Slide 1
Chapter 4
Investment choices
PowerPoint presentation by
Lindsay Cowling
Holmesglen Institute
©2011 John Wiley & Sons Australia, Ltd
Introduction
Investment choices include exposure to the major and alternative asset classes and direct or indirect exposure through a managed fund
In order to build a portfolio the investor must have appreciation of risk and return attributes
Risk and return trade-offs are inherent in all investment analysis
General Attributes of Investors
It is commonly assumed in finance that investors are risk averse, rational and have an unlimited demand for wealth
Risk averse investors dislike volatility in returns
Rationality – the investor is assumed to be able to rank alternative investments consistently and
Unlimited demand – the investor prefers more to less…
General Attributes of Investors continued
Thus an investor will seek to maximise their ‘utility’ or preference functions by building a portfolio that suits their disposition or needs
Exercise: Refer to Table 4.1 – rank yourself according to investor classification, features and approximate asset mix
Broad Investment Classes
Cash
Fixed Interest
Property
Shares
Cash
Safe haven
Usually has a shorter term outlook
Provide interest income - variable
Provide liquidity
Stable returns
Risk free… although banks do fail from time to time – the Federal Government 90 day Treasury Note interest rate is regarded as the risk free rate in Australia
…but adversely affected by tax and inflation
Fixed Interest
Fixed term e.g. term deposit, debenture or government or corporate bond
Fixed interest rate with interest paid on a regular basis (a bond) or factored into the final payment and offered as a discount security (a bank bill)
Issued by institutions and government / semi government
Longer horizon than cash
Low risk – corporate bonds are higher risk than Govt bonds though
Fixed Interest continued
Generally secured apart from Unsecured Notes which are more risky
Hy
id instruments – instruments that have some characteristics of debt and equity e.g. a convertible note is debt but may be converted to a share at a future date
Can have a stabilising affect upon a portfolio
Credit risk can be an issue – more so with corporate bonds
Property
Property is a longer term investment vehicle that usually provides regular rental income with higher risk than bonds but lower risk than shares…
Direct property – apart from the family home – can consist of rental properties; residential, commercial, industrial or rural
Indirect:
Listed property trusts (REITS)
Unlisted property trusts
Property continued
Drawbacks:
Not liquid
It takes time to buy and sell
Transaction costs are high
Diversification can be limited for the smaller investo
Ongoing care and maintenance
Listed property trusts can have similar risk to shares
During the GFC many listed trusts suffered severe falls in value when they were unable to refinance debt and were forced to sell property when the market was at its worst
Shares
Definition: …fractional ownership of a company
Shares are generally high risk and return and therefore suitable for longer term investors
In the long term Australian shares have provided long term growth well above inflation – but in the short term market returns can be quite volatile
Shares continued
Share market returns tend to move in cycles reflecting:
Economic growth, the value of the AUD
Industry trends
Company profitability / dividends
Inflation, interest rate expectations and
General market sentiment
Shares continued
Returns can be both capital growth and dividends
Mature companies can provide good dividend yields, younger, more growth orientated companies may not pay a dividend
Dividends reflect company profitability and can vary from year to yea
Australian companies can provide tax effective dividends
Shares continued
An investor can buy shares on international shares and get exposure to markets at different stages of the business cycle
International shares can provide good diversification but beware of foreign cu
ency risk
A rising AUD can wipe out gains made on international markets - when shares are sold and the foreign cu
ency is exchanged for AUD the investor will receive fewer AUD…
The reverse will also be true
The Risk and Return Relationship
The higher the return the greater the risk
Definitions of risk:
The chance of loss of capital – a negative real return
The chance of loss of purchasing power – will returns be greater or less than the inflation rate?
The variability of returns – in finance we use standard deviation as the measure of risk ie the variability of returns around an expected mean
How can diversification
educe risk?
For a portfolio, we must consider the risk and returns of the whole portfolio rather than just the individual components
The expected return for a portfolio is the weighted average returns of the individual shares
Example
Share A Share B
Expected return 10% 14%
Standard deviation 3% 5%
% of total portfolio 55% 45%
Expected return E(R):
= XXXXXXXXXX% XXXXXXXXXX%)
= 11.8%
How can diversification
educe risk? continued
How can diversification
educe risk? continued
Portfolio risk is not simply a weighted average of the standard deviations of individual shares in portfolio.
Weights used are not simply the fraction of the total portfolio invested in each share.
It is necessary to understand the concept of co
elation between the shares.
How can diversification
educe risk? continued
The co
elation coefficient shows the extent of co
elation among shares.
