Investment and Portfolio Analysis - Essay Example

INVESTMENT AND PORTFOLIO ANALYSIS by Presented to Dr. Due Word Count: 3, 937 Question 1 To value bonds and stocks portfolio managers need to figure out an appropriate required rate of return. The real risk free rate, the inflation one, and “a risk premium” contribute to the needed rate (Reilly and Brown, 2003, p. 394). It is “the risk premium (RP)” that causes “difference in the expected return among” bonds “of the same type” (Reilly and Brown, 2003, p. 394). Therefore, to estimate an appropriate discount rate for valuing a bond an investor can use the marketwide interest rate equal to the yield to maturity of a bond of the respective class and rating as a useful benchmark (Ross, Westerfield and Jaffe 1999, p. 102-103). Such the yields are available for the public. For instance, one can easily find them on the Internet. The characteristics of a bond determine timing and values of associated cash flows. Therefore, an investor can easily discount all cash flows associated with a bond to figure out fairly good estimate of its value. As for the common stocks, the company that issues the stock can invest some portion of its earnings in projects in hope to increase the value of the firm. The rest of the earnings is distributed among the shareholders in the form of dividends. Unfortunately, “the details on forthcoming projects are not generally public information” (Ross, Westerfield and Jaffe 1999, p. 109). Therefore, the patterns of cash flows shareholders receive are not known in advance and can be much more complicated than those bondholders receive. However, a number of techniques for stock valuation were developed. All of them need as input “investor’s required return on the stock” and “growth rate” of one or several indicators of companys performance such as "dividends, earnings, cash flow or sales" (Reilly and Brown, 2003, p. 377). To estimate the first input, investors can use the return of a common stock of the respective class and rating as a useful benchmark (Haugen, 1979, p. 68). Due to above mentioned complexity, accompanied by the fact that the guarantees to the investors in common stocks differ from the ones to the investors in bonds, sometimes these inputs can be estimated only roughly. Moreover, their uncertainties can turn out to be “too large to be practical” (Ross, Westerfield and Jaffe 1999, p. 111). Thus, generally investors produce better estimates of bond values than those of common stock ones. Question 2 To identify appropriate investments, portfolio managers figure out a set of “marketwide and industrywide factors” that makes unsystematic risks of securities to become uncorrelated in the framework of the asset pricing model (ATP) (Ross, Westerfield and Jaffe 1999, p. 284). Using the historical data on the prices of the securities that are available for the general public, investors write the following equation for the part of a stock return that makes a difference in a portfolio composed of a great number of different securities: (1) where is an expected return on the security, is the number of factors in the set, is the difference between the announced value of the factor and its expected value, and is the responsiveness of the chosen security to the value of (Ross, Westerfield and Jaffe 1999, pp 274-285). Moreover, using historical data on the prices of the securities, portfolio managers estimate for every available security on the market where . Then, they construct the Markowitz efficient frontier and assume that it is identical for all investors. The managers draw this frontier with the portfolio standard deviation and the mathematical expectation of its return along the horizontal and vertical axes respectively as shown on fig. 1 and use the current return on UK 3 month Treasury bills as an estimate of the risk free rate. On this figure, Line II is the capital market one. Ross, Westerfield and Jaffe explain that the point A on this figure corresponds to the optimal portfolio of risky assets for the risk levels in the range from the zero one to the one of this portfolio and call it the market portfolio (1999, p. 254). Besides, they explain that combining the riskless investment with the one in the optimal portfolio of risky assets in different proportions, investors can obtain the portfolio that corresponds to any point of the capital market line situated between the intercept of this line with the vertical axis and the point that corresponds to the market portfolio (Ross, Westerfield and Jaffe 1999, p. 254). Moreover, it turns out that every point on the capital market line situated between the point A and the intercept of the capital market line with the vertical axis corresponds to the most appropriate investment opportunity for the level of risk determined by the chosen point (Ross, Westerfield and Jaffe 1999, p. 254). This opportunity consists of the riskless investment and the one in the market portfolio. Fig. 1 (Ross, Westerfield and Jaffe 1999, p. 253). Question 4 Introduction Asset class is a set "of securities that shares similar risk and return characteristics" (Shaw, 2009, p. 1). Consequently, securities from different asset classes "are less than perfectly correlated with each other" (Shaw, 2009, p. 1). Hence, combining them in one portfolio gives rise to diversification effect. The asset class of “cash instruments” includes “certificates of deposit, Treasury bills and money market funds” (Shaw, 2009, p. 1). The one of “fixed