Personal Financial
Management
Semester 2 2008 – 2009
Gareth Myles g.d.myles@ex.ac.uk
Paul Collier p.a.collier@ex.ac.uk
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


Marketable



Assets which can be traded
Included here are bonds and stocks
Derivatives


Assets which cannot be sold to someone else (e.g.
bank accounts)
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


Government savings bonds


Royal Bank of Scotland
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
Marketable Assets

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


Selling short: holding a negative quantity of an
asset


This is the typical investment
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
Asset A
B
Rain
8
1
Sun
2
4
Consider the return on a portfolio: 1/3 of
asset A, 2/3 of asset B
Effect of Covariance
Rain
Return
Sun
(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
rp
Efficient Frontier
Asset B only
r mvp

Asset A only
 mvp
p
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 assetspecific risk

Beta
Return on
Asset
Return on
Asset
A risk-free asset
has a b of 0
The slope of
this line is b
for the asset
Return on
Market
Introducing b
Return on
Market
Risk-free Asset
Beta
Return on
Asset
Return on
Asset
The b of this
asset is less
than 1
45o
The b of this
asset is more
than 1
45o
Return on
Market
Defensive Asset
Return on
Market
Aggressive Asset
Company Betas
Company
Beta
AstraZeneca
0.8573
Barclays Bank
1.5259
BP
1.0082
HSBC Holdings
0.6071
Imperial Tobacco
0.5053
Portfolio Return and Risk
Let X i be the proportion of asset i in the
portfolio
 Portfolio return is r  X1r1  X 2 r2    X n rn
 The b of the portfolio is
b  X1b1  X 2 b 2    X n b n

The portfolio variance is
2
2 2
2
  b M e
 So larger b, larger variance

Portfolio Return and Risk
Portfolio
Return
Market
Return
Choice of
efficient
portfolios
Risk-free
Asset
b=1
Portfolio b
Idiosyncratic Risk

What has happened to the idiosyncratic
risk (risk not due to market)  e2 ?
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 b
 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)
