Success in Investment - Essay Example

Running Head: INVESTMENT PORTFOLIO Investment Portfolio Name: Instructor: Course: Date: Table of Contents Introduction 2 Policy Statement 3 Assets 6 Performance Evaluation 9 Conclusion 11 Reference 13 Appendix 14 INTRODUCTION I have been requested to complete a project on Investment Portfolio. According to the project, 100,000 will be invested in five individual financial products. The portfolio will be in existence between the 2nd April, and 11th of May 2007. I will start with a policy statement performance evaluation and then a concluding remark. According to Sharpe and Alexander, 1990, Investment Portfolio statements provide the foundation for all future investment decisions the investor makes. There are four basic purposes for the Investment Portfolio statement; Setting objectives - this involves establishing clear and definable expectations, risk and return objectives. Defining the asset allocation policy - this involves defining a structure for the investment asset classes as well as the diversification criteria in a bid to achieving the investor's objectives. Establishing management procedures - management practices include; selecting, monitoring and evaluating the performance of the assets. Corrective actions are also spelt out. Determining communication procedures - this is the feedback system. It involves providing concise method of communicating the process and objectives amongst all parties involved with the investments and to assign responsibility for implementations. (Winfield R. G. and Curry S. J., 1995.) Once the Investment Policy has been established other factors affecting the investment such as financial and economic conditions, and risk factors will be examined. How to allocate the 100,000 to specific assets will be determined. RiskGrades will be used for optimal allocation. RiskGradeTM measure is an open and transparent benchmark to measure the risk of the world's financial assets. Another optimization criterion to be looked at briefly is the Markowitz co-variance approach. According to Markowitz, (1952), the co-variance matrix can be used to compute portfolio variance. Peter Zangari (1996)'s document on risk metrics assumes that the market is driven by risk factors with observable co-variance. These risk factors which have been incorporated in the analysis include; time series of prices or levels of stocks, currencies (foreign exchange rates), commodities and interest rates. The evaluation of investment performance is very important to any investor. Evaluation goes hand in hand with re-examining the policies and altering the strategies. The constructed portfolio will be monitored throughout the period under review. The reasons why it is performing in a certain way is examined. Policy Statement This is a statement of Investment Policy and investment goals, which establish the investment management procedures. The five basic components of the statement include; Summary of investor circumstances. Investment objectives, time horizon and risk attitudes. Permissible asset classes, constraints and restrictions. The asset allocation decisions. Selection, monitoring and control procedures. For an investor, investment policy depends on circumstances (Winfield, 2005). Institutional investor will be concerned with long-term investments as opposed to an individual investor who will be limited to personal factors such as financial situation, age, family circumstances, and personal preferences to risk. An elderly investor will invest in investments which are short-term though the risks might be high as opposed to a young investor. Diversification comes in for the issue of risks. Diversification is a risk limiting strategy. Since I am a young investor, I would like to diversify my investment and also take a greater amount of risk to enhance the potential earnings on the investment. According to Winfield (2005), as a rule of thumb, at least 10 percent of capital should be in liquid form. This presents itself as a factor in diversification. The overall investment direction is to maximize the return consistent with the risk level acceptable. Cash reserves will be invested so as to minimize risk, loss, and are instantly available. In line with the above, I have decided to allocate the 100,000 as follows; Cash (liquid investments) 10% 10,000 Fixed income investments 30% 30,000 Equities 60% 60,000 Due to the long-term horizon, which I am undertaking, cash equivalent investments have been kept minimum. This could include treasury bills, money market funds, commercial paper, bankers' acceptances, repurchase agreements and certificate of deposit. For the portfolio, I would also implement socially responsible investing (SRI). This involves integrating personal values and societal concerns with investment decisions. SRI considers both the investor's financial needs and an investment impact on society. There are three key SRI strategies that have been involved over the years. These include; screening, shareholder advocacy and community investment. Screening This strategy includes or excludes corporate securities based on how well the securities fit within the social criteria. Screening is both