Investment and Portfolio Analysis - Assignment Example

INVESTMENT AND PORTFOLIO ANALYSIS By of the of the School An investor in bonds can more confidently value their investments than an investor in common stock. Discuss. Bonds can be confidently valued because of the following reasons. The first reason is that bonds are safe and reliable hence they have all the material facts required in the valuation process since their terms are publicly available to the investors unlike the information on stocks (Johnson, 2010, pg. 470). The second reason is that the investor is assured of face amount repayment at the maturity time. Further, there is assured interest payment. Lastly, it is easier to value a bond because of the predictability of the terms of the contract unlike stocks which has no predictable dividend payment. Dividend is only paid when the company makes a higher profit and the board of directors feels that they should reward stockholders (Reilly & Brown, 2012, pg. 330-340). Bonds can therefore be confidently valued because they have stated return which is usually printed right on the bond unlike stocks that no stated return. Bondholders have a prior claim in the company’s assets than the stockholders in case the company goes belly-up (Johnson, 2010, pg. 470). The stock market is highly volatile, four times that of bond market, for instance, results provided by SCHWERT (1989, 1990) and REILLY, WRIGHT, and CHAN (2000) outlines that the US stock market volatility is about three times that of the bond market. 2. Explain in your own terms how the Markowitz efficient frontier might help a portfolio manager identify appropriate investments. Basically different securities combinations produce different levels of return. The best of the combinations are represented by efficient frontier. These are those combinations that results to maximum expected return for a given risk level (Fabozzi & Markowitz, 2011, PG. 324). Markowitz assumes that portfolios can be constructed from the efficient frontier line which is capable to generate a maximum return. For an investor to identify an appropriate investment, the stocks’ risk, standard deviation and expected return are plotted on a curve(Fabozzi & Markowitz, 2011, PG. 126). The efficient frontier line is the traced. All the investments that lie on the line are then selected to form a highly diversified portfolio hence ensuring that high return is achieved. Every point on the efficient frontier can be used to construct all available portfolios that have the return and expected risk that are desirable (Guerard, 2012, pg. 177). The most important factor in the efficient frontier is the securities’ relationship with each other. Those securities whose prices move in the opposite directions are the identified and then adopted because they can be diversified, that is, the lower the securities’ covariance, the lesser the securities’ risk (standard deviation). The diminishing risk marginal return leads to a curved efficient frontier, implying that when a unit of risk is added, the gains in portfolios become smaller and smaller (Guerard, 2012, pg. 177). The Markowitz efficient frontier has the power of diversification hence allowing portfolio managers to select a well diversified portfolio which considerably reducing the level of risk. It provides the investors with an opportunity to choose those portfolios that have low risk but will generate the greatest possible returns, i.e. investors seek out those portfolios that lie on the efficient frontier (Guerard, 2012, pg. 177). 3. Does the Capital Asset Pricing Model provide an adequate measure of risk for the portfolio manager? CAPM is used in describing the relationship that exist between the expected return and risk and is therefore used in the risky asset pricing. This model has however been criticized due to a number of limitations which makes it applicability impossible. This therefore makes it inadequate to measure the risk for the portfolio for a manager (Pandey, 2011, pg. 99-100) The Capital Asset Pricing Model is usually based on a given number of assumptions that are not realistic in real life situations. The model assumes an existence of a risk free asset. This given assumption is far from reality because even the highly liquid short term government securities have an element of risk due to inflation which basically causes unpredictability about the risk and future rate of return (KüRschner, 2008, pg. 8). The second assumption is that all assets are marketable and perfectly divisible. This is not true because the human capital is usually not divisible. Further, the model assumes that expectations about the future expected returns are homogenous (KüRschner, 2008, pg. 8). Investors hold securities for different reasons. The next assumption is that the borrowing and the lending rate are equal. However, in practice these rates normally differ. Finally, the model assumes a normally distributed asset returns, which is also far from reality (Pandey, 2011, pg. 99-100). The second weakness is that the Capital Asset Pricing Model is basically a single period model hence only looks at year end return and not a multiple period measurement. It is not possible to estimate the expectations of the investors because it is not possible to empirically test the CAPM. The model further assumes that the required rate of return of securities is only based on one factor, beta. However, factors like relative sensitivity to dividend payout and inflation also influences the relative return of a security to other securities (KüRschner, 2008, pg. 8). 