Investment Analysis and

Portfolio Management
 Overview

This semester is about investment in financial

portfolios
Investment is defined as a sacrifice made now to
obtain a return later
 It is current consumption that is sacrificed
Two forms of investment can be defined
 Real investment is the purchase of land, machinery, etc
 Financial investment is the purchase of a "paper"
contract
 Overview

Real investments and financial investments are

linked
The share issue of a firm finances the purchase of capital
 The commitment to a mortgage finances the purchase of
property
Financial investment can provide finance for real
investment decisions
Financial investment can guide real investment
decisions
 Financial Investment

There are numerous components to financial

investment
Markets: where assets are bought and sold, and
the forms of trade
Securities: the kinds of securities available, their
returns and risks
Investment process: the decision about which
securities, and how much of each
Financial theory: the factors that determine the
rewards from investment (and the risks)
 Markets

A market is any organized system for connecting

buyers and sellers
There are many security markets
Markets may have a physical location
 The New York Stock Exchange
Or exist only as computer networks
 The London Stock Exchange
Markets vary in the securities that are traded and
in the way securities are traded
 Characteristics of Markets

 There are a number of ways to classify markets

 Primary/Secondary
 Primary markets are security markets where new
issues of securities are traded
 A secondary market is a market where securities are
resold
 The London Stock Exchange is a secondary market
 Most activity on stock exchanges is in the
secondary market
 Characteristics of Markets

Trades on the primary market raise capital for

firms
Trades on the secondary market do not raise
additional capital for firms
The secondary market is still important
 It gives liquidity to primary issues. New securities would
have a lower value if they could not be subsequently
traded
 It signifies value. Trading in assets reveals information
and provides a valuation of the assets. This helps to guide
investment decisions
 Characteristics of Markets

A second way to classify markets is the times of

trading
Call/continuous
 In a call market trading takes place at a specified time
intervals
 Some call markets have a provision that limits movement
from the prior price. This is to prevent a temporary order
imbalance from dramatically moving the price
 In a continuous market there is trading at all times the
market is open
 Characteristics of Markets

Markets can also be characterized by the lifespan

of the assets traded
Money/Capital
Money market: the market for assets with a life of less
than 1 year
 Capital market: the market for assets with a life greater
than 1 year
Some assets, such as most bonds, have a fixed
lifespan
Common stock have an indefinite lifespan
 Brokers

A broker is a representative appointed by an

individual investor
Brokers have two conflicting roles
 An advisor: a broker can offer investment advice and
information
 A sales person: brokers are rewarded through
commission and have an incentive to encourage trade
A full-service broker is a brokerage house that can
offer a full range of services including investment
advice and portfolio management
 Brokers

 A discount broker offers a restricted range of services at a

lower price
 To complete a trade additional brokers are needed
 A floor broker is located on the floor of the exchange and does
the actual buying and selling
 A specialist ensures trade happens by holding an inventory of
stock and posting prices
 Securities

 The standard definition

of a security is:
"A legal contract
representing the right to
receive future benefits
under a stated set of
conditions"
 The piece of paper
defining the property
rights held by the owner
is the security
 Securities

Money market securities

 Short-term debt instruments sold by governments,
financial institutions and corporations
 They have maturities when issued of one year or less
 The minimum size of transactions is typically large,
1. Treasury Bills
 Treasury Bills are the least risky and the most marketable
of all money markets instruments
 They represent a short-term IOU of the Central
government
 Similar bills are issued by many other governments
 Securities

An active secondary market with very low transactions

costs exists for trading T-bills
 T-bills are sold at a discount from face value and pay no
explicit interest payments.
T-bills are considered to have no risk of default,
have very short-term maturities, and have a known
return
T-bills are the closest approximations that exist to
a risk-free investment
 Securities

Capital market securities

 Instruments having maturities greater than one year and
those having no designated maturity at all
1. Fixed income securities
 Fixed income securities have a specified payment
schedule
 Bonds promise to pay specific amounts at specific times
 Failure to meet any specific payment puts the bond into
default with all remaining payments. The creditor can
put the defaulter into bankruptcy
 Securities

