Investment Strategy - Research Paper Example

Investment Strategy Introduction An investment strategy for an inherited amount of £ 100,000 suggested by a financial advisor seeks a balanced portfolio of investments consisting of building and bank deposits, individual saving accounts (ISAs), unit and/ or investment trusts, gilts, ordinary shares, and premium bonds. This write up contains a discussion on various strategic issues in order to facilitate the decision of financial advisor about the constituents of investment portfolio. 1. Information required by financial advisor from investor to plan investment portfolio A financial advisor would seek following information from the investor before proceeding to extend his professional guidance for an investment portfolio of £ 100000: Long Term goals and objectives The long term objectives of an investor differ from person to person. Objective may constitute arrangement of income after retirement, purchasing of a house property, or any other goal. These days investors seek some sort of financial independence. That implies that investors require certain amount of income from investment portfolio in order to maintain a particular standard or status of life without caring about the future. It is very important for investor to quantify these objectives and convey those in clear terms to the financial consultant. This will provide necessary direction to financial consultant to rank the priorities and make selections of the investment portfolios as per the objectives of the investor. It must be appreciated that “long term goals are typically those goals associated with time frames that are greater than five years. Because a long term goal exists between initial investment and the fund’s requirements, the investor can consider a more aggressive approach. As such, a variety of stocks, bonds, mutual funds, or other investment alternatives should be evaluated as a means to accomplishing long term goals.”(Geoffrey A. Hurt and others, page 3)i Level of risk the investor is willing to accept It is important to decide about the level of risk an investor is ready to undertake before the consultant designs a suitable portfolio of investments. Portfolio risk depends not only on the riskiness of the securities constituting the portfolio but also on relationship among those securities. By selecting securities that have a relationship with each other, an investor is able to reduce the relative risk. “Risk is the chance of financial loss. Assets having greater chances of loss are viewed as more risky than those with lesser chances of loss. More formally, the term risk is used interchangeably with uncertainty to refer to the variability of returns associated with a given asset.” (Lawrence J. Gitman, page 226)ii Time Horizon for Investments The investor has to grant a reasonable time to attain the goals of investment. Where long term is the goal and equities are required to be invested in, the investor should allow at least five years to achieve the goals. Short term goals can be realized by investing into fixed income securities. Time commitment is an important and critical issue. Financial advisor has to keep in mind the time frame of investment in order to decide about the maturities for various alternatives of investments. “The investor’s choice of time horizon is often the key variable in determining the ratio of equity to fixed income investments. Even if the investor has a very high risk tolerance, the investor should not invest in stocks if the money is needed in the next year.” (Donald B. Trone and others, page 9)iii Rate of Return required This is very pertinent information required by the financial advisor, as returns on types of selected investment in the portfolio will be subjective to this rate of return. “The return is the total gain or loss experienced on an investment over a given period of time. It is commonly measured as cash distribution during the period plus the change in value of the firm, expressed as a percentage of the beginning of the period investment value.” (Lawrence J. Gitman, page 226)iv The investor will have to further specify whether the rate of return required is pre-tax or post- tax return. The rate of return depends a lot on type of risk an investor is ready to undertake. Under normal circumstances any investors are risk averse. “For a given increase in risk, they require an increase in return on their investments.” (Lawrence J. Gitman, page 230)v An investor has to assess his cost of capital to decide about the rate of return required on his investments. Normally required rate return should exceed the related cost of capital. 2. Balanced Portfolio A balanced portfolio of investment is the one “that includes cash users and cash generators and both high and low- risk investments for both short and long term.” (National Committee of Engineering, page 16)vi. There are no set rules to define a balanced portfolio. But a balanced portfolio has to be well diversified. In fact diversifications required for a balanced portfolio depends upon variables discussed earlier in this essay as the information required from investor by financial advisor. Diversification required in a balanced portfolio is important as “it is designed to help reduce the risk of the portfolio as a whole. Different investment types tend to move in different directions. Thus, when returns in the stock market are low, the bond market may be performing well. Over time, a well diversified portfolio can provide higher returns than a portfolio too highly concentrated in one area.” (Stuart Horowitz, page 63)vii A balanced portfolio is in fact an efficient portfolio. It is always the objective of financial advisor to create an efficient portfolio. The return on investments in a portfolio is the weighted average of returns of individual investments in the portfolio. An efficient and balanced portfolio provides maximum return at a given level of risk. At the same time it minimizes the risk at a given level of return. Diversification in a balanced portfolio is designed to reduce the overall risks, and it also depends upon the relationships of diversified investments in the portfolio. These relationships are measured by statistical concept of correlation. “A correlation relationship where both asset classes move in the same direction and in similar proportion to market changes is called a positive correlation. When two assets classes reflect no measureable systematic movement, they deemed to have no correlation. When two asset classes move in opposite directions most of the time, they are said to have negative correlation.” (Don Chambers, page 56)viii. In order to make various combinations for a balanced portfolio, the consultant has to consider the three possibilities of correlations, as stated above, between the assets namely, positive correlation, uncorrelated, and negative correlation. It is interesting to note that when correlation between two assets is negative, the risk is highly reduced, and accordingly the related returns are also reduced. Balanced portfolio is created by combination of assets with perfectly positively correlated returns. Some time financial advisor has to suggest investment in assets, keeping in view the objectives of the investors, which are uncorrelated. Uncorrelated assets in a portfolio can reduce total risk but not so effectively. But correlated assets reduce the total risk in a portfolio more effectively. Also perfection has no place in the world of investments. Diversification is required to attain a balanced and an efficient portfolio. 