is a passive investment, and the other part is an active investment. Treynor-Black Dual Portfolio The passively invested market portfolio contains securities in proportion to their market value, such as with an index fund. The investor assumes that the expected return and Professional 4: Investment and Portfolio Management | 37 standard deviation of these passive investments can be estimated through macroeconomic forecasting. In the active portfolio—which is a long/short fund, each security is weighted according to the ratio of its alpha to its unsystematic risk. Unsystematic risk is the industry-specific risk attached to an investment or an inherently unpredictable category of investments. Examples of such risk include a new market competitor who gobbles up market share or a natural disaster that destroys revenue. The Treynor-Black ratio or appraisal ratio measures the value the security under scrutiny would add to the portfolio, on a risk-adjusted basis. The higher a security's alpha, the higher the weight assigned to it within the active portion of the portfolio. The more unsystematic risk the stock has, the less weighting it receives. The Treynor-Black Dual Portfolio The passively invested market portfolio contains securities in proportion to their market value, such as with an index fund. The investor assumes that the expected return and standard deviation of these passive investments can be estimated through macroeconomic forecasting. In the active portfolio—which is a long/short fund, each security is weighted according to the ratio of its alpha to its unsystematic risk. Unsystematic risk is the industry-specific risk attached to an investment or an inherently unpredictable category of investments. Examples of such risk include a new market competitor who gobbles up market share or a natural disaster that destroys revenue. Key Takeaways  The Treynor-Black model aims to optimize portfolio construction based on its Sharpe ratio.  Treynor-Black assumes that markets are highly, but not perfectly efficient, allowing for some alpha opportunities.  The model calls for two portfolio segments: an actively-managed component built from select mispriced securities; and a passively-managed index component. Final Thoughts on Treynor-Black The Treynor-Black model does provide an efficient way of implementing an active investment strategy. Because it is hard to pick stocks accurately as the model requires, and restrictions on short selling may limit the ability to exploit market efficiencies and generate alpha, the model has gained little traction with investment managers. Supplemental Readings/Videos  Treynor-Black Model https://www.youtube.com/watch?v=N7qux839jUk References  https://www.investopedia.com/  https://www.investopedia.com/terms/t/treynorblack.asp Professional 4: Investment and Portfolio Management | 38 Assessing Learning Name:_______________________________________ Date:____________________ Section: _____________________________ Score:___________________ ACTIVITY 5 IDENTIFICATION. Identify what words or terms being described in the following statement. Write your answer on the space provided before each number. _______________1.It usually involves more frequent trades than passive management. _______________2.Portfolio Management that described as it mimics the investment holdings of a particular index in order to achieve similar results. _______________3. They are the one engaged in active investing follow market trends, shifts in the economy, changes to the political landscape, and any other factors that may affect specific companies. _______________4.It is referred to as index fund management. _______________5.It is branded as passively managed rather than unmanaged because each has a portfolio manager who is in charge of replicating the index. ______________6. Type of family offices that supports one affluent individual or family, while the more common multifamily office supports multiple families and individuals ______________7. Type of family offices are more prevalent due to economies of scale that allow for cost-sharing among the clientele. ______________8. is a portfolio-optimization model that seeks to maximize a portfolio's Sharpe ratio by combining an actively managed portfolio built with a few mispriced securities and a passively managed market index fund. ______________9. The investor using the Treynor-Black model will select a mix of securities to create. _____________10. It measures the value the security under scrutiny would add to the portfolio, on a risk-adjusted basis. Professional 4: Investment and Portfolio Management | 39 UNIT VI. FIXED INCOME PORTFOLIO MANAGEMENT Overview In this unit you will able to understand fixed income portfolio management, anticipate the interest rate and importance of understanding interest rates and you will able to analyze methods can be used by investors to be able to identify and compare relative value and intrinsic valuation. Learning Objectives At the end of the unit, the students should be able to: 1. Discuss Fixed Income Portfolio Management; 2. Understand interest rate anticipation and its importance; 3. Analyze the different strategies in reducing investment risk; 4. Apply the wide array of technical analysis methods used by investors; 5. Discuss relative value and its steps, benefits and criticism;and 6. Compare relative value and Intrinsic valuation. Introduction Bond portfolio management strategies are based on managing fixed income investments in pursuit of a particular objective – usually maximizing return on investment by minimizing risk and managing interest rates. The management of the portfolio can be done by professional investment managers or by investors themselves. Bond portfolio management strategies can help investors get the most of their portfolio, by actively managing fixed income investments to ensure maximum returns. These strategies include interest rate anticipation, sector rotation and security selection. Lesson Proper I. INTEREST RATE ANTICIPATION Bond portfolio management strategies that involve forecasting interest rates and altering a bond portfolio to take advantage of those forecasts are called “interest rate anticipation” strategies. Interest rates are the most important factor in the pricing of bonds. The price of a bond is based on its interest rate, or yield, at any particular time. The most important influence on a bond’s yield is the term structure of interest rates. Generally, the market interest rate for any particular term of bond is represented by the yields on government bonds, as these are viewed as highly liquid and of very low default risk. Basic interest