 Fixed income securities differ from each other in promised

return for several reasons
 The maturity of the bonds
 The creditworthiness of the issuer
 The taxable status of the bond
 Income and capital gains are taxed differently in many
countries
 Bonds are designed to exploit these differences
 Securities

1.1 Treasury notes and bonds

 The government issues fixed income securities over a
broad range of the maturity spectrum
 Both notes and bonds pay interest twice a year and repay
principal on the maturity date
1.2 Corporate bonds
 These promise to pay interest at periodic intervals and to
return principal at a fixed date
 These bonds are issued by business entities and thus have
a risk of default
 Securities

2. Common stock (shares, equity)

 Common stock represents an ownership claim on the
earnings and assets of a corporation
 After holders of debt claims are paid, the management of
the company can either pay out the remaining earnings to
stockholdings in the form of dividends or reinvest part or
all of the earnings
 The holder of a common stock has limited liability – the
most they can lose is the value of the shares
 Securities

3. Derivative instruments

 Derivative instruments are securities whose value derives
from the value of an underlying security or basket of
securities
 The instruments are also known as contingent claims,
since their values are contingent on the performance of
underlying assets
 The most common contingent claims are options and
futures
 3.1 An option on a security gives the holder the right to
either buy (a call option) or sell (a put option) a particular
asset at a future date or during a particular period of time
for a specified price
 Securities

 3.2 A future is the obligation to buy or sell a particular

security or bundle of securities at a particular time for a
stated price
 A future is simply a delayed purchase or sale of a security

 3.3 The corporation can issue contingent claims.

 Corporate-issued contingent claims include rights and
warrants, which allow the holder to purchase common
stocks from the corporation at a set price for a particular
period of time
 Securities

5. Indirect investing

 The purchase of a shares of an investment portfolio
 A mutual fund holds a portfolio of securities, usually in
line with a stated policy objective.
 Unit trusts invest depositors' funds in bonds or equities.
Size is determined by inflow of funds.
 Investment trusts Issue a certain fixed sum of stock to
raise capital. This fixed capital is then managed by the
trust. The initial investors purchase shares, which are
then traded on the stock market
 Hedge funds actively manage deposits in excess of
£100,000. Trade in all financial markets, including
derivatives.
 Return

end - of - period wealth -- beginning - of - period wealth

Return 
beginning - of - period wealth

V0 Initial value of investment

V1 Final value of investment

V1  V0
Return is r
V0

V1  V0
Or as a percentage r 100
V0
 Return
Example 1
 An initial investment of $10,000 is made. One year
later, the value of the investment has risen to
$12,500. The return on the investment is
12500  10000
r 100  25%
10000
Example 2
 Aninvestment initially costs $5,000. Three
months later, the investment is sold for $6,000.
The return on the investment per three months is
6000  5000
r 100  20%
5000
 Return and Risk
The risk inherent in holding a security is the
variability, or the uncertainty, of its return
Factors that affect risk are
 1. Maturity
 Underlying factors have more chance to change over a longer
horizon
 Maturity value of the security may be eroded by inflation or
currency fluctuations
 Increased chance of the issuer defaulting the longer is the time
horizon
 Return and Risk
 2. Creditworthiness
 The governments of the US, UK and other developed countries are
all judged as safe since they have no history of default in the
payment of their liabilities
 Some other countries have defaulted in the recent past
 Corporations vary even more in their creditworthiness. Some are
so lacking in creditworthiness that an active ''junk bond'' market
exists for high return, high risk corporate bonds that are judged
very likely to default
 Return and Risk
 3. Priority
 Bond holders have the first claim on the assets of a liquidated
firm
 Bond holders are also able to put the corporation into
bankruptcy if it defaults on payment
 4. Liquidity
 Liquidity relates to how easy it is to sell an asset
 The existence of a highly developed and active secondary
market raises liquidity
 A security's risk is raised if it is lacking liquidity
 Risk and Return
 5. Underlying Activities
 The economic activities of the issuer of the security can affect how
risky it is
 Stock in small firms and in firms operating in high-technology
sectors are on average more risky than those of large firms in
traditional sectors
 Return and Risk
The greater the risk of a security, the higher is
expected return
Return is the compensation that has to be paid to
induce investors to accept risk
Success in investing is about balancing risk and
return to achieve an optimal combination
The risk always remains because of unpredictable
variability in the returns on assets
Investors make two major
29
steps or decisions
in constructing their own portfolios
Portfolio is simply collection of investment
assets

The asset allocation decision is the choice

among broad asset classes such as stocks, bonds,
real estate, commodities, and so on.