3. Unit Trusts and Investment Trusts A “unit trust is a fund to which individuals and companies may contribute in order to obtain a share in the returns generated by the trust.”(M. Buckle and John L. Thompson, page 124)ix A unit trust is constituted under a trust deed. Trustees act as guardian of assets on behalf of beneficial owners. Management of the trust is controlled by personnel other than trustees but appointed as per the provisions of trust deed. Trustees appointed under the trust deed are mostly bankers or insurance companies. Contributions are made by only persons allowed to invest as per trust deed. Unit trust funds are open ended making the funds expandable at the behest of management and trustees. All sales and purchases of units are dealt by the management of the unit trust as there is no secondary market for units of the unit trusts. “The purchase and sale of units by individual investors causes the fund to expand or contract. Likewise, the number of units increases or decreases.” (Keith Redhead, page 164)x. The price of units of the unit trust fund is calculated on daily basis. Last transacted price of units by the management is called historic or backward price. There is also a method of forward pricing which is based on valuation immediately after the processing of offer by the management of trust.”Unit trusts are singularly British institution and many are converting to the continental style open ended investment company (OEIC), which have only one price for buying and selling, with separate charges.”(John Claxton, page 52)xi. Investment trusts are companies registered under the companies act. “In contrast to unit trusts, investment trusts are public limited companies whose business is the investment of funds in financial assets.”(M. Buckle and John L. Thompson, page 124)xii. An investor has to purchase the shares in the company either directly on public offering or through stock exchange transactions where the company is listed. There is board of directors responsible for day to day working of the investment trust. “Like other publicly quoted firms, they are subject to the full range of Companies Act and to the regulation that the stock exchange imposes upon firms wanting a stock exchange listing.”(Peter Howells and Keith Bain, page 101)xiii Shares of investment trust maintain their prices based on the performance of the company. Investment trust company shares are fixed as are issued and subscribed by the public at large. “In terms of taxation, the unit and investment trust routes are very similar. Where these investments are held outside of an ISA (or PEP), in both cases the capital gain tax liability falls on the investor.”(Debbie Harrison, page 93)xiv 4. Bank or Building Society Accounts Building society account is similar to bank accounts, but interest paid on these accounts is lower than interest in bank deposits. The limitation with building society accounts is that funds cannot be transferred by cheques. Building society account is not a medium of exchange, as are bank accounts. Therefore investments of funds as envisaged in the assignment is a not at all a preferable approach. Banks accounts may be saving accounts or a deposit for fixed term. Bank deposits are transferable by issuing cheques as well by using on line banking facilities. Investment in bank accounts is safest of all, but it is not lucrative in comparison with other sources of investments. “The similarity between bank and building society deposits would seem to indicate that both should be included with in the official monetary definitions, and by implication with in the field of monetary control.”(Mark Boleat, page 4)xv But that has so far not happened with building society deposits. Individual Savings Accounts (ISAs) “An ISA is the tax free scheme launched by the government in 1999 to encourage people to save money.” (BBC News)xvi. Individual saving accounts are of two types, namely cash ISAs and stock & shares ISAs. HMRC does not levy tax on income from ISAs. Similarly no capital gain tax is levied that arise on investments in ISAs. Funds in cash ISA can be transferred to any other cash ISA or stock and shares ISA. “There is no minimum subscription limit (although there is a maximum), only qualifying individuals may have an ISA, and the account itself must be managed by the fund manager in accordance with detailed regulations.” (FL Memo Ltd., page 340)xvii Units and/ Investment Trusts Part 3 herein above carries full information (also the information required for this part of assignment) about Unit trusts and Investment trusts. Gilts Gilts are “UK government securities issued primarily to finance government borrowings.” (Kevin Rothwell, page 470)xviii. Investment in the Gilts is riskless. Moreover, “the liquidity of guilt edged securities is still important and all British banks like to preserve a cushion of them between their liquid assets, which are vulnerable to official policy, and their advances.”(Maxwell Gaskin, page 130)xix. The interest rate of Gilt is normally based on prevailing rate of interest as well the target buyers of such government securities. It is safe but not an aggressive investment. Ordinary Shares Ordinary shares in a company are also known as equity shares. A company is held by its ordinary shareholders. A company can raise equity capital either through private placement or offering issue to the public at large. Listed companies’ equity shares are traded at stock exchanges. Equity share holders are the residual claimants, as in the event of winding up of the company the equity shareholders get only left over capital after meeting all debts and liabilities, including the liabilities of preference share holders. All companies initially issue ordinary shares to raise capital. This is mainly because equity capital is not a liability like debt capital till the company is liquidated. In most of cases equities are issued with voting rights. These way equity holders have a say in the election of board of directors. Moreover, equity holders’ liability is limited to unpaid called up capital. They are compensated with equity dividends and finally with capital gains in the event of liquidation of the company. Premium Bonds “Bonds are long term debt instruments used by business and government to raise large sum of money, typically from a diverse group of lenders.” (Lawrence J. Gitman, page 299)xx Interest is paid on half yearly basis on most of bonds at a rate called coupon interest rate. Basic value of a bond is the present value of payments a bond holder has to make from current time to the maturity of the bond. Premium bonds are generally senior claims or they may be subordinates to senior bonds or to all other creditors. If the company defaults, senior bonds come first in the pecking order and then other bonds, but ahead of the preferred shareholders and ordinary shareholders. Conclusion Various issues discussed in this paper would provide necessary information to a financial adviser to design a balanced and efficient portfolio of investment. Word Count: 2668 References Read More