Managing Your Own Portfolio Chapter 13 Managing Your Own Portfolio

Administering Your Own Portfolio Learning Goals Explain how to use an asset allocation scheme to construct a portfolio consistent with investor objectives. Discuss the data and indexes needed to measure and compare investment performance. Understand the techniques used to measure income, capital gains, and total portfolio return.

Administering Your Own Portfolio Learning Goals (cont’d) Use the Sharpe, Treynor, and Jensen measures to compare a portfolio’s return with risk-adjusted, market-adjusted rate of return, and discuss portfolio revision. Describe the role and logic of dollar-cost averaging, constant-dollar plans, and variable-ratio plans. Explain the role of limit and stop-loss orders in investment timing, warehousing liquidity, and timing investment sales.

Constructing a Portfolio Using Asset Allocation Individual investor characteristics and objectives determine relative income needs and ability to bear risk Investor characteristics to consider: Level and stability of income, net worth Age and family factors Investment experience and ability to handle risk Tax considerations Investor objectives to consider: High level of current income Significant capital appreciation

Portfolio Objectives and Policies Current Income/Capital Preservation Objective Low-risk, conservative investment strategy Emphasis on current income and capital preservation Normally contains low-beta securities Capital Growth Objective Higher-risk investment strategy Emphasis on more speculative investments Normally contains higher-beta securities Tax Efficient Objective Emphasis on capital gains and longer holding periods to defer income taxes

Constructing a Portfolio Using Asset Allocation Asset Allocation is the process of dividing an investment portfolio into various asset classes to preserve capital by protecting against negative developments while taking advantage of positive ones. In other words, don’t put all of your eggs in one basket, and choose your baskets carefully.

Constructing a Portfolio Using Asset Allocation An asset allocation scheme must be developed before buying any investment vehicles. Focus is on investment in various asset classes, rather than emphasis on selecting specific securities. As much as 90% or more of a portfolio’s return comes from asset allocation between various asset classes.

Approaches to Asset Allocation Fixed-Weightings Approach: asset allocation plan in which a fixed percentage of the portfolio is allocated to each asset category Flexible-Weightings Approach: asset allocation plan in which weights for each asset category are adjusted periodically based on market analysis Tactical Approach: asset allocation plan that uses stock-index futures and bond futures to change a portfolio’s asset allocation based on market behavior

Table 13.1 Alternative Asset Allocations

Applying Asset Allocation Consider impact of economic and other factors on your investment objective Design your asset allocation plan for the long haul (at least 7 to 10 years) Stress capital preservation Provide for periodic reviews to maintain consistency with changing investments goals Consider using mutual funds, especially for portfolios under $100,000

Evaluating Performance of Individual Investments Step 1: Obtain Needed Data Returns on owned investments Economic and market activity Step 2: Compare Returns with Broad-Based Market Measures DJIA, S&P 500, Nasdaq Composite Index, Lipper indexes Step 3: Compare Performance to Investment Goals “Am I getting the proper return for the amount of investment risk I am taking?” “Do I have a problem investment?” Step 4: Determine appropriate action on each investment Keep, sell, or monitor closely

Calculating Return: Holding Period Return Returns include current income and capital gains/losses Return for specific holding period

Measuring Portfolio Return: Holding Period Return Returns include current income and capital gains/losses for all investments held in portfolio

Measuring Portfolio Return: Sharpe’s Measure Compares the risk premium on a portfolio to the portfolio’s standard deviation of return In general, the higher the Sharpe’s measure, the better

Measuring Portfolio Return: Treynor’s Measure Uses the portfolio beta to measure the portfolio’s risk In general, the higher the Treynor’s measure, the better

Measuring Portfolio Return: Jensen’s Measure Uses the Capital Asset Pricing Model (CAPM) to calculate the portfolio’s excess return (actual return compared to required return) Positive returns are preferred; negative returns indicate required return was not earned

Assessing Portfolio Performance Portfolio Revision: the process of selling certain issues in a portfolio and purchasing new ones to replace them Periodic reallocation and rebalancing are necessary Reasons to revise portfolio: Changes in economic conditions Major life event Proportion of one asset class increases or decreases substantially Expect to reach specific goal within two years Percentage allocation of asset class varies from original allocation by 10% or more.

Timing Transactions Dollar-Cost Averaging Fixed dollar amount is invested at fixed intervals Discipline to invest on regular basis is vital Purchase more shares when prices are low and fewer shares when prices are high

Timing Transactions (cont’d) Constant-Dollar Plan Speculative portion seeks capital gains Conservative portion seeks low risk When speculative portion increases to a predetermined dollar amount, profits are transferred to conservative portion If speculative portion decreases, funds are added from conservative portion

Timing Transactions (cont’d) Constant-Ratio Plan Similar to constant-dollar plan, only the ratio between the speculative and conservative portions is fixed Variable-Ratio Plan Similar to constant-ratio plan, only the ratio between the speculative and conservative portions is allowed to fluctuate to predetermined levels Moderately aggressive strategy which tries to “buy low and sell high”

Using Limit and Stop-Loss Orders Limit Orders May be used to purchase additional securities only at desired purchase price or below Stop-Loss Orders Used to limit downside loss or protect a profit by selling security when price falls below predetermined price

Other Portfolio Considerations Warehousing Liquidity Keep portion of portfolio in low-risk, highly liquid investments to protect against loss or to wait for future investment opportunities Tax Consequences Use long-term capital gains when possible Use capital losses to offset capital gains Achieving Investment Goals When an investment becomes more or less risky, or it does not meet its return objective, sell it Don’t hold out for top price; take your profits and reinvest in more suitable investment

Chapter 13 Review Learning Goals Explain how to use an asset allocation scheme to construct a portfolio consistent with investor objectives. Discuss the data and indexes needed to measure and compare investment performance. Understand the techniques used to measure income, capital gains, and total portfolio return.

Chapter 13 Review (cont’d) Learning Goals (cont’d) Use the Sharpe, Treynor, and Jensen measures to compare a portfolio’s return with risk-adjusted, market-adjusted rate of return, and discuss portfolio revision. Describe the role and logic of dollar-cost averaging, constant-dollar plans, and variable-ratio plans. Explain the role of limit and stop-loss orders in investment timing, warehousing liquidity, and timing investment sales.

Additional Chapter Art

Table 13.2 Calculation of Pretax HPR on a Common Stock

Table 13.3 Calculation of Pretax HPR on a Bond

Table 13.4 Calculation of Pretax HPR on a Mutual Fund

Table 13.5 Bob Hathaway’s Portfolio (January 1, 2008)

Table 13.6 Dividend Income on Hathaway’s Portfolio (Calendar year 2008)

Table 13.7 Unrealized Gains in Value of Hathaway’s Portfolio (January 1, 2008, to December 31, 2008)

Table 13.8 Holding Period Return Calculation on Hathaway’s Portfolio (January 1, 2008, to December 31, 2008, holding period)

Table 13.9 Dollar-Cost Averaging ($500 per month, Wolverine Mutual Fund shares)

Table 13.10 Constant-Dollar Plan

Table 13.11 Constant-Ratio Plan

Table 13.12 Variable-Ratio Plan