negative and positive. In positive screening companies are included not only because they meet the social criteria, but also because the investor feels a company sets itself for future financial base because of the social implementation. Shareholder advocacy According to this strategy, the investor buys a stake in a company with the intention of agitating for the implementation of his or her social agenda. Community investment This describes investing that supports development initiatives in low-income communities both in the West and in developing countries. Frequently asked question is whether investing using social criteria will mean that the investor will be sacrificing performance. The answer is NO as studies have shown that socially responsible investing results in equal or even superior financial performance than non-screened investments. I will now analyze the different asset classes and the specific assets that have been chosen as investments. In this project, I have taken the stand of being risk averse implying that given two assets with the same expected return, I will prefer the less risk one. For a risk averse investor to take an increased return, he must be compensated by high expected returns. According to Rutterford (2003), most shares quoted in the UK stock market are positively correlated, but less than perfectly, with each other. I have also placed great emphasis to the modern portfolio theory (MPT) on how rational investors will use diversification to optimize their portfolios. To determine the best combination every asset combination can be plotted in a risk return space. The line along the upper space of this region is efficient frontier, sometimes referred to as Markowitz frontier. Combinations along this line present the best combinations giving the highest returns with a low risk. The investor can also use nave diversification. This is a strategy whereby an investor simply invests in a number of assets and hopes that the variance of the expected return on the portfolio is lowered. Risk Grades have also been used to determine which SRI's will provide the highest possible return with an acceptable amount of risk within the period between 2nd April and 11th May 2007. ASSETS Equity Equity refers to security representing an ownership interest in any company's financial structure, equity forms a major part. I will now look at the shares which I have decided to invest in. The shares selected had a RiskGrade of between 130 and 200. Any investment with a RiskGrade over 125 is considered speculative. Shares have been selected in three different companies whose RiskGrade is speculative. Cabot Corporation (CBT) RiskGrade rating 137 Parker Drilling Co. (PKD) RiskGrade rating 194 Peabody Energy Corporation (BTU) RiskGrade rating 171 With such diversification, the shares will reduce the unsystematic risk and at the same provide a desirable return. In determining which SRI's are stable but also yielding a relative high return, I used the DOW Jones sustainability index with special reference to RiskGradesTM. At the outset $60,000 was to be invested in equity and so I have decided to allocate them among the shares in the following way; Cabot Corporation 25% 15,000 Parker Drilling Company 50% 30,000 Peabody Energy Corporation 25% 15,000 This can be illustrated as below; Fixed Income Investing Fixed income investments are loanership assets. Investors loan their money to a government entity corporation or any financial institution and in return they receive a regular interest. The interest is paid on regular basis such as annually, semiannually, monthly or even weekly. The rare of interest can be fixed for the entire investment life or can vary with the general movement of interest rates. Fixed income securities with longer maturities pay a higher interest rate than shorter term investments. The rationale for this is to compensate the investors for the time and risk associated with such period. 30% of 100,000, that is 30,000, is to be invested in a two-year US treasury security. Treasury securities are risk free though the return might be low as compared to other forms of securities. They are considered the safest of all debt instruments because there has never been any default in payment. This is a short term investment with its maturity being in 2009. Cash (Liquid investments) These are investments that convert to money relatively quickly. Cash investments are short term and safe investments with lower return. Such investments are basically for up to six months in maturity. Risk with cash investments is usually low. There are various types of cash investments such as savings accounts in banks, money market mutual funds, treasury bills, savings bonds, fixed annuities and certificates of deposit. I have also decided to invest the 10% that is 10,000 in treasury bills. In understanding the risk volatility associated with cash investments as compared to other forms of investments, this can be illustrated by the following pyramid. Speculative Stocks Increasing risk Decreasing risk volatility Volatility Bonds Money that might be needed within the next 3 years that must stay completely liquid. Source: Rutterford, J. (1993). Performance Evaluation The performance of the shares will be evaluated. This is done through risk verses return analysis over the period under review. 