income” comprises bonds and bond mutual funds. The equity class includes “stocks and stock mutual funds” (Shaw, 2009, p. 1). Investors use a set of allocation strategies. One of them is “insured asset allocation’. Insured Asset Allocation In this strategy, “an investor adjusts the portfolio’s allocation to stocks in relation to a predetermined portfolio floor value, below which the portfolio should not fall” (Shaw, 2009, p. 2). According to “insured asset allocation”, an investor has to “sell stocks as they depreciate, reducing the allocation to stocks to zero as the portfolio value approaches the floor value” (Shaw, 2009, p. 2). However, this strategy assumes that “the investor will buy more stocks as stocks appreciate and the portfolio rises father above the floor value” (Shaw, 2009, p. 2). Insured asset allocation suits for “an investor who wishes to establish a minimum standard of living during retirement” or pursues similar goals (Van Bergen, 2013). Another asset allocation strategy is the strategic one. Strategic Asset Allocation In this strategy, “the investor establishes target portfolio percentages for each asset class, based on long-term capital market assumptions and the investors long-term attitude towards risk” (Shaw, 2009, p. 2). According to strategic asset allocation, “the investor makes periodic adjustments to restore this targeted portfolio mix as the relative values of the asset classes change with respect to each other” (Shaw, 2009, p. 2). Specifically, “the investor will sell those asset classes that have grown at a slower rate” (Shaw, 2009, p. 2). Although in the framework of the strategic asset allocation "the investor will hold stocks in the targeted proportions regardless of the direction of the market" (Shaw, 2009, p. 2), in reality “a constant mix target allocation can be reviewed periodically and revised to reflect changes in the investors circumstances” (Shaw, 2009, p. 2). Individual portfolio managers often use this strategy because it is fairly simple “and regular rebalancing helps instil discipline” (Shaw, 2009, p. 3). Data on historical performance of various asset allocation strategies suggest that “strategic asset allocation tends to outperform other allocation approaches during an oscillating, sideways market” (Shaw, 2009, p. 3). Among a number of asset allocation strategies there is the tactical one. Tactical Asset Allocation In this strategy, “the investor adjusts the portfolio’s target asset allocation to reflect changes in his/her own shorter-term capital market expectations for the different asset classes” (Shaw, 2009, p. 2). Frequently, “such the adjustments reflect views about future capital market developments that” contradict “mainstream thinking” (Shaw, 2009, p. 2). According to this strategy, the portfolio manager sells securities belonging “to asset classes that have appreciated beyond his/her estimate of fair value and reinvests the proceeds in asset classes he/she estimates are undervalued” (Shaw, 2009, p. 2). This strategy requires “a great deal of expertise and talent in using particular tools for timing” market movements (Van Bergen, 2013). The simplest asset allocation strategy is the “buy and hold” one. Buy and Hold Strategy In this strategy, “an investor determines an initial allocation — for example 40 % cash equivalents and 60 % stocks — and then holds this portfolio throughout market fluctuations, without making adjustments” (Shaw, 2009, p. 2). This approach to asset allocation assumes that “an investor will hold a greater percentage of stocks as stocks appreciate and a smaller percentage of stocks as stocks depreciate” (Shaw, 2009, p. 2). Question 5 For a portfolio manager it is important not only to achieve a high return of his or her portfolio but also to make the risk of this portfolio to be as small as possible. There are three ways to estimate the performance of such the manager. The first one is Treynor measure. To calculate this measure one has to divide the difference between the observed return of the portfolio and the risk free rate by of the portfolio (Pareto, 2012). This is equal to covariance between the return on portfolio and the one on the market divided by the variance of the market. A well diversified portfolio with a high return and small is better than the one with a low return and large . Therefore, if the portfolio is well diversified; then the higher the measure is, the better the portfolio is. However, this measure does not shed light on how good the manager diversified his or her portfolio. Therefore, the poorly diversified portfolio can have fairly high Treynor measure. This drawback is absent in the Sharpe ratio. To calculate this ratio one has to divide the difference between the observed return of the portfolio and the risk free rate by the standard deviation of the portfolio (Pareto, 2012). A portfolio with a high return and small standard deviation is better than the one with a low return and large standard deviation. Therefore, the higher the measure is, the better the portfolio is. The third measure of portfolio performance is as good as the first one. It is the Jensen measure and it assumes that the portfolio is diversified very well. The value of this measure for a portfolio is equal to the difference between the observed return of this portfolio and the expected return on it in the framework of the capital asset pricing model (Pareto, 2012). According to this model, the expected return on the portfolio of securities can be