Investment and portfolio managementMGT 531

MGT 531  

Lecture # 16

Investment and portfolio management

The course assumes little prior applied knowledge in the area of finance.

Kristina Levišauskait (2010) ‘Investment Analysis and Portfolio Management’

References

Why no market can be fully efficient optimal portfolio selection Diversification Summary points

Summary of last lecture

Key-terms Questions and problems Chapter 4: Investment in Stocks 1. Stock as specific investment. 2. Stock analysis for investment decision

making. 3.E-I-C analysis. 4.Fundamental analysis S

Contents of today’s lecture

• Arbitrage, • Arbitrage Pricing Theory (APT), Coefficient Beta (β) • Capital Market Line (CML) • Capital Asset Pricing Model • (CAPM) • Efficient frontier • Efficient set of portfolios • Expected rate of return

of the portfolio • Feasible set • Indifference curves • Map of Indifference Curves • Market efficiency • Markowitz Portfolio Theory

• Market Portfolio • Non-satiation • Portfolio Beta • Risk aversion • Risk free rate of return • Risk of the portfolio • Security Market Line

(SML) • Systematic risk • Standard deviation of the • portfolio • Semi- strong form of market • efficiency • Strong form of market • efficiency • Total risk • Unsystematic (specific) risk • Weak form of

market efficiency

Key-terms

1. Explain why most investors prefer to hold a diversified portfolio of securities as opposed to placing all of their wealth in a single asset.

2. In terms of the Markowitz portfolio model, explain, how an investor identify his / her optimal portfolio. What specific information does an investor need to identify optimal portfolio?

3. How many portfolios are on an efficient frontier? How is an investor’s risk aversion indicated in an indifference curve?

4. Describe the key assumptions underlying CAPM.

Questions and problems

5. Many of underlying assumptions of the CAPM are violated in some degree in “real world”. Does that fact invalidate model’s calculations? Explain.

6. Under the CAPM, at what common point do the security market lines of individual stocks intersect?

7. How does the CAPM differs from the APT model?

8. What is meant by an efficient market? What are the benefits to the economy from an efficient market?

9. If the efficient market hypothesis is true, what are the implications for the investors?

Questions and problems

Mini-contents 1. Stock as specific investment. 2. Stock analysis for investment decision making. 3.E-I-C analysis. 4.Fundamental analysis. 4.1. Decision making of investment in stocks. Stock valuation 4.2. Formation of stock portfolios. 4.3. Strategies for investing in stocks. Summary

Chapter 4 Investment in Stocks

Stock as specific investment Stock represents part ownership in a firm. 2 main types of stock (see Chapter 1) • Common stock • Preferred stock In this chapter we focus only on the investment in common stocks. Common stock = Common share = Equity The main features of the common stock: • Typically each common stock owned entitles an investor to one

vote in corporate shareholders’ meeting.

Investment in Stocks

• Investor receives benefits in the form of dividends, capital gains or both.

But: dividends are paid to shareholders only after other liabilities such as interest payments have been settled;

typically the firm does not pay all its earnings in cash dividends;

special form of dividend is stock dividend, in which the corporation pays in stocks rather than cash.

• Common stock has no stated maturity.

Common stock does not have a date on which the corporation must buy it back.

Investment in Stocks

But: some corporations pay cash to their shareholders by purchasing their own shares.

These are known as share buy backs. Common stocks on the whole historically have provided: a higher return, but they also have higher risk.

An investor earns capital gains (the difference between the purchase price and selling price)

when he / she sell at a higher price than the purchase price.

Investment in Stocks

• the investment income is usually higher;

• the investor can receive operating income in cash dividends;

• common stock has a very high liquidity and can easily be moved from one investor to the other;

• the costs of transaction with common stocks involved are relatively low;

• the nominal price of common stock is lower in comparison with the other securities.

Main advantages of common stock as investment:

• common stock is more risky in comparison with many other types of securities;

• the selection of these securities is complicated: high supply and difficult to evaluate;

• the operating income is relatively low (the main income is received from the capital gain – change in stock price).

Main disadvantages of common stock as investment:

Here the focus is on the fundamental analysis of common stocks.

Although technical analysis is used by many investors, fundamental analysis is far more prevalent.

By performing fundamental analysis, investor forecasts among other Things:,

the future changes in GDP, changes serials, other performance indicators for a number of industries and, in particular, future sales, earnings for a number of the firms.

The main objective of this analysis for investor is to identify the attractive potential investments in stocks.

Stock analysis for investment decision making

Analysts and investors use two alternative approaches for fundamental analysis:

• “Top-down” forecasting approach; • “Bottom-up” forecasting approach.

Using “top-down” forecasting approach the investors are first involved in making the analysis and ;

The industry forecasts are based on the forecasts for the economy and;

a company’s forecasts are based on the forecasts for both its industry and the economy.

Stock analysis for investment decision making

Using “bottom-up” forecasting approach, the investors start:

with the analysis and forecast for companies,

then made analysis and forecasts for industries and for the economy.

In practice “top down” approach prevail in analysis and forecasting because:

logically for forecasting of the companies performance ; the changes in macroeconomic environment must be analyzed first. otherwise the inconsistent assumptions could be drawn.

Stock analysis

The combination of two approaches is used by analysts too.

For example, analysis and forecasts are made for the economy using “top-down” approach and then using “bottom-up” approach continuing with the forecasts for individual companies.

But despite of the different approaches to the sequence of the analysis the content of it is based on the E-I-C analysis.

Stock analysis

E-I-C analysis includes: E - Economic (macroeconomic) analysis (describes the

macroeconomic situation in the particular country and its potential influence on the profitability of stocks).

I - Industry analysis (evaluates the situation in the particular industry/economic sector and its potential influence on the profitability of stocks).

E-I-C analysis

C - Company analysis (the financial analysis of the individual

companies from the shareholder approach) The contents of Macroeconomic analysis:

• The behavior of economics in the context of economic cycle (at what point of this cycle is the economy now: growth stage? peak? Decline stage? recession stage?);

• Fiscal policy of the government (financial stability, budget deficit, public debt, etc.)

Company analysis