Basics of Investment

(Part-II)
Instructor:

Md. Thasinul Abedin

MBA(AIS,DU), BBA(AIS,DU)

Lecturer, Department of Accounting

Faculty of Business Administration
University of Chittagong
Portfolio?
 A portfolio is a grouping of assets (Financial or Real or In
combination).
 Portfolios are held directly by investors and/or managed by
financial professionals (For example, the fund managers).
Portfolio Management
 Portfolio management refers to the professional management of
securities and other financial assets or real assets. Also referred to
as “asset management” and “wealth management”.
 More specifically, Portfolio management includes a range of
professional services to manage an individual's and company's
securities, such as stocks and bonds, and other assets, such as real
estate.
 Portfolio management is executed in accordance with a specific
investment goal and investment profile and takes into
consideration the level of risk, diversification, period of
investment or maturity etc.
Portfolio Management Process
The process of managing an investment portfolio never stops. Once the
funds are initially invested according to the plan, the real work begins in
evaluating the portfolio’s performance and updating the portfolio
based on changes in economic environment and the investor’s needs.
Steps in Portfolio Management Process
1. Construction of a Policy Statement.
2. Examine current and projected financial, economic, political,
and social conditions.
3. Implement the plan by constructing the portfolio.
4. Feedback Loop.
Construction of a Policy Statement
 The first step in portfolio management process for the investor is
to construct a policy statement either alone or with the assistance
of the investment advisor.
 The policy statement is a road map. In it, investors specify the
types of risk they are willing to take and their investment goals
and constraints.
 All investment decisions are based on the policy statement to
ensure that these decisions are appropriate for the investor.
Construction of a Policy Statement (cont..)
 Because the investor needs, goals, and constraints change over
time, the policy statement must be periodically reviewed and
updated.
 It is an invaluable planning tool that will help the investor
understand his or her needs better as well as assist an advisor or
portfolio manager in managing client’s funds.
 Though it does not guarantee investment success, a policy
statement will provide discipline for the investment process and
reduce the possibility of making hasty and inappropriate
decisions.
Construction of a Policy Statement (cont..)
• There are two important reasons for constructing a portfolio
policy statement:
 First, it helps the investor decide on realistic investment
goals after learning about the financial markets and the risks of
investing.
 Second, it creates a standard by which to judge the
performance of the portfolio manager.
Investment Objectives (Goals)
 The investor’s objectives are his or her investment goals expressed in
terms of both risk and return.
 The relationship between risk and return (+ve) requires that goals not
be expressed only in terms of return. Expressing goals only in terms of
returns can lead to inappropriate investment practices by the portfolio
manager such as the use of high-risk investment strategies or account
churning (agitating) which involves moving quickly in and out of
investments in an attempt to buy low and sell high.
Investment Objectives (Goals) (cont…)
 For example, a person may have a stated return goal such as
“double my investment in five years”. Before such a statement
becomes part of the policy statement, the client must become
fully informed of investment risks associated with such a goal.
 A careful analysis of the client’s risk tolerance should precede any
discussion of return objectives.
 Investment firms survey clients to gauge their risk tolerance.
 Sometimes investment magazines or books contain tests that
individuals can take to help them evaluate their risk tolerance.
Investment Objectives (Goals) (cont…)
 Risk tolerance is more than a function of an individual’s
psychological make up. It is affected by other factors, including a
person’s current insurance coverage and cash reserves. Risk tolerance
is also affected by an individual’s family situation (for example,
marital status and the number and ages of children) and by his or her
age.
Investment Objectives (Goals) (cont…)
 Even though a person’s return objective may be stated in terms of
absolute or relative return, it may also be stated in terms of
general goals such as capital preservation, current income, capital
appreciation, or total return.
a. Capital Preservation: Investors want to minimize their
risk of loss, usually in real terms: they seek to maintain the
purchasing power of their investment. In other words, the return
needs to be no less than the rate of inflation. Generally, this is a
strategy for strongly risk-averse investors or for funds needed
in short run, such as for next year tuition payment or down
payment of a house.
 Investment Objectives (Goals) (cont…)
b. Capital Appreciation: It is an appropriate objective when
investors want the portfolio to grow in real terms over time to
meet some future needs. This is an aggressive strategy for
investors willing to take on risk to meet their objectives.
Generally longer term investors seeking to build a retirement or
college education fund may have this plan. Under this strategy
growth mainly occurs through capital gains.
c. Current Income: Investors mainly concentrate generating
income from the portfolio rather than capital gains. This
strategy generally suits investors who want to supplement their
earnings with the income generated by the portfolio to meet
their living expenses.
Investment Objectives (Goals) (cont…)
d. Total return: It is similar as capital appreciation
objective. However capital appreciation objective wants to grow
up capital through the capital gain, the total return wants the
capital grow up by capital gain and reinvesting current income.
Because the total return strategy has both income and capital
gain components, its risk exposure lies between risk of the
current income and capital appreciation strategies.
Investment Objectives (Goals) (cont…)
 Investment Objective: 25 years old [ See: Reily and Brown]
 Investment Objective: 65 years old [ See: Reily and Brown]
Investment Constraints
 Liquidity Needs
 Time Horizon
 Tax Concern
 Legal and Regulatory Requirements
 Unique Needs and Preferences
Note: Investment Objectives and Constraints are the input to the policy
statement.
Evaluating Portfolio Performance
 Select a benchmark portfolio.
 The benchmark may be S&P 500 Index, DSEX, DSE30 etc.
 For example, portfolio return is 10% where the S&P 500 return is
9%. The portfolio has beat or outperformed the market.
A few questions raised to construct a policy
statement
 What are the real risks of an adverse financial outcome, especially in
the short run.
 What probable emotional reactions will I have to an adverse financial
outcome?
 How knowledgeable am I about investments and financial markets?
 What other capital and income sources do I have?
 How important is this particular portfolio to my overall financial
position?
 What, if any , legal restrictions may affect my investment needs?
A few questions raised to construct a policy
statement (cont…)
 How would any unanticipated fluctuations in my portfolio value affect
my investment policy?
Examine current and projected financial,
economic, political, and social conditions.
 In the second step of the portfolio management process, the portfolio
manager studies current financial and economic conditions (interest rate,
inflation, exchange rate, and central bank policies etc.) and forecast
future trends.
 The investor’s needs, as reflected in the policy statement, and financial
market expectations will jointly determine investment strategy.
 Economies are dynamic. They are affected by numerous industry
policies, politics, and changing demographic and social attributes.
Examine current and projected financial,
economic, political, and social conditions (cont..)
 Thus, the portfolio will require constant monitoring and updating to
reflect changes in financial market expectations.
Implement the plan by constructing the
portfolio
 The third step is to construct the portfolio.
 With the investor’s policy statement and financial market forecasts as
input, the advisors implement the investment strategy and determine
how to allocate available funds across different countries, asset
classes, and securities.
 This involves constructing a portfolio that will minimize the investor’s
risk while meeting the needs specified in the policy statement.
Feedback Loop (Continual Monitoring)
 The fourth step in the portfolio management process is the continual
monitoring of investor’s needs and capital market expectations and,
when necessary, updating the policy statement. Based upon all of this,
the investment strategy is modified accordingly.
 An important component of the monitoring process is to evaluate a
portfolio’s performance and compare the relative results to the
expectations and the requirements listed in the policy statement.