calculated according to the following formula: (2) where is a risk free rate, is an expected return on market, and to calculate one has to divide the covariance between the return on market and the return on portfolio with the variance of the market (Ross, Westerfield and Jaffe 1999, pp. 260-261). Historical data on prices of various securities suggest that (Ross, Westerfield and Jaffe 1999, pp. 260). Therefore, the smaller the value of is, the larger the value of the Jensen measure is. Similarly, the larger the observed return of the portfolio at hand is, the larger the value of this measure is. However, the high values of the Jensen measure do not prevent the portfolios to which they correspond from being poorly diversified. Between the discussed measures of portfolio performance I favour the Sharpe ratio because it is the only measure that can not assign high rating to the poorly diversified portfolio. Questions 6 and 3 Theoretically stock markets can respond to some types of information more quickly than to other ones. Therefore, researchers distinguish three types of efficient stock markets. On a weakly efficient market, traders can not improve performance of their investments basing their decisions on historical stock prices. As for the semi-strong efficiency of the market, it implies that traders can not benefit from the publicly available information. Finally, traders on the strongly efficient market have no chance to improve performance of their investments using any information including the one not available for the general public. From the definition of the semi-strong efficient market, it follows that a portfolio manager working on such the market will do as good as the traders who base their buy and sell decisions on various public announcements. If a portfolio manager adheres to the buy and hold strategy trading on a semi-strong efficient market, he or she will do as good as the traders who base their buy and sell decisions on various public announcements. In recent research Fernandes and Mergulhão have developed a strategy of trading the portfolio of stocks that corresponds to the FTSE 100 Index that outperforms the buy and hold one. This strategy assumes the usage of publicly available information “to anticipate the outcomes of the FTSE committee review”. Results of “the out-of-sample analysis” point out “that such a trading strategy easily outperforms a passive strategy that tracks the FTSE 100 index even after controlling for transaction costs in a very conservative manner” (Fernandes and Margulhão 2011, p. 26). Since FTSE 100 “represents the major companies from UK” (Konak and Seker, 2014, p. 30), this result suggests that UK stock market, as well as any other developed market, is not semi-strong efficient. However, this result can be a consequence of the impropriate linkage between the publicly available information used and the trading strategy developed. Nevertheless, another result from the study at hand points at the first explanation. Specifically, based on this study one can conduct the following consistency check. Since all information includes the publicly available one, from the fact that the market is not semi-strong efficient, it follows that this market is not strongly efficient too. Therefore, using insider information one can rip off extra profits trading on it. The authors observe above average profits during the time frame “from 44 days before to 22 days after the committee review meetings”. Moreover, “most of the impact is within the pre-event window, with cumulative abnormal returns stabilizing after the announcement” (Fernandes and Margulhão 2011, p. 26). Hence, this brand new strategy produces the same result as insider information in the market that is not strongly efficient. Therefore, no inconsistency arises in this argument. Thus, I consider the UK market as being not semi-strong efficient. As for the US market, there is evidence that “the turn of the month effect” takes place on the US market (Konak and Seker, 2014, p. 29). Therefore, it is likely that the trader on US market can profit using the information about historical stock prices. Since historical stock prices are the subset of the information available for the general public, it implies that the US market is not semi-strong efficient too. Asbell and Bacon provide additional evidence about the fact that US market is not semi-strong efficient (2010). They study the reaction of the US market to “the legal trades by insiders” information about which becomes publicly available on the day of trading (Asbell and Bacon, 2010, p. 174). Asbell and Bacon report that “investors appear to receive the insider purchase news as an opportunity to buy and gain in the future from their investments” (2010, p. 180). Thus, I believe that it is likely that stock markets in the USA and UK are not semi-strong efficient. Asbell and Bacon used the capital asset pricing model (CAMP) to estimate the expected returns for the stocks traded on NYSE and NASDAQ (2010, p. 176-178). Using these estimates they produced evidence that the US market is not semi-strong efficient (Asbell and Bacon, 2010, p. 180). Since there is the research that provides another evidence for this claim (Lakonishok and Seymour, 1988), I believe that a portfolio manager can rely on CAMP to some extent evaluating risks of different common stocks. Question 7 Numerous empirical studies conducted in “70’s provided evidence of market efficiency that offered strong support for