The security selection decision is the choice of

which particular securities to hold within each
asset class.
 The Investment Process
A description of the process is:
 1. Set investment policy
 Objectives
 Amount
 Choice of assets
 2. Conduct security analysis
 Examine securities (identify those which are mispriced?)
Use
 a. Technical analysis – the examination of past prices for trends
 b. Fundamental analysis – true value based on future expected
returns
 The Investment Process

 3. Portfolio Construction
 Identify assets
 Choose extent of diversification
 4. Portfolio Evaluation
 Assess the performance of portfolio
 5. Portfolio Revision
 Repeat previous three steps
 The Six Steps of Portfolio Management
32

1) Learn the basic principles of finance

2) Set portfolio objectives
3) Formulate an investment strategy
4) Have a game plan for portfolio revision
5) Evaluate performance
6) Protect the portfolio when appropriate
The Six Steps of Portfolio Management
33

Learn the Basic

Principles of Finance

Set Portfolio Objectives

Evaluate
Performance
Protect the
Portfolio When Formulate an
Appropriate Investment Strategy

Have a Game Plan for

Portfolio Revision
 Background, Basic Principles, and
Investment Policy
34

A person cannot be an effective portfolio

manager without a solid grounding in the
basic principles of finance
Egos sometimes get involved
 Take time to review “simple” material
 Fluff and bluster have no place in the formation of
investment policy or strategy
 Background, Basic Principles, and Investment Policy
(cont’d)
35

There is a distinction between “good

companies” and “good investments”
 The stock of a well-managed company may be too
expensive
 The stock of a poorly-run company can be a great
investment if it is cheap enough
 Background, Basic Principles, and Investment Policy
(cont’d)
36

 The two key concepts in finance are:

1) A dollar today is worth more than a dollar tomorrow
2) A safe dollar is worth more than a risky dollar

 These two ideas form the basis for all aspects

of financial management
Background, Basic Principles, and Investment Policy (cont’d)
37

 Other important concepts

 The economic concept of utility

 Return maximization
Background, Basic Principles, and Investment Policy
(cont’d)
38

 Setting objectives
 It is difficult to accomplish your objectives until you
know what they are

 Terms like growth or income may mean different

things to different people
 Background, Basic Principles, and Investment Policy
(cont’d)
39

 Investment policy
 The separation of investment policy from
investment management is a fundamental tenet of
institutional money management
 Board of directors or investment policy committee
establish policy
 Investment manager implements policy
 Portfolio Construction
40

 Formulate an investment strategy

based on the investment policy statement
 Portfolio managers must understand the basic
elements of capital market theory
 Informed diversification
 Naïve diversification
 Beta
 Portfolio Construction (cont’d)
41

 International investment
 Emerging markets carry special risk

 Emerging markets may not be informationally

efficient
 Portfolio Construction (cont’d)
42

 Stock categories and security analysis

 Preferred stock
 Blue chips, defensive stocks, cyclical stocks

 Security screening
 A screen is a logical protocol to reduce the total to a
workable number for closer investigation
 Portfolio Construction (cont’d)
43

 Debt securities
 Pricing

 Duration
 Enables the portfolio manager to alter the risk of the
fixed-income portfolio component

 Bond diversification
 Portfolio Construction (cont’d)
44

 Pension funds
 Significant holdings in gold and timberland (real
assets)

 In many respects, timberland is an ideal investment

for long-term investors with no liquidity problems
 Portfolio Management
45

 Subsequent to portfolio construction:

 Conditions change

 Portfolios need maintenance

 Portfolio Management (cont’d)
46

 Passive management has the following

characteristics:
 Follow a predetermined investment strategy that is
invariant to market conditions or

