Investments Finals Stanton Ott 12/12/2020 You are an Investment Advisor and are meeting with one of your clients, Susie. Susie has an existing portfolio of $1,000,000 which consists of 30% fixed income, 60% equity, and 10% cash. Susie wants to add another $100,000 to her portfolio, and invest the entire $100,000 in the bond market. Describe the risk that exists NOW (Yr 2020) if she wanted to invest in bonds. How could she reduce those risks? What are the methods, strategies, etc? What are other asset classes she might consider? What are the pros and cons of investing in those asset classes? Response: Investing in bonds is a safe alternative to other asset classes such as equity or commodities. Bonds offer a fixed rate of return, and serve to anchor a portfolio, they hedge against volatility in the stock market. They also help to provide an emotional hedge to a diversified portfolio as they don’t fluctuate with the market like equity does. Investing in bonds at their current rates helps to lower your short-term risk at the sacrifice of long-term returns. They are an essential part of a diversified portfolio, and the distribution of assets generally depends on the investor’s risk tolerance. A young person who is willing to take on greater risk to gain possible higher long-term returns should have a higher percentage of their portfolio invested in equity, and a lower percentage in fixed income. Someone closer to retirement would invest more heavily in fixed income because of greater security. In the last 25 years interest rates have been extremely low, rarely outperforming inflation. If Susie were to invest in 1-year T-Bill right now, she would only be able to get an interest rate of 0.11. The best bond rate she could receive is on a 30-year bond at 1.731. She would be losing 1 https://www.federalreserve.gov/releases/h15/ money to inflation which is occurring at an average rate of 3.22%, it would be like keeping the 100,000 in a savings account or CD. It is hard to recommend investing in US government bonds currently because of their low rates. It would almost be more beneficial to keep cash rather than tying up capitol in a bond that is yielding less than the inflation rate. In Susie’s situation, I would have her take a risk assessment to ascertain what her priorities are regarding her portfolio. Given she currently has 60% of her assets allocated to equity, it could be inferred that she finds some level of risk acceptable. Her desire to allocate additional funds to fixed income also tells me that she is looking for more security, or maybe to hedge the market with her investments. This is achievable to some degree through mutual funds or ETFs (Exchange Traded Funds). Mutual funds and ETFs are vehicles that provide investors with extremely well diversified and professionally managed investments that take much of the risk and uncertainty away from investing. There is of course still systemic risk, but specific risk can be minimized through these vehicles. For example, The Income Fund of America (AMECX) is a mutual fund created by Capital Group. Its asset allocation is 51.2% in US equity, 19.9% in non-US equity, 21.2% in US-bonds, 3.9% in non-US bonds, and 3.8% in Cash and Equivalents. Its 10-year return is 7.81% and prioritizes lower volatility and better downside resilience.2 There are still other funds that prioritize income rather than growth and are more heavily invested in bonds. I would suggest investing in one or more of these kinds of funds rather than directly in the bond market, as they still have relatively low volatility while still providing a return above the inflation rate. There of course is still a certain amount of risk, but when comparing the risk to 2 https://www.capitalgroup.com/individual/investments/fund/amecx reward ratio of bonds versus a low-risk mutual fund, it is hard to justify investing directly in US government bonds. Would an increase in the use of Artificial Intelligence to pick stocks affect the return of the market? Why or Why not? Describe the pros and cons of using AI/Algorithms to pick stocks. How might this affect the public’s perception of the market? Response: The answer to this question rests on how human behavior effects the market. The EMH (efficient market hypothesis) would say that share prices reflect all publicly available information, so there is no way to purchase undervalued or overvalued stocks. This also means that there should be no way to outperform the market through market timing or expert stock picking. In theory, the EMH should be true, there is an incredible amount of information available to both the financial industry as well as the public. If everyone involved in the market made rational decisions based on the available information, the EMH would be true. The issue is that humans historically do not act rationally all the time. There is a concept called Behavioral Finance that explains how psychological influences and biases that can disrupt the EMH. Biases can affect the stocks people pick and can influence them to make decisions that do not reflect the available data. For example, Tesla (TSLA) experienced close to 750% growth in the past year and currently has a price/earnings ratio of 1,166.3 This extreme growth is based at least in some part in behavioral finance. The stock has been extremely popular and has snowballed to an extreme degree. The company has not created value for itself through capital gain, but rather is relying on consumers to give it value. If we saw an increase in Artificial Intelligence in the stock market, there would be a dramatic decrease in inexplicable events in the market. AI is best used to recognize patterns, anticipate future events, and make sound and informed decision. These abilities make it the 3 https://finance.yahoo.com/quote/TSLA/ perfect technology to use in the financial industry. In the case of portfolio management, AI would be able to identify relationships between securities and market indicators that humans have a hard time making intuitively. Implementation of AI would cause earnings and trends to even out, as there would be less chance for human bias to influence security valuation. The EMH would likely manifest more as all decisions would be based on all currently available information and wouldn’t be informed by emotion. Situations like the current one with Tesla would no longer happen. The market would be less volatile, and everyone returns would standardize to the average market return. Some would see the changes AI would bring as beneficial, and some would see them as negative. Those who passively invest and are satisfied with market returns would likely welcome AI, as there would be less volatility and risk in the market. Those who are more active in their investing strategies would likely be discouraged by AI implantation as there would be fewer mistakes to capitalize on. Those that try to beat the market rely on the ability to pick up on trends and take advantage of them. Humans would likely not be able to compete with AI’s ability to recognize patterns, and so active investors would have less success. The public’s perception of the market would likely change as events like the market crash in 2008, and the crash we saw in March 2020 would likely never happen again. Systemic risk would still exist, but human emotions like panic would no longer exacerbate financial challenges. AI would help to mitigate dips, and so it would be less intimidating for the public to enter the market. Currently there is at least some sense of mystery around the market that dissuades the average person from risking their hard-earned money. It is hard to define any technology as helpful or harmful, as it is just a tool. AI is an incredibly powerful tool that has had and will continue to have drastic effects on different sectors. The financial industry is no different, and his new technology with bring with it many changes.