the CAMP and the models that followed, such the Arbitrage Pricing Theory and Option Pricing models” (Aguila 2009, p. 53). However, in the second half of 80’s American scholars “began to discover a host of empirical results that were not consistent with the view that market returns were determined in accordance with the CAMP and the efficient market hypothesis” (Aguila 2009, p. 54). Defenders “of Traditional Finance regarded these findings as anomalous and thus called them anomalies” (Aguila 2009, p. 54). Additional evidence challenges the assumption of the modern finance theory that all investors behave rationally. Specifically, it was shown that “while attempting to avoid the pain associated with acknowledgements of their mistakes, people often end up incurring more pain and making themselves worse off” (Aguila 2009, p. 53). Moreover, it was argued that "this non-rational behaviour is not random" (Aguila 2009, p. 53). Besides, in the literature it is suggested “that such counterproductive defensive responses derive from the biological and chemical structure of the brain, and are connected to the brain’s ‘flight or flight’ response” (Aguila 2009, p. 53). Question 8 Variance of historical returns of a stock is defined as a mathematical expectation of the square of the difference between returns in different years of the chosen time frame and the mathematical expectation of this return for this time frame. As for the standard deviation, it is a square root of the variance. It is naturally to assume that the more spread-out the frequency distribution of the historical returns of a stock is, the more uncertain are the values of these returns. Since the distribution of historical returns of commons stocks resembles the normal distribution (Ross, Westerfield and Jaffe 1999, pp. 220), the variance and standard deviation of historical returns of a common stock provides an estimate of the risk of this stock. Covariance between historical returns of two common stocks is defined as a mathematical expectation of the product of the difference between returns of the first common stock and the mathematical expectation of these returns and the difference between returns of the second common stock and the mathematical expectation of these returns. Since the variance of a common stock is an estimate of the risk of this stock, the variance of the portfolio is an estimation of the risk of the portfolio. However, the variance of a portfolio is a linear combination of variances of different stocks and covariances between different pairs of stocks (Ross, Westerfield and Jaffe 1999, pp. 246-247). Since for a large number of stocks in a portfolio net contribution from variances of different stocks to the variance of the entire portfolio vanishes (Ross, Westerfield and Jaffe 1999, p. 248), this contribution can be interpreted as an unsystematic risk of the portfolio. As for the net contribution from covariances between different pairs of stocks to the variance of the entire portfolio, for a large portfolio it can be interpreted as systematic risk. For the following discussion it is convenient to introduce such the notation , (3) where is a return of a security with number in the portfolio, is the return of the portfolio, is a covariance between and , and is the variance of the portfolio. Assuming that the unsystematic risk of the portfolio vanishes, one can write the following: . (4) If investors can not only lend but also borrow at the risk free, then assuming that “all investors possess the same estimates on expected returns, variances, and covariances” one can assert all investors hold “the same portfolio of risky assets” that is called the market portfolio (Ross, Westerfield and Jaffe 1999, p. 255). The of a security is defined as , (5) where is a return of a security with number in the market portfolio, is the return of the market portfolio, is a covariance between and , and is the variance of the market portfolio. From Eqs, (3)-(5) and the fact that the market portfolio is large enough for all unsystematic risk to vanish, it follows that is the contribution of the stock to the variance of the market portfolio. Question 9 Investors estimate values of bonds and preferred stocks through discounting their expected cash flows. The characteristics of these securities determine timing and values of these cash flows. To come up with appropriate discount rates to value bonds and preferred stocks, an investor can use the marketwide interest rates which are equal to the yields to maturity of securities of the respective classes and rating (Ross, Westerfield and Jaffe 1999, p. 102-103). One can easily find these yields on the Internet. As for the common stocks, there are two approaches to value them: “the discounted cash flow valuation techniques” and “the relative valuation techniques” (Reilly and Brown, 2003, p. 377). In the first approach there are three different techniques (see fig. 2) and “the value of the stock is estimated based upon the present value of some measure of cash flow, including dividends, operating cash flow, and free cash flow” (Reilly and Brown, 2003, p. 377). The second approach encompasses four methods of security valuation (see fig. 2). In it “the value of a stock is estimated based upon its current price relative to variables considered to be significant to valuation, such as earnings, cash flow, book value, or sales” (Reilly and Brown, 2003, p. 377). The dividend discount model belongs to the first approach. In this