 Do nothing

 Let the chips fall where they may

 Portfolio Management (cont’d)
47

 Active management:
 Requires the periodic changing of the portfolio
components as the manager’s outlook for the market
changes
 Portfolio Management (cont’d)
48

 Performance evaluation
 Did the portfolio manager do what he or she was
hired to do?
 Someone needs to verify that the firm followed
directions
 Interpreting the numbers
 How much did the portfolio earn?
 How much risk did the portfolio bear?
 Must consider return in conjunction with risk
 Portfolio Management (cont’d)
49

 Performance evaluation (cont’d)

 More complicated when there are cash deposits
and/or withdrawals
 More complicated when the manager uses options
to enhance the portfolio yield

 Fiduciary duties
 Responsibilities for looking after someone else’s
money and having some discretion in its
investment
 Stock Selection Philosophy
50

Fundamental analysis
Technical analysis
 Fundamental Analysis
51

A fundamental analyst tries to discern the

logical worth of a security based on its anticipated
earnings stream

The fundamental analyst considers:

 Financial statements
 Industry conditions
 Prospects for the economy
 Technical Analysis
52

A technical analyst attempts to predict the supply

and demand for a stock by observing the past series
of stock prices

Financial statements and market conditions are of

secondary importance to the technical analyst
 Security Analysis
53

 A three-step process
1) The analyst considers prospects for the economy, given the
state of the business cycle
2) The analyst determines which industries are likely to fare
well in the forecasted economic conditions
3) The analyst chooses particular companies within the
favored industries
   An understanding of the risk/return trade-off
54

Assets with higher expected returns have greater

risk.
Higher risk assets offer higher expected returns
than lower-risk assets.
Risk tolerance: The investor’s willingness to accept
higher risk to attain higher expected returns.
Risk aversion: The investor is also reluctant to
accept risk
An investor’s objectives can be classified as return
requirement and risk tolerance
 Investors Constraints
55
Constraints are the kind of financial circumstances
imposed on an investor’s choice.
Five common types of constraints are:
1. Liquidity: refers to how easy an asset can be converted
to cash
2. Investment horizon: is the planned liquidation
duration of investment.
3. Regulations: Professional and institutional investors
are constrained by regulations- investors who manage
other people’s money have fiduciary responsibility to
restrict investment to assets that would have been
approved by a prudent investor.
 Investors Constraints
56

4.Tax considerations: special considerations

related to tax position of the investor. The
performance of any investment strategy are
always measured by its rate of return after tax.
5.Unique needs: often centre around the
investor’s stage in the life cycle such as
retirement, housing and children’s education.
 Risk Versus Uncertainty
57

Uncertainty involves a doubtful outcome

 What you will get for your birthday
 If a particular horse will win at the track

Risk involves the chance of loss

 If a particular horse will win at the track if you made a bet
 Measuring Risk

58

 Risk = The chance that an investment's actual return will be

different than expected. Risk includes the possibility of losing some
or all of the original investment. 

 Usually measured by calculating the standard deviation of

the historical returns or average returns of a specific investment. A
high standard deviation indicates a high degree of risk.

 For investors, risk is the probability of earning an inadequate

return.
 If investors require a 10% rate of return on a given investment,
then any return less than 10% is considered harmful.
 Risk

59

The range of total possible returns

on the stock A runs from -30% to
Probability
more than +40%. If the required
return on the stock is 10%, then
those outcomes less than 10%
Outcomes that produce harm represent risk to the investor.

