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Contemporary Investments: Chapter 20 Chapter 20 BUILDING AND MANAGING AN INVESTMENTPORTFOLIO What is the process of building and managing an investment portfolio? How is an investment policy developed? How do capital market assumptions affect the investment process? What is asset allocation? What does monitoring a portfolio involve?

Chapter 20 BUILDING AND MANAGING AN INVESTMENTPORTFOLIO

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Chapter 20 BUILDING AND MANAGING AN INVESTMENTPORTFOLIO. What is the process of building and managing an investment portfolio? How is an investment policy developed? How do capital market assumptions affect the investment process? What is asset allocation? - PowerPoint PPT Presentation

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Page 1: Chapter 20 BUILDING AND MANAGING AN INVESTMENTPORTFOLIO

Contemporary Investments: Chapter 20

Chapter 20 BUILDING AND MANAGING AN

INVESTMENTPORTFOLIO• What is the process of building and

managing an investment portfolio?

• How is an investment policy developed?

• How do capital market assumptions affect the investment process?

• What is asset allocation?

• What does monitoring a portfolio involve?

Page 2: Chapter 20 BUILDING AND MANAGING AN INVESTMENTPORTFOLIO

Contemporary Investments: Chapter 20

Constructing and managing an investment portfolio

• Investment policy

– Investment objectives

– Investment constraints

– Preferences

• Formulating financial market expectations

Page 3: Chapter 20 BUILDING AND MANAGING AN INVESTMENTPORTFOLIO

Contemporary Investments: Chapter 20

Constructing and managing an investment portfolio-Cont.

• Portfolio construction

– Strategic asset allocation

– Tactical asset allocation

• Portfolio monitoring

Page 4: Chapter 20 BUILDING AND MANAGING AN INVESTMENTPORTFOLIO

Contemporary Investments: Chapter 20

Figure 20.1 – An Outline of Portfolio Construction and Management Process

Page 5: Chapter 20 BUILDING AND MANAGING AN INVESTMENTPORTFOLIO

Contemporary Investments: Chapter 20

Developing an investment policy• Differences between individuals and

institutions

– Time horizon

– Changes in investor characteristics

– Risk and behavior

– Reasons for investing

– Regulatory and legal constraints

– Taxes

Page 6: Chapter 20 BUILDING AND MANAGING AN INVESTMENTPORTFOLIO

Contemporary Investments: Chapter 20

Formulating investment objectives

• The three objectives– Growth in capital

– Preservation of capital

– Current income

• Prioritizing these objectives

• Real life examples– Mark’s retirement

– Kim’s daughter’s college education

Page 7: Chapter 20 BUILDING AND MANAGING AN INVESTMENTPORTFOLIO

Contemporary Investments: Chapter 20

Constraints

• Definition

• Time horizon

• Liquidity needs

Page 8: Chapter 20 BUILDING AND MANAGING AN INVESTMENTPORTFOLIO

Contemporary Investments: Chapter 20

Constraints –Cont.

• Taxes– Capital gains are taxed at a lower rate than

ordinary income

– Only realized capital gains are taxed

– Retirement plans offer substantial tax benefits

– Estate tax rates are higher than income tax rates

• Regulatory and legal constraints

• Special needs, circumstances and goals

Page 9: Chapter 20 BUILDING AND MANAGING AN INVESTMENTPORTFOLIO

Contemporary Investments: Chapter 20

Financial market expectations

• Macro-expectations– Based on the historical record

– Stocks have outperformed bonds and cash investments by substantial margins

– Stock returns have exhibited much more year-to-year variability than other investment returns

– Much of the variability in stock returns has disappeared over longer holding periods

Page 10: Chapter 20 BUILDING AND MANAGING AN INVESTMENTPORTFOLIO

Contemporary Investments: Chapter 20

Figure 20.2 – The Growth of a $1,000 Investment, 1925-2001

Page 11: Chapter 20 BUILDING AND MANAGING AN INVESTMENTPORTFOLIO

Contemporary Investments: Chapter 20

Some observations

• Stocks are better long-term investments than other financial assets

• Long-term returns are far more predictable (or less uncertain) than short-term returns

• The historical record is just that, a record of what happened

Page 12: Chapter 20 BUILDING AND MANAGING AN INVESTMENTPORTFOLIO

Contemporary Investments: Chapter 20

Financial market expectations - Cont.

• Micro-expectations

– Definition

– Based on the historical record

–Micro-expectations are more difficult

Page 13: Chapter 20 BUILDING AND MANAGING AN INVESTMENTPORTFOLIO

Contemporary Investments: Chapter 20

Figure 20.3 – Returns from Large- and Small-Company Stocks

Page 14: Chapter 20 BUILDING AND MANAGING AN INVESTMENTPORTFOLIO

Contemporary Investments: Chapter 20

Asset allocation

• Types of asset allocation decisions

– Strategic asset allocation

• Based on objectives, return requirements, time horizon and risk preferences

• Role of macro and micro-expectations

– Tactical asset allocation

–Which is more important

Page 15: Chapter 20 BUILDING AND MANAGING AN INVESTMENTPORTFOLIO

Contemporary Investments: Chapter 20

Asset allocation - Cont.

– Life cycle approach to asset allocation

– Diversification and portfolio optimization

Page 16: Chapter 20 BUILDING AND MANAGING AN INVESTMENTPORTFOLIO

Contemporary Investments: Chapter 20

Figure 20.4 – A Simple Model of

Asset Allocation

Page 17: Chapter 20 BUILDING AND MANAGING AN INVESTMENTPORTFOLIO

Contemporary Investments: Chapter 20

Investment Insight – Some Suggested Retirement Portfolios

Page 18: Chapter 20 BUILDING AND MANAGING AN INVESTMENTPORTFOLIO

Contemporary Investments: Chapter 20

Figure 20.5 – Efficient Frontier: Combinations of Large Stocks, Small Stocks, Bonds, and Bills

Page 19: Chapter 20 BUILDING AND MANAGING AN INVESTMENTPORTFOLIO

Contemporary Investments: Chapter 20

Monitoring portfolios

• Active versus passive management

• Changes in investor circumstances– Getting older

– Increases in wealth

– Change in family status

• Rebalancing

• Performance measures and evaluation