4. Describe briefly the four main asset allocation strategies and discuss the merits of each. Integrated Asset Allocation This method considers both risk and economic expectations when an asset mix is established (Isbitts, 2010, pg. 96). Hence takes into account aspects of all strategies including accounting for capital market actual changes and the risk tolerance unlike other strategies that only take into account future market returns expectations (Hinz, 2010, 98-101). Merits i) Includes not only risk and economic expectation but also the actual changes that occur in the market. ii) It is a broader strategy for allocating assets since it takes into account a variety of factors. iii) It accounts for the risk tolerance of an investment Insured Asset Allocation A base portfolio value is established that shows the lowest value that the portfolio should not drop below (Isbitts, 2010, pg. 96). An active management is exercised so that the portfolio value is tried to be increased if the portfolio return achieved is above the base established. To fix the base value in case the portfolio drops to the base, one needs to invest in risk free assets (Hinz, 2010, 98-101). Merits i) Suitable for the investors who are risk averse. ii) Establishes flow through which a portfolio can be appreciated. iii) Ideally suit those with management goals such as a give living standard during retirement. Strategic asset allocation This is strategy requires that the target allocation is set and then the portfolio is rebalanced periodically back to the set target when the returns on investment skew the originally set asset allocation percentage (Collins & Fabozzi, 1999, pg. 143). Merits i) Allows for continuous rebalance of portfolio targets in case the client’s goals or needs change. ii) Provides an opportunity of buy and hold then sell when returns increase. iii) Assesses risk tolerance level of an investors (Isbitts, 2010, pg. 99). Tactical Asset Allocation This is a flexible and moderately active strategy that allows an investor to tactically deviate from the asset mix in short term basis in order to capitalize on the exceptional or unusual investment opportunities (Hinz, 2010, 98-101). Merits i) Less rigid than other models allowing for tactical deviations ii) One returns to the asset mix when the desired profits are achieved in the short term. iii) One takes part in economic conditions that are more favorable for a give asset class than for others (Isbitts, 2010, pg. 100). 5. Discuss the range of portfolio performance measurements available to portfolio managers. What are the major differences and what do you think should be the most appropriate measure to evaluate performance. Treynor Measure This measure was advanced by Jack L. Treynor and it includes risk in the measurement process. It therefore applies to all investors irrespective of their preferences for personal risks. It proposes that there are two risk components: those from individual securities fluctuations and those from fluctuations in the market (Knight & Satchell, 2002, pg. 119). He introduced the security market line concept whose slope measures the relative volatility of between the market and the portfolio, as indicated by beta. Greater slope of the line shows better tradeoff between risk and return (Christopherson et al 2009, pg 6-13). The Treynor measure= (Portfolio Return – Risk-Free Rate) / Beta. Numerator shows risk premium while the denominator shows the portfolio risk. The higher the measure, the better the portfolio. Unsystematic risk is not considered by this measure because it uses systematic risk only, making it more preferred by those investors with diversifiable portfolios. Sharpe Ratio This measure use standard deviation to measure risk instead of beta which only uses systematic risk. The Sharpe ratio = (Portfolio Return – Risk-Free Rate) / Standard Deviation. This measure evaluates portfolios using both the diversification and the rate of return hence taking care of both systematic risk and unsystematic risk unlike Treynor which only uses systematic risk (Knight & Satchell, 2002, pg. 117). By accurately taking the portfolio risk into account, the Sharpe ratio is more appropriate for portfolios that are well diversified. This approach selects a portfolio with risk-adjusted return that is most superior instead on one with highest return. Jensen Measure This measure is also based on the CAPM. It is also called alpha and it measures the excess returns generated by the portfolio over its expected return. it indicates how much of the rate of return of a portfolio that can be attributed to the ability of the manager to deliver the above-average returns, that is adjusted for the market risk. Better risk adjusted returns is indicated by higher ratio. Positive alpha shows a positive excess return while a negative one indicates a negative excess returns (Christopherson et al 2009, pg 6-13). Jensen\s Alpha = Portfolio Return – (CAPM) Benchmark Portfolio Return Where: (CAPM) = Rf + Beta (Market return – Risk-Free Rate of Return) In my view the best portfolio measurement technique is Sharpe because it takes into consideration both systematic and unsystematic risk. Further, it accurately takes the portfolio risk into account hence the more appropriate for portfolios that are well diversified. Finally, the ratio selects a portfolio with risk-adjusted return that is most superior instead on one with highest return. The main difference between Jensen measure and Treynor and Sharpe’s measures is that Jensen’s alpha basically calculate risk premium normally in terms of beta hence assuming that the portfolio is adequately diversified. Conversely, both the Sharpe and the Treynor measures examine the average returns on an investment for the total period being considered by looking at all variables in the formula (Knight & Satchell, 2002, pg. 117). 