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Apply risk and return principles to investments.
Develop an overall asset allocation.
Evaluate the factors that enter into investing in financial assets.
Relate financial investing to overall household operations.
Recognize how portfolio management differs from individual asset selection.
Distinguish among investment alternatives.
Utilize leading ways of measuring investment risk.

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The planning system for asset allocation includes the following steps:
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Establish goals.
Consider personal factors.
Include capital market factors.
Identify and review investment alternatives.
Evaluate specific investment considerations.
Employ portfolio management principles.
Implement portfolio management decisions.
Review and update the portfolio.
We will consider each in turn.

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Goals are determined by our needs and the things and activities that we enjoy.
Once we have established our goals we are in position to identify the role savings and investments play in the process.
Investments can be viewed as a delivery mechanism: they help create sufficient assets to fund our goals.
Our investment focus is on the appropriate asset allocation to help meet our goals.

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 Personal considerations include:
– Time Horizon for Investments.
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Liquidity Needs.
Current Available Resources.
Projected Future Cash Flows.
Taxes.
Restrictions: limitations on freedom of choice in investment alternatives or investment practices.
Risk Tolerance: The amount of risk you are willing to undertake.

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 We can group goals for investment purposes into five time horizons:

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We have established the goals and the distinguishing features of individuals.
At the same time, we need to examine the characteristics of the overall financial markets and of the various types of securities likely to be considered for the asset allocation.
We begin by discussing two of the most basic characteristics of finance: risk and return.

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 Return is the total of income and growth of monies invested over a period of time.
Sum of Dividends or Interest Paid
Gain in Principal
Invested
Holding Period
Return (HPR)
Original Cost

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Time-weighted returns give effect to how long you have owned a security and the timing of income payments during that period.
The internal rate of return (IRR) is often used to obtain this return.
By a bond that is expected to be held until it matures, the IRR is also known as the yield to maturity (YTM).

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Risk, is the chance of loss on an investment.
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Types of risk for financial assets:
Market: The risk of a decline in the overall stock or bond market.
Liquidity: The risk of receiving a lower than market price upon sale of your holding.
Economic: The risk of unfavorable business conditions caused by weakness in the overall economy.
Inflation: The risk of an unexpected rise in prices that reduces purchasing power.
(Continues next slide).

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Political: The risk of a change in government or governmental policy adversely affecting operations.
Regulatory: The risk of a shift in regulatory policy impacting activities.
Currency: The extra risk in international activities arising from currency fluctuations.
Technological: The risk of obsolescence of a product line or inputs in producing it.
Preference: The risk of a shift in consumer taste.
Other Industry: The risks other than the ones given above that affect companies in an industry.
Company: The operating and financial risks that apply to a particular firm.

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The wider the fluctuations around its average price, the greater the stock’s risk.
The most common measurement of price fluctuation is the standard deviation.
Hence, stocks can have identical mean returns and different risks:
Stock Price Company A
Company B
Time

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The capital asset pricing model (CAPM) is a specialized modern investment theory model that is based on risk-return principles.
Under the CAPM, risk is measured using price change of a security relative to a benchmark’s price performance.
The benchmark for large company stocks is usually the S&P 500, the Standard and Poor’s index of the
500 largest companies in the United States.

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The CAPM risk measurement is the beta coefficient.
The greater the price fluctuation of a security relative to the benchmark’s movements, the greater the security’s beta coefficient.
The benchmark is automatically given a beta of 1 and stocks or mutual funds of stocks having a beta coefficient of greater than 1 are deemed to have more risk than the market, while those having a beta of less than 1 have below average risk.

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The beta coefficient measures systematic risk.
Systematic risk : The risk of overall market factors.
Unsystematic risk : Risk related to an individual company.
CAPM says individual company risk can be diversified away when you hold a large portfolio of securities.
Therefore, CAPM says that all you need to know is systematic risk as measured by the beta coefficient.

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Expected Rate of Return
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Risk-Free Rate Risk Premium
Risk premium : The extra return that compensates you for the additional amount of risk you are taking with a particular security over a completely safe one.
The risk-free rate is the rate of return you require even if there is no risk. The yield on 30-day U.S.
Government Treasury Bills is generally used.

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 The more risky the security, the greater the risk premium and the greater the expected or required rate of return.

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The Efficient Market Hypothesis (EMH) says that the best valuation for an individual security is its current market price.
A major conclusion of the EMH is that it will not be profitable to attempt to outperform the market.
Even if there are those not fully informed or capable of appraising shares, and their actions could create particularly appealing prices, other investors would quickly step in to take advantage.
By doing so these investors would eliminate any above-average profit opportunities.