rate anticipation strategy involves moving between long-term government bonds and very short-term treasury bills, based on a forecast of interest rates over a certain time horizon. Since long-term bonds change the most in value for a given change in interest rates, a manager would want to hold long-term bonds when rates are falling. This would provide the maximum increase in price for a portfolio. The reverse is true in a rising interest rate environment. Long-term bonds fall the most in price for a given rise in interest rates and a Professional 4: Investment and Portfolio Management | 40 manager would want to hold treasury bills. Treasury bills have a very short duration and do not change very much in value. Yield curve strategies are more sophisticated interest rate anticipation strategies that take into account the differences in interest rates for different terms of bonds, called the “term structure” of interest rates. A chart of the interest rates for bonds of different terms is called the “yield curve.” A yield curve strategy would position a bond portfolio to profit the most from an expected change in the yield curve, based on an economic or market forecast. Sector Rotation in Bonds Bond portfolio management strategies based on sector rotation involve varying the weight of different types of bonds held within a portfolio. An investment manager will form an opinion on the valuation of a specific sector of the bond market, based on fundamental credit factors, technical factors (such as supply and demand), and relative valuations compared to historical norms within that sector. A manager will usually compare her portfolio to the weightings of the benchmark index that she is being compared to on a performance basis. Security Selection for Bonds Security selection for bond management involves fundamental and credit analysis and quantitative valuation techniques at the individual security level. Fundamental analysis of a bond considers the nature of the security and the potential cash flows attached to it. Credit analysis evaluates the likelihood that the payments will continue to be made over the bond’s term. Modern quantitative techniques use statistical analysis and advanced mathematical techniques to attach values to the cash flows and assess the probabilities inherent in their nature. (www.finpipe.com) II. STRATEGIES IN REDUCING INVESTMENT RISK History shows that when people invest and stay invested, they're more likely to earn positive returns in the long run. When markets start to fluctuate, it may be tempting to make financial decisions in reaction to changes to your portfolio. But people who base their financial decisions on emotion often end up buying when the market is high and selling when prices are low. These investors ultimately have a harder time reaching their long- term financial goals. Strategy 1: Asset allocation Appropriate asset allocation refers to the way you weight the investments in your portfolio to try to meet a specific objective — and it may be the single most important factor in the success of your portfolio. For instance, if your goal is to pursue growth, and you're willing to take on market risk to reach that goal, you may decide to place as much as 80% of your assets in stocks and as little as 20% in bonds. Before you decide how you'll divide the asset classes in your portfolio, make sure you know your investment timeframe and the possible risks and rewards of each asset class. Risks and rewards of major asset classes Stocks Can carry a high level of market risk over the short term due to fluctuating markets Professional 4: Investment and Portfolio Management | 41  Historically earn higher long-term returns than other asset classes Generally outpace inflation better than most other investments over the long term Bonds Generally have less severe short-term price fluctuations than stocks and therefore offer lower market risk Can preserve principal and tend to provide lower long-term returns and have higher inflation risks over time Bond prices are likely to fall when interest rates rise (if you sell a bond before it matures, you may get a higher or lower price than you paid, depending on the direction of interest rates) Money market instruments Among the most stable of all asset classes in terms of returns, money market instruments carry low market risk (managers of these securities try to keep the per-share price at $1 and distribute returns as dividends) Generally don't have the potential to outpace inflation by a large margin Not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency (there’s no guarantee that any fund will maintain a stable $1 share price) Different asset classes offer varying levels of potential return and market risk. For example, unlike stocks and corporate bonds, government T-bills offer guaranteed principal and interest — although money market funds that invest in them do not. As with any security, past performance doesn't necessarily indicate future results. And asset allocation does not guarantee a profit. Strategy 2: Portfolio diversification Asset allocation and portfolio diversification go hand in hand. Portfolio diversification is the process of selecting a variety of investments within each asset class to help reduce investment risk. Diversification across asset classes may also help lessen the impact of major market swings on your portfolio. How portfolio diversification works If you were to invest in the stock of just one company, you'd be taking on greater risk by relying solely on the performance of that company to grow your investment. This is known as "single-security risk" — the risk that your investment will fluctuate widely in value with the price of one holding. But if you instead buy stocks in 15 or 20 companies in several different industries, you can reduce the potential for a substantial loss. If the return on one investment is falling, the return on another may be rising, which may help offset the poor performer. Keep in mind, this doesn’t eliminate risk, and there is no guarantee against investment loss. Strategy 3: Dollar-cost averaging Dollar-cost averaging is a disciplined investment strategy that can help smooth out the effects of market fluctuations in your portfolio. Professional 4: Investment and Portfolio Management | 42 With this approach, you apply a specific dollar amount toward the purchase of stocks, bonds and/or mutual funds on a regular basis. As a result, you purchase more shares when prices are low and fewer shares when prices are high. Over time, the average cost of your shares will usually be lower than the average price of those shares. And because this strategy is systematic, it can help you avoid making emotional investment decisions. How dollar-cost averaging might work in rising and declining markets In the illustration below, the cost of the investment ranges between $10 and $25 from January through April. A fixed monthly investment of $100 buys as many as 10 shares when the price is lowest but only four shares when the price is highest. In this example, dollar- cost averaging results in a lower average share price during the period, while the market average price — for someone who bought an equal number of shares each month — is higher.