6. In your opinion, are markets in the UK and US semi-strong efficient? Discuss with reference to the empirical studies which challenge this. The semi-strong is a basic form of efficient market hypothesis implying the market is efficient, hence able to reflect all the publicly available information. The main basic assumption made by this hypothesis is that the stocks are able to quickly adjust to absorb this new information available to the public (Barnes, 2009, pg 47-50). Considering the above information in relation to the UK and the US market, it is right to conclude that the markets are semi-strong. A more efficient market has a lower cost of transaction in a market especially the cost of trading and obtaining the information. For instance in the United States, it is relatively cheap to obtain a reliable information about the companies hence cheap trading in securities (Barnes, 2009, pg 49). This cheap obtaining of information is partly due to the mandated disclosure and partly due to the provision of technology of information (Barnes, 2009, pg 47-50). The same study about the UK market indicates the same characteristics as those of the US market. The above reasons places both the UK and the US market in the semi-strong form off efficient market hypothesis (Barnes, 2009, pg 51). This makes them to be relatively efficient because by using fundamental analysis the investors cannot achieve the excess returns (Barnes, 2009, pg 48). The empirical studies provided by the Action Forex which was conducted on capital markets by Firth (1976, 1979 and 1980) especially on the UK and US, indicated that these markets are semi-strong because the share prices adjust themselves fully and instantaneously to the correct levels (American Finance Association, 1979, pg. 839). This is a clear indication that both the markets are semi-strong in nature with regards to efficient market hypothesis, EMH. Further, an empirical studies conducted on both capital markets in 2004 indicates the same findings. The stokcs prices adjust instantly when new information is presented hence reflecting all available information. In addition, fundamental analysis does not provide excess returns in the markets (Park and Irwin, 2004, pg. 7) 7. Explain why proponents of behavioral finance regard modern finance theory as being somewhat incomplete. Behavioral finance is a financial field that basically proposes theories that are psychology-based in explaining the stock market anomalies. The assumption made here is that characteristics of the participants in the market and the information structure systematically influence the investment decisions of individuals as well as the market outcomes. The proponents of this theory regard modern finances as incomplete because, behavioral finance addresses certain anomalies that are not fully addressed by the later theory (Hens & Bachmann, 2008, pg 59). Modern financial theory indicates that the world and the participants are rational wealth maximizers. However, people tend to behave in irrational and unpredictable ways because their decisions are influenced by their psychology and emotion. Due to these anomalies, the behavioral finance tries to combine cognitive psychological and behavioral theory with convectional finance and economics in order to provide explanations why people normally make these irrational financial decisions (Hens & Bachmann, 2008, pg 65). The first anomaly that is solved by behavioral finance is the January effect. This anomaly indicates that monthly average returns for smaller firms are consistently higher in January than other months. This is in contrary to the efficient market hypothesis which shows that the stocks should basically move at a "random walk". This is not the case since the said stocks follow a consistent pattern implying that this regular pattern is caused by some other unconventional factor and not by random-walk process. The probable factor is that investors sell loser stocks in December so that they can lock in tax losses making the stocks to have a bounce back in January (Hens & Bachmann, 2008, pg 67). In bidding process it is assumed that bidders are rational enough to be aware of the asset’s true value hence have an access to the same relevant information to arrive at the same valuation, a case which is not possible since some bidders quote higher prices. This implies that some factors that are not directly given asset affect the bidding (Hens & Bachmann, 2008, pg 69). These factors include the number of bidders and the bidding aggressiveness. The two examples indicate that the modern theory is incomplete compared to behavioral finance. 8. Explain the concepts of systematic and unsystematic risk, variance, covariance, standard deviation and beta as each of these relate to investment management. Systematic risk also known as market risk or undiversifiable risk or volatility is the risk that is usually inherent to the whole market or an entire market segment. This kind of risk normally affects the entire or the overall market and not just one industry or stock. It is normally impossible to avoid because it is unpredictable. It can be mitigated by employing an asset allocation strategy that is right or through hedging. Unsystematic risk which is also known as residual risk or specific risk or nonsystematic risk or diversifiable risk. It is normally an industry or company specific hazard which is usually inherent in each investment and can be mitigated through diversification (Reilly & Brown, 2012, pg. 69). Variance is measurement that shows the range between the numbers in a set of data. It measures how far each of the numbers in the given set are from the mean. It is calculated by squaring the differences between the numbers in the given set and their respective means. The sum of these squares is then divided by the values number in the set. Covariance measures the degree to which the returns on any two risky assets move in a tandem. When the assets move inversely, the covariance is negative while a positive one imply that the return on assets move together (Reilly & Brown, 2012, pg. 78). Standard deviation measures the dispersion of a given set of data from its mean. It is usually the square root of the variance. The greater the spread, the higher the deviation from the mean. It is normally applied in the measurement of investments’ volatility. Beta also known as beta coefficient is the measure of the systematic risk or volatility of a portfolio or a security in comparison to the whole or entire market (Reilly & Brown, 2012, pg. 88). 