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The Efficient Market Hypothesis, cont.
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Three forms of the EMH:
The Weak Form: Looking at current and past information on stock price patterns and the number of shares traded is not useful.
The Semi-Strong Form: All publicly available information is incorporated in a stock’s price. The
Strong Form: The share prices fully reflect both public and private information.

Mean Reversion and Efficient Markets
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Mean reversion : Returns for securities tend to move toward average performance when returns are examined over longer time frames.
Therefore, if securities underperform for a period, they may be more likely to outperform later on.
When their results are highly favorable for a period of time, they can be vulnerable to poor returns in the period beyond.
Thus, in contrast to efficient markets beliefs, future stock price movements may be somewhat predictable.

Identify and Review Investment
Alternatives
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Bonds
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Bonds: Contracts in which an investor lends money to a borrower. As compensation for receiving the money, the borrower agrees to pay interest.
Maturity date : The date that the loan is to be repaid.
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Bonds are relatively safe investments as:
The annual income is generally fixed in advance.
The principal is likely to be fully repaid on the stated date.
The company will be faced with bankruptcy if it defaults, at which time bondholders have priority in receiving the proceeds from liquidation of business assets.

Identify and Review Investment
Alternatives, cont.
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Common Stocks (Equities)
 A common stockholder is an owner, and is entitled to participate in the current profits and anticipated future growth of the enterprise.
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Stocks present potentially higher returns than bonds, but the shareholder must be prepared to take greater risk.
We categorize common stocks based on relative growth rates, sector and industry, geographic area, company size, and quality.

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Identify and Review Investment
Alternatives, cont.
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Relative Growth Rates
Growth stocks : Companies that grow more rapidly in sales and earnings than the overall economy and are less affected by cyclical business conditions.
Defensive stocks : Companies that generally grow at average or below-average rates but are also less affected by business conditions .
Cyclical stocks: Firms whose growth rates are at or below those for the overall economy but whose operations are highly sensitive to aggregate business conditions.

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Identify and Review Investment
Alternatives, cont.
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Sector and Industry
Economic sectors include basic materials, capital goods, consumer cyclicals, consumer noncyclicals, energy, financial, healthcare, services, technology, transportation, and utility.
Each sector, in turn, is divided into a number of industries.
For example, consumer cyclicals would include among others autos, consumer appliances, and retail chains.
Since sectors tend to share some similar characteristics, some active managers use these categories and industries to decide which areas to over- or underemphasize.

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Identify and Review Investment
Alternatives, cont.
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Geographic Area
One may wish to invest in faster-growing sections of the
U.S. or in parts of the world that present potentially more rapid growth rates than the U.S.
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Company Size
Larger companies are generally more secure, often having entrenched positions in major markets.
Smaller companies can be more flexible since they may have more entrepreneurial management, but may be risky.
Medium sized companies are a blend of the previous two.

Identify and Review Investment
Alternatives, cont.
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Quality
Quality measure how confident we are that the anticipated prospects for a company will be fulfilled.
High quality ( blue chips ) companies are likely to be large and have a strong position in their markets.
Often they have good returns on investment and are less likely to have large noneconomic related disappointments in earnings.
Speculative investments are companies whose operations are less predictable, their profitability more precarious with current or potential losses possible.
Sometimes these companies have a large amount of debt in relation to the value of their equity.

Identify and Review Investment
Alternatives, cont.
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Mutual Funds
C ombine stock or bond assets for investors who receive centralized administration and investment management.
Year
Industry Net Assets
(billions of dollars)
Total Number of
Funds
1970
1975
1980
1985
1990
1995
Stock Funds
45.1
37.5
44.4
111.3
239.5
1,249.1
Bond Funds
2.5
4.7
14.0
122.7
291.3
598.9
Total
47.6
45.9
134.8
495.4
1
1,065.2
2,811.3
2000 3,961.9
811.2
6,964.7
2004 4,384.1
1,290.3
8,106.9
1 Hybrid and money market funds are also included in total.
Source: Investment Company Institute, Mutual Fund Fact Book 42 nd ed.
361
426
564
1,528
3,079
5,725
8,155
8,044

Identify and Review Investment
Alternatives, cont.
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Mutual Funds, cont.
Mutual fund characteristics include strengths and weaknesses.
 Strengths:
Expertise.
Low Cost.
Diversification.
Low Minimum Investment.
Professional Recordkeeping.
General Information.
Safety.
Reinvestment and Payout.
Daily Pricing.
 Weaknesses:
Cost. Performance. Tax. Liquidity.

Identify and Review Investment
Alternatives, cont.
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Mutual Fund Classification System
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Size: Small, medium, and large size categories, based on the overall stock market worth of the companies in the mutual fund.
Smaller capitalization companies provide greater potential returns, but also have greater risk.
Larger capitalization companies have more consistency of performance and lower company fundamental and stock market risk.
Medium capitalization companies provide a blend of the other two categories.

