Vicentiu Covrig Portfolio management 1 Vicentiu Covrig Never

Vicentiu Covrig Portfolio management 1

Vicentiu Covrig “ Never tell people how to do things. Tell them what to do and they will surprise you with their ingenuity” General George Patton 2

Vicentiu Covrig How Finance is organized n Corporate finance n Investments International Finance n Financial Derivatives n 3

Vicentiu Covrig Risk and Return The investment process consists of two broad tasks: • security and market analysis • portfolio management 4

Vicentiu Covrig Risk and Return Investors are concerned with both: § Expected return: comes from a valuation model §Risk As an investor you want to maximize the returns for a given level of risk. 5

Vicentiu Covrig Return: Calculating the expected return for each alternative Outcome Prob. of outcome 1(recession). 1 2 (normal growth). 6 3 (boom). 3 Return in -15% 25% k^ =expected rate of return = (. 1)(-15) + (. 6)(15) +(. 3)(25)=15% 6

Vicentiu Covrig What is investment risk? n n Investment risk is related to the probability of earning a low or negative actual return. The greater the chance of lower than expected or negative returns, the riskier the investment. Firm X Firm Y -70 0 15 100 Rate of Return (%) Expected Rate of Return Firm X (red) has a lower distribution of returns than firm Y (purple) though both have the same average return. We say that firm X’s returns are less variable/volatile (lower standard deviation ) and thus X is a less risky investment than Y 7

Vicentiu Covrig Selected Realized Returns, 1926 – 2006 Average Standard Return Deviation 18. 4% 36. 9% 12. 2 20. 2 5. 8 9. 4 5. 6 8. 1 3. 7 3. 1 Small-company stocks Large-company stocks L-T corporate bonds L-T government bonds U. S. Treasury bills 8

Vicentiu Covrig Investor attitude towards risk: Does it matter? n n Risk aversion – assumes investors dislike risk and require higher rates of return to encourage them to hold riskier securities. Some individuals are risk lovers, meaning that they purchase/ invest in instruments with negative expected rate of return Ex: Risk premium – the difference between the return on a risky asset and less risky asset, which serves as compensation for investors to hold riskier securities Very often risk premium refers to the difference between the return on a risky asset and risk-free rate (ex. a treasury bond) 9

Vicentiu Covrig Top Down Asset Allocation 1. Capital Allocation decision: the choice of the proportion of the overall portfolio to place in risk-free assets versus risky assets. 2. Asset Allocation decision: the distribution of risky investments across broad asset classes such as bonds, small stocks, large stocks, real estate etc. 3. Security Selection decision: the choice of which particular securities to hold within each asset class. 10

Vicentiu Covrig Terminology n n n Investment (portfolio) management: professional management of a collection (i. e. portfolio) of securities to meet specific goals for the benefit of investors Asset management is similar to Investment or Portfolio Management Wealth manager is more of a broker , financial manager or investment advisor for wealthy clients Portfolio management involve a long investment horizon Trading focuses on securities selection with a short term horizon 11

Vicentiu Covrig Top Down Asset allocation n n Capital Allocation decision: the choice of the proportion of the overall portfolio to place in risk-free assets versus risky assets Asset Allocation decision: the distribution of risky investments across broad asset classes such as bonds, small stocks, large stocks, real estate etc. Security Selection decision: the choice of which particular securities to hold within each asset class. 90% of the portfolio performance is determined by the first two steps 12

Vicentiu Covrig Portfolio Management n A properly constructed portfolio achieves a given level of expected return with the least possible risk n Portfolio management primarily involves reducing risk rather than increasing return n The investment horizon is intermediate to long term n Portfolio managers have a duty to create the best possible collection of investments for each customer’s unique needs and circumstances 13

Vicentiu Covrig Tactical Asset Allocation n Also known as Market Timing n Shifting the relative proportion of the asset classes in the portfolio 14

Vicentiu Covrig Portfolio Management n The heart of the Portfolio Management is the concept of diversification n The empirical evidence shows that the markets are quite efficient n Passive (Indexing) vs. Active Investing 15

Vicentiu Covrig Expected Portfolio Rate of Return - Weighted average of expected returns (Ri) for the - individual investments in the portfolio Percentages invested in each asset (wi) serve as the weights E(Rport) = S wi Ri 16

Vicentiu Covrig Portfolio Risk (two assets only) When two risky assets with variances 12 and 22, respectively, are combined into a portfolio with portfolio weights w 1 and w 2, respectively, the portfolio variance is given by: p 2 = w 12 12 + w 22 22 + 2 W 1 W 2 Cov(r 1 r 2) = Covariance of returns for Security 1 and Security 2 17

Vicentiu Covrig Correlation between the returns of two securities Correlation, : a measure of the strength of the linear relationship between two variables n n -1. 0 < < +1. 0 If = +1. 0, securities 1 and 2 are perfectly positively correlated If = -1. 0, 1 and 2 are perfectly negatively correlated If = 0, 1 and 2 are not correlated 18

Vicentiu Covrig Efficient Diversification Let’s consider a portfolio invested 50% in an equity mutual fund and 50% in a bond fund. Equity fund Bond fund E(Return) 11% 7% Standard dev. 14. 31% 8. 16% Correlation -1 19

Vicentiu Covrig 100% stocks 100% bonds Note that some portfolios are “better” than others. They have higher returns for the same level of risk or less. We call this portfolios EFFICIENT. 20

Vicentiu Covrig E(r) The Minimum-Variance Frontier of Risky Assets Efficient frontier Individual assets Global minimum variance portfolio Minimum variance frontier St. Dev. 21

Vicentiu Covrig return Two-Security Portfolios with Various Correlations 100% stocks = -1. 0 = 0. 2 100% bonds 22

Vicentiu Covrig The benefits of diversification n Come from the correlation between asset returns n The smaller the correlation, the greater the risk reduction potential greater the benefit of diversification n If = +1. 0, no risk reduction is possible § Adding extra securities with lower corr/cov with the existing ones decreases the total risk of the portfolio 23

Vicentiu Covrig Estimation Issues n n Results of portfolio analysis depend on accurate statistical inputs Estimates of - Expected returns - Standard deviations - Correlation coefficients 24

Vicentiu Covrig Portfolio Risk as a Function of the Number of Stocks in the Portfolio Thus diversification can eliminate some, but not all of the risk of individual securities. Diversifiable Risk; Nonsystematic Risk; Firm Specific Risk; Unique Risk Portfolio risk Nondiversifiable risk; Systematic Risk; Market Risk n 25

Vicentiu Covrig Optimal Risky Portfolios and a Risk Free Asset CAL (O) CAL (A) E(rp) M M O O A CAL (Global minimum variance) A G rf O M 26 p