-30% -20% -10% 0% 10% 20% 30% 40%

Possible Returns on the Stock
 Differences in Levels of Risk

60

Outcomes that produce harm The wider the range of probable

outcomes the greater the risk of the
Probability
investment.
B A is a much riskier investment than B

-30% -20% -10% 0% 10% 20% 30% 40%

Possible Returns on the Stock
 Risk and Return
61

Risk and return are the two

most important attributes
of an investment.
Return
Research has shown that the %
two are linked in the
capital markets and that Risk Premium
generally, higher returns
can only be achieved by
taking on greater risk. RF Real Return

Expected Inflation Rate

Risk isn’t just the potential
loss of return, it is the Risk
potential loss of the entire
investment itself (loss of
both principal and
interest).
 Relationship Between Risk and Return
62

The more risk someone bears, the higher the

expected return
The appropriate discount rate depends on the risk
level of the investment
The risk-less rate of interest can be earned
without bearing any risk
Relationship Between Risk and Return
63

Expected return

Rf

0 Risk
 Returns and Risk of Different Asset Classes
64

Historically, small company stocks have

generated the highest returns. But the volatility
of returns have been the highest too
Inflation and taxes have a major impact on
returns
Returns on Treasury Bills have barely kept pace
with inflation
Historical Returns on Different Asset Classes
65

Next figure illustrates the volatility in annual returns

on three different assets classes from 1938 – 2005.
Note:
 Treasury bills always yielded returns greater than 0%
 Long Canadian bond returns have been less than 0% in some
years (when prices fall because of rising interest rates), and
the range of returns has been greater than T-bills but less than
stocks
 Common stock returns have experienced the greatest range of
returns
 Measuring Risk
Annual Returns by Asset Class, 1938 - 2005
66
Portfolio Size and Total Risk

67
 Investment Choices
The Concept of Dominance Illustrated
68

Return
% A dominates B
because it offers
A B the same return
10% but for less risk.
A dominates C
C because it offers a
5% higher return but
for the same risk.

5% 20% Risk

To the risk-averse wealth maximizer, the choices are clear, A dominates B,

A dominates C.
 Risk Aversion
69

Most investors are risk averse

 People will take a risk only if they expect to be adequately
rewarded for taking it

People have different degrees of risk aversion

 Some people are more willing to take a chance than others
 Dispersion and Chance of Loss
70

There are two material factors we use in judging risk:

 The average outcome

 The scattering of the other possibilities around the average

Dispersion and Chance of Loss (cont’d)
71

Investment value

Investment A
Investment B

Time
 Dispersion and Chance of Loss (cont’d)
72

Investments A and B have the same arithmetic mean

Investment B is riskier than Investment A

 Types of Risk
73

Total risk refers to the overall variability of the

returns of financial assets

Undiversifiable risk is risk that must be borne by

virtue of being in the market
 Arises from systematic factors that affect all securities of a
particular type
 Types of Risk (cont’d)
74

Diversifiable risk can be removed by proper

portfolio diversification
 The ups and down of individual securities due to company-
specific events will cancel each other out
 The only return variability that remains will be due to
economic events affecting all stocks
 Growth of Income
75

 Benefits from time value of money

 Sacrifices some current return for some purchasing power
protection

 Differs from income objective

 Income lower in earlier years
 Income higher in later years
 Growth of Income (cont’d)
76

 Often seek to have the annual income increase by

at least the rate of inflation

 Requires some investment in equity securities

 Growth of Income (cont’d)
77

Example

Two portfolios have an initial value of $50,000. Interest rates

are expected to remain at a constant 10% per year for the next
ten years.

Portfolio A has an income objective and seeks to provide

maximum income each year. The portfolio is invested 100%
in debt securities. Thus, Portfolio A generates $5,000 in
income each year.
 Growth of Income (cont’d)
78

Example (cont’d)

Portfolio B seeks growth of income and contains both debt

and equity securities. Portfolio B has an annual total return of
13%. In the first year, Portfolio B provides $3,500 in income
(a 7% income yield) and experiences capital appreciation of
5%.

The income generated by both portfolios over the next ten

years is shown graphically on the following slide.
 Growth of Income (cont’d)
79

Example (cont’d)

$7,000
$6,180
$6,000
$5,000 $5,000

$4,000
Portfolio A
$3,000 Portfolio B
$2,000
$1,000
$0
1999 2001 2003 2005 2007 2009
 Categories of Stock
80

Blue chip stock

Income stocks
Cyclical stocks
Defensive stocks
Growth stocks
Speculative stocks
Penny stocks
 Blue Chip Stock
81

Blue chip has become a colloquial term meaning

“high quality”
 Some define blue chips as firms with a long, uninterrupted
history of dividend payments
 The term blue chip lacks precise meaning
 Income Stocks
82