It has a numerical value of –1 to +1 which indicates the risk reduction between shares:
Negative co
elation (–1) Large risk reduction
Positive co
elation (+1) No risk reduction
On average, the co
elation coefficient for returns on two randomly selected shares would be in the range of +0.5 to +0.7.
XXXXXXXXXXShare Share XXXXXXXXXXCo
elation
XXXXXXXXXXC XXXXXXXXXXD XXXXXXXXXXCoefficient
Standard deviation 4% 4% – XXXXXXXXXX1.0
Portfolio risk XXXXXXXXXX0% 3.1% 3.6% 4%
(Standard deviation of the portfolio)
Providing the co
elation coefficient between
shares C and D is less than 1.0, investor will be able to make a higher return at reduced risk
How can diversification
educe risk? continued
Diversification Across
Asset Classes
Application of the
Diversification Decision
The efficient portfolio – investors have return and risk data for a collection of securities
This data can be graphed as an upward sloping concave cure called the ‘efficient frontier’
There is no one best portfolio that lies on the frontier – just different combinations of risk and return
A portfolio on the frontier is efficient – a portfolio inside the curve is inefficient in terms of risk or return…
The risk – return ratio can be minimised or optimised by combing securities with a minimised covariance – a negative covariance would be better still!
The efficient frontier shows where the most efficient portfolio’s are located but the Sharpe ratio identifies the best possible proportions of these securities to use in a portfolio
Application of the Diversification Decision continued
Modern portfolio theory assumes there are only two asset types
risky assets
risk-free assets
Financial planners need to help clients make decisions about investments in
growth assets
fixed-interest assets
Application of the Diversification Decision continued
Recommendations for the selection of client investments will depend on a client’s risk tolerance which can be assessed by risk profiling.
Application of the Diversification Decision continued
Recent Performance of Asset Classes
Modern portfolio theory states the
isk-return relationship by the formula:
where:
E(Rp) = expected return on entire portfolio
E(Rpi) = expected return on the risky fund
p = standard deviation of entire portfolio
pi = standard deviation of risky fund
Rf = risk-free interest rate
Application of the Diversification Decision continued
General Investment Strategies
Diversification – ‘don’t put all your eggs in one basket’
Diversification raises the question as to how an investment portfolio should be allocated
Investors must have allocation decisions based on their risk, return profile
General Investment Strategies continued
Risk tolerance will be:
In some part innate and…
Governed by:
A person’s age
Income
Wealth
Years to retirement
Past financial experiences
General Investment Strategies continued
Gibson XXXXXXXXXXargued that the risk of portfolios was reduced and the average return increased if four asset classes were held in a portfolio
The reasoning is based on the fact that the four asset classes are not strongly related to each othe
As one asset class performs well the others are less likely to perform as well and as the better performing asset class reverses its performance the other asset classes tend to perform better…
The performances tend to counteract each other which provides for a better long term average and lower level of risk of such a portfolio
Investor Behaviou
The traditional view is that the market is efficient – Efficient Market Theory
Loss aversion – prospect theory
Overconfidence – many investors mistakenly believe they can beat the market
Biased judgements – ‘house prices never go down’
Investor Behaviour continued
Investment scams
If it seems to good to be true it probably is!
Ponzi schemes
Recent ASIC research shows internet scamming is on the rise…
Is there really a pot of gold at the end of the rainbow?
Information Sources for Investment Choices
Economic fundamentals
Industry characteristics and reports
Company background, prospects, annual reports
Cu
ent market prices
Government reports, ASIC website
Analyst reports
Using the internet as a search engine
Summary
A financial planner needs to understand the basic features of an asset class
To consider investment choice you need to have an understanding of risk and return
Risk and return also needs to be understood in terms of recent performance history and timeframes
Behavioural finance research shows that some investors do not behave rationally – scams take advantage of this…
Summary continued
An assessment of risk and return attributes including measurement principles allows the financial planner to tailor investment alternatives to a client’s specific requirements
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Slide 1
Chapter 5
Direct Investment
Power Point presentation by
Lindsay Cowling
Holmesglen Institute
©2008 John Wiley & Sons Australia, Ltd
Introduction
Direct investment occurs when investors make their own decisions where funds are ultimately placed
Indirect investment involves investors placing their funds with fund managers
It is important to appreciate the nature and structure of the relevant investment markets
Cash and Fixed-Interest Securities
Deregulation of the Australian financial system in the early 1980s produced a highly competitive finance industry
Process of deregulation was to free financial markets by removing many of the legal controls and regulations that restricted competition and stifled technological development
Cash and Fixed-Interest Securities
Deregulation included:
- floating of Australian