INTRODUCTION TO BUILDING A PORTFOLIO by Matt Ingram Invest Ed® All Rights Reserved Oklahoma Securities Commission July 2016

What is a Portfolio? Portfolio is a collection of investments assembled to meet one or more investment goals. What is diversification? Why should we diversify? 2

Correlation and Covariance : Why Works Correlation is a statistical measure of the relationship between two series of numbers representing data. Positively Correlated items tend to move in the same direction. Negatively Correlated items tend to move in opposite directions. 3

Correlation and Covariance : Why Diversification Works, Correlation and Covariance : Why Diversification Works, cont’d. Correlation Coefficient is a measure of the degree of correlation between two series of numbers representing data. Assets that are less than perfectly positively correlated tend to offset each other’s movements, thus reducing the overall risk in a portfolio. 4

Correlation 5

Combining Negatively Correlated Assets to Diversify Risk 6

? What About ? What is risk? Why do we require more return for more risk? Company-specific risk Market risk We can’t escape the risk that comes from the economy, political events, global events. How do we adjust for this? 7

What is Beta? A measure of non-diversifiable risk Indicates how the price of a security responds to market forces Compares historical return of an investment to the market return (the S&P 500 Index) The beta for the market is Stocks may have positive or negative betas; nearly all are positive

Does Beta Matter? It’s really just a measure of past volatility. High beta stocks tend to be growth stocks. Low beta stocks tend to be value stocks. Beta does not have great predictive power for returns. Other factors seem to matter more, like size and market-to-book value. 9

How to Diversify “Balance” the portfolio using a wide variety of stocks. Use a broad range of industries to diversify the portfolio. 15 to 20 stocks = best 10

Diversification Lowers Volatility 11

A Little Volatility Can Go a Long Way In a sense, the high volatility of the riskier asset classes is one of the most valuable attributes for a portfolio. A 5% allocation to a risky asset class with low correlation to “mainstream” asset classes might contribute as much diversification as a 20% allocation to a less volatile asset class, so only a small amount needs to be invested to improve portfolio diversification. 12

Why Diversify Internationally? Offers more diverse investment alternatives than U.S.-only based investing Foreign economic cycles may move independently from U.S. economic cycle. Foreign markets may not be as “efficient” as U.S. markets, allowing true gains from superior research. 13

International Investing Advantages of International Diversification – Broader investment choices – Potentially greater returns than in U.S. – Reduction of overall portfolio risk Disadvantages of International Diversification – Currency exchange risk – Less convenient to invest than U.S. stocks – More expensive to invest – Riskier than investing in U.S. 14

How Do We Invest Internationally? Foreign company stocks listed on U.S. stock exchanges – American Depository Shares (ADSs) – Mutual funds investing in foreign stocks – U.S. multinational companies (typically not considered a true international investment for diversification purposes) 15

Different Approaches Private company vs. Public company Information asymmetry There is value in buying what you know and understand. There can be value in buying something that no one else wants. 16

What is it Worth? How would you value the following assets? 4 bedroom, 2 bathroom house built after 1995 in Broken Arrow, OK 50% of an ice cream truck that drives around Norman, OK 1999 Toyota Camry, manual transmission, sunroof, spoiler, new tires 5% of the OKC Thunder 100 acres of land near Broken Bow, OK 17

Another Class Activity Rules and Regulations, part 1 Each team owns three identical assets and $20. The activity lasts for 10 time periods. Each asset generates $1 dividend at the end of each time period. At the end of 10 time periods, each asset pays $6. But at the end of each time period, after the dividend is paid, there is a 1/6 chance of default. 18

Rules and Regulations, part 2 If default occurs, the asset is destroyed and can no longer be traded. Each time period, teams can buy or sell assets. (auction style) At the end of the activity, the team with the most cash is declared the Value Champions. Each team needs to consider the true value of the assets and whether to buy or sell or sit tight each round. 19 Another Class Activity