9. Discuss the security valuation techniques available to investors; are these approaches competitive or complementary? DCF technique This is a valuation method that is used in the estimation of how an investment opportunity is attractive. Discount Cash Flow analysis usually uses the projections of the future free cash flow and then discounts them to arrive at the present value (PV) that is then used in the valuation of the investment’s potential. Most often, the discounting process uses the WACC. This valuation technique requires an investor to forecast future cash flow, estimate the discount rate, calculate the company’s or corporation’s value using WACC and finally calculate the intrinsic value of the stock (Hooke, 2013, pg. 156). In the valuation process, the opportunity is deemed good in case the value that is arrived at is higher or greater than the investment’s current cost. The investor will therefore be advised to take the investment opportunity because it promises attractive and higher return. The second type of investment techniques is relative valuation technique. It is also known as comparable valuation. It is generally a valuation model that aims at comparing the value of a firm to that of the firm’s competitors so that its financial value or worth can be determined. It is usually an alternative to the absolute models such as Discount Cash Flows. It is basically a most effective and useful tool in asset valuation. It requires that a similar and comparable asset be used in the valuation of another asset. The most useful and common metrics that should be utilized in the comparable valuation includes enterprise value, return to equity, price to free cash flow, operating margin and price to earnings ratio. The investor will therefore be advised to take the investment opportunity which promises attractive and higher return when compared to the selected assets (Larrabee &Voss, 2013, pg. 140-150). To increase the effectiveness and efficiency in the selection process these two methods should be used in combination. This therefore implies that they are complementary. 10. Why might investors choose to favor investment in common stock over corporate bonds? In a long period of time, stocks have actually outperformed the corporate bonds and there exist substantial evidence that the outperformance is going to continue (Apostolou & Crumbley, 2000, pg. 3-5). First, investing with a stock provides an investor with an opportunity to become a part-owner while investing with a corporate bond enables one to become a creditor. Common stocks enable an investor to have partial ownership in the company thereby presenting them with the right to take part in votes that automatically impact the business. This therefore provides the investor with the opportunity to participate in the control of the company unlike corporate bonds that are debt securities (Reilly & Brown, 2012, pg. 90). In addition, stocks entitle the investors to share in the profits of the company which is not the case with the bonds. The bondholders therefore have the opportunity to keep a larger amount of the money that the company earns from using the funds. This share is usually paid to the stockholders in form of annual dividends (Apostolou & Crumbley, 2000, pg. 3-5) The common stocks have a transferability clause which allows them to be easily transferred from one investor to another unlike corporate bonds that cannot easily be transferred to another person. Stocks guarantees the ownership right to the investors in the company until such a time they would want to sell their stocks. This time is not predictable and some investors do no actually sell their stocks but rather transfer them to someone else when they pass away through such vehicles like wills. Conversely, bonds have specific maturity dates upon which they are repaid alongside the interest (Reilly & Brown, 2012, pg. 91). Finally, stocks are given much attention by the financial media and investors. This therefore means that there is sufficient information about them which allows the investors to make sound decisions regarding them (Reilly & Brown, 2012, pg. 93). (word count-3153, excluding questions) References American Finance Association. (1979). The Journal Of Finance - Volume 34, Issues 4-5 - Page 839.New York. Apostolou, N. G., & Crumbley, D. L. (2000). Keys to understanding the financial news. Hauppauge, NY, Barrons. Barnes, P. (2009). Stock market efficiency, insider dealing and market abuse. Farnham, Surrey, England, Gower. Pg. 47-50 Christopherson, J. A., Cariño, D. R., & Ferson, W. E. (2009). Portfolio performance measurement and benchmarking. New York, McGraw-Hill. Pg 6-17 Collins, B. M., & Fabozzi, F. J. (1999). Derivatives and equity portfolio management. New Hope, Fabozzi Ass. Fabozzi, F. J., & Markowitz, H. (2011). The theory and practice of investment management asset allocation, valuation, portfolio construction, and strategies. Hoboken, N.J., John Wiley & Sons. 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T., & Voss, J. A. (2013). Valuation techniques discounted cash flow, earnings quality, measures of value added, and real options. Hoboken, N.J., John Wiley & Sons. Pandey, I. M. (2011). Financial management. [Delhi], Vikas Publishing House. Reilly, F. K., & Brown, K. C. (2012). Investment analysis and portfolio management. Mason, Ohio, South-Western Cengage Learning. Reilly, F. K., & Brown, K. C. (2012). Investment analysis and portfolio management. Mason, Ohio, South-Western Cengage Learning. Read More