Income stocks are those that historically have paid

a larger-than-average percentage of their net income
as dividends
 The proportion of net income paid out as dividends is the
payout ratio
 The proportion of net income retained is the retention ratio
Examples include Consolidated Edison and
Allegheny Energy
 Cyclical Stocks
83

Cyclical stocks are stocks whose fortunes are

directly tied to the state of the overall national
economy

Examples include steel companies, industrial

chemical firms, and automobile producers
 Defensive Stocks
84

Defensive stocks are the opposite of cyclical

stocks
 They are largely immune to changes in the macroeconomy and
have low betas

Examples include retail food chains, tobacco and

alcohol firms, and utilities
 Growth Stocks
85

Growth stocks do not pay out a high percentage of

their earnings as dividends
 They reinvest most of their earnings into investment
opportunities

 Many growth stocks do pay dividends

 Speculative Stocks
86

Speculative stocks are those that have the

potential to make their owners rich quickly
Speculative stocks carry an above-average level of
risk
Most speculative stocks are relatively new companies
with representation in the technology, bioresearch,
and pharmaceutical industries
 Penny Stocks
87

Penny stocks are inexpensive shares

Penny stocks sell for $1 per share or less

 Categories Are Not
Mutually Exclusive
88

An income stock or a growth stock can also be a blue

chip
 E.g., Potomac Electric Power

Defensive or cyclical stocks can be growth stocks

 E.g., Dow Chemical is a cyclical growth stock
 Capitalization
89

Capitalization refers to the aggregate value of a

company’s common stock

Typical divisions :
 Large cap
 Mid-cap
 Small cap
 Micro cap
 Investment Styles
90

1-Value investing

2-Growth investing
 1-Value Investing
91

Value investors look for undervalued stock

Utilize the firm’s earnings history and balance sheet

 PE ratio, price/book ratio

Place much emphasis on known facts

 Price/Earnings Ratio
92

The PE ratio is stock price divided by EPS

A forward-looking PE uses earnings forecasts

A trailing PE uses historical earnings

 Price/Book Ratio
93

The price/book ratio is the stock price divided by

book value per share
 Book value is the firm’s assets minus its liabilities
 Book value is different from market value

Value investors look for low price/book ratios

 2-Growth Investing
94

Growth investors look for price momentum

 Look for stocks that are in favor and have been advancing
 Look for stocks that are likely to be propelled even higher
The market moves in cycles
 Many investors own both growth and value stocks
 Why Do Individuals
95
Invest ?

By saving money (instead of spending it),

individuals tradeoff present consumption for
a larger future consumption.
How Do We Measure The Rate of Return on An Investment ?
96

 The pure rate of interest is the exchange rate between future consumption and present
consumption. Market forces determine this rate.

 People’s willingness to pay the difference for borrowing today and their desire to
receive a surplus on their savings give rise to an interest rate referred to as the pure
time value of money.

 If the future payment will be diminished in value because of inflation, then the
investor will demand an interest rate higher than the pure time value of money to also
cover the expected inflation expense.

 If the future payment from the investment is not certain, the investor will demand an
interest rate that exceeds the pure time value of money plus the inflation rate to
provide a risk premium to cover the investment risk.
 Defining an Investment
97

A current commitment of $ for a period of time in

order to derive future payments that will
compensate for:
 the time the funds are committed

 the expected rate of inflation

 uncertainty of future flow of funds.

 Risk Aversion
98

The assumption that most investors will

choose the least risky alternative, all else
being equal and that they will not accept
additional risk unless they are compensated
in the form of higher return
 Probability Distributions
99

Risk-free Investment
1.00
0.80
0.60
0.40
0.20
0.00
-5% 0% 5% 10% 15%
 Probability Distributions
100

Risky Investment with 3 Possible Returns

1.00
0.80
0.60
0.40
0.20
0.00
-30% -10% 10% 30%
 Probability Distributions
101

Risky investment with ten possible rates of return

1.00
0.80
0.60
0.40
0.20
0.00
-40% -20% 0% 20% 40%