(www.ameriprise.com) Dollar-cost averaging at $100 per month. III. RELATIVE VALUE Relative value is a method of determining an asset's worth that takes into account the value of similar assets. This is in contrast with absolute value, which looks only at an asset's intrinsic value and does not compare it to other assets. The price-to-earnings ratio (P/E ratio) is a popular valuation method that can be used to measure the relative value of stocks. Understanding Relative Value Value investors examine the financial statements of competing companies before deciding where to invest their money. They look at relevant footnotes, management commentary, and economic data to assess the stock's value relative to its peers Steps in relative valuation may include: Professional 4: Investment and Portfolio Management | 43  First, identifying comparable assets and corporations. In these cases, it can be useful to view market capitalizations and revenue or sales figures. Their stock prices represent how the market values comparable companies at any given time. Deriving price multiples from these initial figures. Price multiples can include ratios, such as the P/E ratio or the price-to-sales ratio (P/S ratio). Comparing these multiples across a company’s peer or competitor group to determine if the company's stock is undervalued relative to other firms. Benefits of Relative Valuation Investors must always choose among the investments that are actually available at any given time, and relative valuation helps them to do that. By 2019, it was easy to look back at the prices of most U.S. stocks in 2009 and realize that they were undervalued. However, that does not help one to choose better investments today. That is where a relative valuation method like the stock market capitalization-to-GDP ratio shines. The World Bank maintains data on stock market capitalization as a percentage of GDP for many nations covering several decades. With U.S. stocks near record highs in terms of stock market capitalization as a percentage of GDP in 2019, stocks in most other countries were relatively inexpensive. Criticism of Relative Valuation The primary flaw of relative valuation is that it may condemn investors to making the best of a bad situation. When limited to a single asset class, relative valuation can do little more than reduce losses in extreme circumstances. For example, value funds generally did much better than the S&P 500 during the 2000-2002 bear market. Unfortunately, most of them still lost money. Relative Valuation vs. Intrinsic Valuation Relative valuation is one of two important methods of placing a monetary value on a company; the other is intrinsic valuation. Investors might be familiar with the Discounted Cash Flows (DCF) method for determining the intrinsic value of a company. While relative valuation incorporates many multiples, a DCF model uses a company’s future free cash flow projections and discounts them. That is achieved by using a required annual rate. Eventually, an analyst will arrive at a present value estimate, which can then be used to evaluate the potential for investment. If the DCF value is higher than the cost of the investment, the opportunity may be a good one. An Example of Relative Value Consider the following table of financial information comparing Microsoft to other technology firms. Supplemental Readings/Videos  Fixed Income Portfolio Management  https://www.youtube.com/watch?v=kmiLsYlIhTs Professional 4: Investment and Portfolio Management | 44 References  https://www.investopedia.com/  https://www.edx.org/course/fixed-income-portfolio-management Assessing Learning Name:_______________________________________ Date:____________________ Section: _____________________________ Score:___________________ ACTIVITY 6 TRUE OR FALSE. Write True if the statement is correct and F if the statement is incorrect. 1. Fixed income investments are based on managing Bond portfolio management strategies. 2. The management of the portfolio can be done by professional investment managers or by investors themselves. 3. Bond portfolio management strategies can help investors get the most of their portfolio, by actively managing fixed income investments to ensure maximumreturns. 4. Bond portfolio management strategies that involve forecasting interest rates and altering a bond portfolio to take advantage of those forecasts are called “interest rate anticipation” strategies. 5. Yield curve strategies are more primitive interest rate anticipation strategies that take into account the differences in interest rates for different terms of bonds, called the “term structure” of interest rates. 6. The management of the portfolio can be done by professional investment managers or by investors themselves. 7. Bond portfolio management strategies based on sector rotation involve varying the weight of different types of bonds held within a portfolio. 8. Investment Risk for bond management involves fundamental and credit analysis and quantitative valuation techniques at the individual security level. 9. Dollar-cost averaging refers to the way you weight the investments in your portfolio to try to meet a specific objective — and it may be the single most important factor in the success of your portfolio. 10. Portfolio diversification is the process of selecting a variety of investments within each asset class to help reduce investment risk. 11. Portfolio diversification is the process of selecting a variety of investments within each asset class to help reduce investment risk. 12.Verification across asset classes may also help lessen the impact of major market swings on your portfolio. 13.Dollar-cost averaging is a disciplined investment strategy that can help smooth out the effects of market fluctuations in your portfolio. 14.Relative value is a method of determining an asset's worth that takes into account the value of similar assets. 15.Value investors examine the financial statements of competing companies before deciding where to invest their money. Professional 4: Investment and Portfolio Management | 45