Personal Financial Management Semester – 2009 Gareth Myles Paul Collier

Reading Callaghan: Chapter 5 McRae: Chapter 2

Investing in Financial Assets There are many financial assets available Some are accessible to private investors Some are primarily for institutions We will focus on the former but mention some of the latter Investment funds allow access to all assets

Portfolio Choice The basic investment issue is to construct a portfolio of investments This should have return and risk characteristics that match the investor’s needs Example 1. An investor aged 25 in full-time employment may feel safe to “take a chance” and aim for a high risk/high return portfolio Example 2. An investor aged 65 who is retired may want primarily to protect their capital in a low return/low risk portfolio

Portfolio Choice Example 3. (Annuitisation) A private pension is invested in a range of assets during working life Upon retirement the majority of the fund is used to buy an annuity An annuity pays a fixed income for remainder of life This represents transfer from risky to safe assets

Portfolio Choice The basic issue in portfolio design is to choose the assets to match risk preference We need to know The risk and return characteristics of individual assets How they interact with other assets But first we need to know the available assets

Assets Non-Marketable Assets which cannot be sold to someone else (e.g. bank accounts) Marketable Assets which can be traded Included here are bonds and stocks Derivatives A specialised group of assets for institutions or very sophisticated private investors Indirect Investments Simplify portfolio construction and reduce costs

Non-Marketable Assets The most important assets within this category are Bank and building society accounts Royal Bank of Scotland Government savings bonds National Savings and Investments To purchase these private information must be revealed Name, age, address, employment status, even source of income

Marketable Assets Shares (common stock, equity) Issued by companies to fund investment Holder receives a dividend (share of profit), Holder has ownership rights (voting) To trade must open an account at a broker On-line Broker Information is readily available Yahoo Finance

Bonds (government or corporate) Promise a flow of payments (coupon payments – equivalent to interest) Pay face value on maturity Maturity (at issue) from 3 months to many years Return depends on market assessment of risk (default) Example Marketable Assets

Derivatives Assets based on the price of other “underlying assets” Call option: the right to buy Put option: the right to sell Futures: contracts in advance of delivery

Marketable Assets Indirect Investing Purchase of a share in a portfolio Choice of portfolio (ethical, trackers) Allows diversification at low cost Abbey

Trading Going long: holding a positive quantity of an asset This is the typical investment Selling short: holding a negative quantity of an asset Takes advantage of expected price falls Buying on the margin: borrowing money to invest Increases expected return and risk

Portfolio A set of assets and the proportion of the portfolio in value terms they constitute Example ICI shares (20%), BP shares (10%), Deposit account (30%), Bonds (30%), Unit trust (10%) The return on a portfolio is the weighted average of that on the assets in the portfolio The risk is more complex to compute

Effect of Covariance Consider the returns on two assets in the two possible events next year Consider the return on a portfolio: 1/3 of asset A, 2/3 of asset B AssetAB Rain81 Sun24

Effect of Covariance RainSun Return(1/3)8+(2/3)1=10/3(1/3)2+(2/3)4=10/3 In this example the risk in the individual assets cancels when they are combined Each asset does well in a different state

Effect of Covariance This is an example of negative covariance Because of the strong influence of market factors most assets have returns with positive covariance But some combinations of assets have lower risk than other combinations with the same return

Portfolio Risk When assets are combined into a portfolio it is possible to trade risk for return There are some portfolios which are efficient (maximum return for given risk) Some portfolios are inefficient There is always a portfolio will least risk (the minimum variance portfolio)

Return and Risk Asset A only Asset B only

Market Model Consider the entire set of financial assets: these form the “market” The riskiness of each individual asset can then be measured relative to the market This gives an asset’s “beta” Portfolio risk is then proportional to weighted average beta plus asset- specific risk

Beta Return on Market Return on Asset The slope of this line is  for the asset Return on Market Return on Asset A risk-free asset has a  of 0 Introducing  Risk-free Asset

Return on Market Return on Asset The  of this asset is less than 1 Defensive Asset 45 o Return on Market Return on Asset The  of this asset is more than 1 Aggressive Asset 45 o Beta

Company Betas CompanyBeta AstraZeneca Barclays Bank BP HSBC Holdings Imperial Tobacco0.5053

Portfolio Return and Risk Let be the proportion of asset i in the portfolio Portfolio return is The  of the portfolio is The portfolio variance is So larger , larger variance

Portfolio Return and Risk Portfolio  Portfolio Return Risk-free Asset  = 1 Market Return Choice of efficient portfolios

Idiosyncratic Risk What has happened to the idiosyncratic risk (risk not due to market) ? this is eliminated by diversification as the number of assets held rises, the individual variations cancel How can we diversify economically? by buying a tracker fund

Practical Observations Risk is reduced by diversification Higher returns bring higher risk Risk can be assessed by using  By altering ratio of risk-free and market, can run through all feasible returns A return higher than the market can be obtained by going short in the risk-free: borrowing to invest (yes, this is risky)