The portfolio management process
The portfolio management process
• Set objective and policy goals
• Examine and understand the environment
• Construct the portfolio: asset allocation & security selection
• Monitor and update
Individual investment objectives?
Popular belief:
Investments are aimed at “making money”
Suggested strategies for “making money”
Put $1 in the bank at 3%.
Eventually you will become a billionaire
Put all of your earnings in the lottery.
Eventually you’ll hit the jackpot
Goals vs. objectives
Financial Goals
Broad financial ends, such as, buying a home, paying for children’s
education, etc.
Investment objectives
Stated in terms of risk and return - a function of goals, investment
horizon etc.
Investment objectives
Are dictated by risk tolerance and time horizon
•
•
•
Capital preservation
Income
Growth
Individual investment objectives
Age considerations
Risk consideration
Individual investor life cycle
• Accumulation phase
• Consolidation phase
• Spending phase
• Gifting phase
Accumulation phase
Long-term goals
• Retirement
• Children’s education
• Etc
Short-term goals
• Car
• House
Consolidation phase
Long-term goals
• Retirement
Short-term goals
• Children’s education
• Vacation
• Etc.
Spending phase
Long-term goals
• Estate planning
Short-term
• Life style
• Gifts
Gifting phase
Long-term goals
• Estate planning
Short-term
• Life style
• Gifts
Risk considerations
Factors:
• Psychological makeup
• Family situation
• Income
• Age
Investment constraints
• Liquidity needs
• Tax concerns
• Regulations
• Unique needs
Liquidity needs
Related to investment horizon & age
Longer horizons = accept less liquidity & more risk
Tax concerns
Investors think in terms of after-tax return
Regulations
Impose restrictions and constraints
Ex:
RRSP: Foreign content rule
Unique needs
A function of each individual
Asset classes
Classification according to risk and expected return characteristics
•
•
•
Stocks
Bonds
Risk-free investments
Asset classes
Each class can be further divided into subclasses
Bonds:
•
•
•
•
Long-term corporate bonds
Long-term government bonds
Medium-term corporate bonds
Medium -term government bonds
Etc.
Historical record: 1926-1998 (US)
Inflation
Geometric
mean
Arithmetic
mean
Standard
deviation
Large stocks
11.2%
13.2%
20.3%
Small stocks
12.4%
17.4%
33.8%
Long-term corporate bonds
5.8%
6.1%
8.6%
Long-term government bonds
5.3%
5.7%
9.25
US T-bills
3.8%
3.8%
3.25
Inflation
3.1%
3.2
4.5%
Historical record: 1948 -1998 (Canada)
Arithmetic
mean
Risk premium
Standard
deviation
Large stocks
13.2%
7.16%
16.6%
Small stocks
14.8%
8.75%
23.68%
7.6%
1.6%
10.6%
6%
0
4%
4.25%
-1.8%
3.5%
Long-term bonds
T-bills
Inflation
Inflation
Returns from investing $1: 1948-1999
$ 357.3
TSE300
Bonds
$ 36.4
$ 20.4
T-bills
Inflation
1945
1975
$ 8.4
2000
Asset allocation: Various countries
US & Canada
UK
Germany
Japan
Equity (domestic)
41%
54%
9%
22%
Equity (foreign)
4%
18%
2%
2%
Bonds
29%
12%
45%
22%
Real Estate
8%
9%
5%
6%
Cash
10%
5%
4%
6%
Other
8%
2%
35%
42%
World stock markets annual rates of return and risk in local currency 1986-1997
Return
27%
22%
17%
12%
7%
20%
30%
Standard
deviation