Identify and Review Investment
Alternatives, cont.
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Mutual Fund Classification System, cont.
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Investment Style: Growth, value, and blend.
Growth style of investing involves selecting companies that are expected to have rapid growth in revenues and earnings per share.
Value style of investing emphasizes price in making purchase decisions. The manager looks for companies that are out of favor or otherwise mispriced in relation to their outlook for earnings growth.
The blend category may entail a manager who moves from value to growth style or buys a mix of the two, or a style of investing that cannot be defined in value or growth terms.

Evaluate Specific Investment
Considerations
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Passive approach to investing: No attempt is made to receive greater than market returns.
Proponents believe efforts can better be used to diversify in order to reduce risk and keep costs low.
Passive investors tend to purchase index mutual funds of all types.
Active approach to investing: changes are made in holdings over time to take advantage of new opportunities. Based on the belief that it is possible to outperform the market.

Evaluate Specific Investment
Considerations, cont.
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Individual securities purchased by the household involve no fund-overhead expenses and allow one to buy and sell for tax planning purposes.
Mutual funds offer professional advice at reasonable cost, the ability to delegate the investment management and recordkeeping function, and simple diversification with low investment minimums by specialists.
Although there are notable exceptions, the majority of mutual funds underperform the market.

Employ Portfolio Management
Principles
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Portfolio : a grouping of assets held by an individual or a business.
A portfolio is more than the sum of its parts because the individual assets are often related to each other.
A portfolio that holds a diversified grouping of assets can be said to be attractively balanced and not easily influenced by events other than those that affect overall markets.
Under portfolio theory we strive to achieve the highest return we can, given the risk we are willing to undertake.

Employ Portfolio Management
Principles, cont.
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Portfolio return is the sum of the returns for each security multiplied by the weighting it has in the portfolio.
The correlation coefficient measures the degree to which investment in a portfolio is related to other investments in that portfolio.
By reducing correlations we lessen price fluctuations and overall risk in the portfolio.
Under Markowitz, forecasts of return, risk, and correlation are combined to form what is called the mean-variance model.

Employ Portfolio Management
Principles, cont.
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Total Portfolio Management (TPM) is a model of the individual household.
It proposes that households make investment decisions based not only on marketable financial securities but on all assets that it possesses.
Under TPM, all household assets interact and their correlations are taken into account.
Investment decisions that are made incorporate individual asset returns, risks, and the degree to which they are correlated.

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Implement Portfolio Management
Decisions
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We implement portfolio management decisions through the following steps:
Establish an active or passive management style: Active management requires belief that changes can add to portfolio performance. Passive management makes no attempt to anticipate future events.
Construct a strategic asset allocation: the normal portfolio makeup over the longer term
Develop a tactical asset allocation: modifies the breakdown of the portfolio to attempt to profit from current circumstances.

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Implement Portfolio Management
Decisions, cont.
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Select individual assets: the goal is to select the assets that provide the highest returns for the overall risk taken.
Finalize and implement the portfolio: Questions to ask include:
 Is the portfolio consistent with the overall tolerance for risk?
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Can risk be reduced with little sacrifice in return?
Am I properly diversified and will my portfolio produce attractive returns?

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Review and update the portfolio
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As time moves on, the economic outlook and relative valuations change, as do household circumstances.
Both passive and active investors must take into account current actual allocations relative to strategic ones and consider making changes.
Active investors may want to purchase newly attractive securities and sell old ones that no longer fit performance requirements.

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Review and update the portfolio, cont.
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A performance evaluation should answer the following questions:
How did I do?
What were the reasons for the under or overperformance?
What can I do to improve future performance?
The evaluation should also be done when examining a potential future holding, as, for example, a mutual fund.

Chapter Summary
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Financial assets consist primarily of stocks, bonds, and mutual funds.
Having an appropriate asset allocation is the goal of most investors.
Important personal factors in asset allocations include time horizon, liquidity needs, available current resources, projected future resources, taxes, restrictions, and risk tolerance.
Risk and return are a basic finance concept. In theory the two factors move in proportion.

Chapter Summary, cont.
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A securities’ expected rate of return includes the risk free rate plus a risk premium.
The efficient market hypothesis indicates that efforts to systematically outperform the market will be unsuccessful.
Mean reversion indicates that there may be patterns in stocks that can lead to outperformance.
Portfolio management looks at all financial investments overall in making decisions, and the
Markowitz approach includes correlations among them.

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Chapter Summary, cont.
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Total Portfolio Management incorporates all assets and liabilities and includes correlations in its riskreturn framework.
A strategic asset allocation looks at investment policy over the long term while at tactical one makes cyclical changes based on opportunities at the time.