model, an investor has to estimate “the date of first dividend, the growth rates of dividends after that date, and the ultimate merger price” (Ross, Westerfield and Jaffe 1999, p. 114). There are a bunch of companies for which it is difficult to come up with fairly good estimations of these characteristics. An example of such the company is McDonalds Corporation. It paid its first dividend only after 25 years of doing business although it became "a billion-dollar company (in both sales and market value of stockholder’s equity)" much earlier (Ross, Westerfield and Jaffe 1999, p. 114). Figure 2 (Reilly and Brown, 2003, p. 377). “Why did it wait so long to pay a dividend? It waited because it had so many positive growth opportunities, that is, additional locations for new hamburger outlets, to take advantage of. Utilities are an interesting contrast because, as a group, they have few growth opportunities. Because of this, they pay out a large fraction of their earnings in dividends. For example, Commonwealth Edison, Detroit Edison, and Philadelphia Electric have payout ratios of over 90 percent in many recent years ”. (Ross, Westerfield and Jaffe 1999, p. 114-115) Hence, there are companies for which the dividend-growth model can provide estimations of values of shares of their common stock. However, to apply this model an investor has to figure out the return on “currently retained earnings” (Ross, Westerfield and Jaffe 1999, p. 109). It can be a challenge “because the details on forthcoming projects are not generally public information” (Ross, Westerfield and Jaffe 1999, p. 109). However, “the historical return on equity” can serve as a good approximation of the needed value since it is “the return on the cumulation of all the firm’s past projects ” (Ross, Westerfield and Jaffe 1999, p. 109). Unfortunately, sometimes the substitution gives rise to a mistake because “some managers find it emotionally difficult to pay high dividends” (Ross, Westerfield and Jaffe 1999, p. 113). They “enjoy controlling a large company” and reinvest even when the market in the respective industry declines since "paying dividends in lieu of reinvesting earnings reduces the size of the firm" (Ross, Westerfield and Jaffe 1999, p. 113). However, an investor can use “operating free cash flow” discount model to value common stocks of the firm that has too many “high rate of return investment alternatives available” to afford paying dividends if this firm can boast its “diverse capital” structure (Reilly and Brown, 2003, p. 378). In this case, this technique complements the dividend discount one. However, for a firm with a “diverse capital” structure these techniques become competitive if the firm is “a stable, mature entity where the assumption of relatively constant growth for the long term is appropriate” (Reilly and Brown, 2003, p. 378). As for “the relative valuation techniques” (Reilly and Brown, 2003, p. 379), they “are appropriated to consider under two conditions: 1. You have a good set of comparable entities— that is, comparable companies that are similar in terms of industry, size, and, hopefully, risk. 2. The aggregate market and the company’s industry are not at a valuation extreme — that is, they are not either seriously undervalued or overvalued”. (Reilly and Brown, 2003, p. 379) Hence, if these conditions hold for a company with a diverse capital structure, then the relative valuation techniques, as well as the operating free cash flow discount model, are competitive. However, if these conditions hold for a company that has too many very good investments opportunities to afford paying dividends, then the relative valuation techniques complement the dividend discount model. Question 10 Since “dividends can be changed at any time by the company”, an investor places a part of its capital in bond investment to produce a "steady income” (Nelson, 2011). However, there is another reason for investors to prefer bonds over stocks. Although data on historical prices of securities suggest that investing in common stocks performs better than the one in corporate bonds (Ross, Westerfield and Jaffe 1999, p. 221), “in the short run” bonds can outperform stocks (Nelson, 2011). Prices of bonds and interest rates move in opposite directions (Ross, Westerfield and Jaffe 1999, p. 102). Hence, investors should prefer bonds to common stocks when they have evidence “that interest rates will be trending downward” (Nelson, 2011). The rates will do so “when the economy stutters and business revenues and profits dry up, making their stock less valuable” (Nelson, 2011). However, when both stock returns and the bond ones are low, investors expect the increase in the interest rates and do not buy bonds. Moreover, they prefer an "alternative investment" to the one in common stock due to volatility of the latter. It is only when “interest rates rise to some level that can be considered ‘normal’ or otherwise sustainable for an extended period of time”, a financial economist prefers an investment in common stocks to the one in corporate bonds due to better performance of common stocks (Nelson, 2011). Reference List Aguila, N. 2009. Behavioral finance: Learning from market anomalies an psychological factors. Revista de Instituciones, Ideas у Mercados, 50, pp. 47-104. Asbell, D. J. and Bacon, F. W. 2010. Insider trading: A test of market efficiency. [online] ASBBS Available at: [Accessed on 09 May 2014] Blume, M. 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