40% *BTU 36% 32% 28% 24% *Portfolio 20% *PKD 16% *CBT 12% 8% 4% Return 50 73 96 119 142 164 187 210 233 Average RiskGrade Each asset is matched with its RiskGrade (x-axis) and Return (y-axis) over the time period between 2nd April and 11th May 2007. In terms of performance, this can be illustrated as follows; Performance Index 125 120 115 110 105 100 April May 2007 2007 According to the analysis, the portfolio fell short of expectations. The individual shares were exposed to variance risks during the period under review. For example, in the case of Cabot Corporation, materials were over exposed to risk affecting the cost of production, overall profit and hence the price of the shares. In the case of Parker Drilling Company, energy is the most exposed sector to risk. In the case of Peabody Energy Corporation, materials are the most exposed sector to risk. All these risk levels are compared to industry benchmarks. Parker Drilling Company and Peabody Energy Corporation belong to the energy sector. The portfolio has a risk ranking of 74% implying that 26% of the stocks in S&P 500 are riskier than the portfolio. In terms of NASDAQ 100, the portfolio has a rank of 45% implying that 55% of the stocks in NASDAQ 100 are riskier than the portfolio. The portfolio's RiskGrade is 128. However, due to diversification, the risk has been lowered by 20%. The portfolio has lost 3.33%. The value has been reduced to $98907. However, the diversification benefit is 22.88%. Increasing the price of the share as in the case of PKD can have a negative as well as positive impact upon the performance of the company. The cash investment in treasury bills performed well under the period under review as the interest rate is specific and known with certainty. This can be illustrated as below; 122% 92% 62% 32% 2% *CBT *PKD BTU -28% -58% -88% -118% 50 73 96 119 142 164 187 210 233 The performance of the Treasury bond was also fair though not as expected. This is due to the time horizon taking into consideration that long term bonds offer a higher return as compared to short term ones. The percentage lose is 0.2%. This can be illustrated as below; 160 120 80 Maturity date May 10th 2009 40 0 The RiskGrades for the shares can be illustrated as follows; RiskGrades Conclusion The portfolio performed far much below than the market expectations as represented by the S&P 500 index. Various reasons can be advanced for such under performance. This includes; risk events and other factors affecting the company such as departure of key personnel and implication in corruption scandals. These have a psychological effect on investors in that their confidence in the company may be reduced. Additionally, the economy did not perform very well within the time frame. This creates the need for diversification. Diversification eliminates or rather reduces these risks to a greater extent since the factors affecting the marketing are hard to predict and in certain circumstances are known. The portfolio would have performed much better if I had invested in long term securities. The portfolio's growth according to S&P 500 is; stocks 80% and bond 20%. In case of conservative plan the stocks would be 20%, bond 70% and treasury bills 10%. I would recommend that long-term investment would produce better results. Short-term investments are highly speculative as evidence by the portfolio with a RiskGrade of 125. A less speculative investment strategy would greatly reduce the RiskGrade (S&P 500 index). As a concluding remark, investment in securities is a highly speculative business marked by various risks and return and for an investor to reduce these risks and at the same time improve on the returns, diversification strategy has to be employed as the market for securities is highly volatile. Reference Markowitz, Harry M. (1952): Portfolio Selection. The Journal of Finance. Winfield R. G., Curry, S. J. (1995): Success in Investment. John Murray Publishers Ltd. 5th Ed. Swensen David (2000): Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment. New York. The Free Press. Rutterford J. (1993): Introduction to Stock Exchange Investment. McMillan Press Ltd. 2nd Ed. Sharpe, W. F., Alexander, G. (1990): Investments. Prentice-Hall Int. London. Tucker, A. L. irkt. (1994): Contemporary Portfolio Theory and Risk Management. West Publishing Co. London. Atril, P.(2004) Financial Accounting for Decision Makers. 4th Ed. Prentice Hall . Michael W. Maher, William N. Lanen, Madhav V. Rajan(2004). Introduction to Accounting management. McGraw-Hill/Irwin. Michael R. Kinney, Cecily A. Raiborn(2005). Cost Accounting. Jenice Prather-Kinsey. Lipkin, Lawrence (1988). Accountant's Handbook of Formulas and Tables. 3rd ed. Englewood Cliffs, NJ: Prentice-Hall. Lynch foulks (2001) Interpretation of Financial statement, ACCA Text book,. Needles, Belverd E., and Powers, Marian (1998). Financial Accounting. Boston: Houghton Mifflin. Abraham, F.J. (May, 1988). "Pitfalls to Using the Real-Rates or Age-Earnings Profile Models in Calculating Economic Loss," Journal of Forensic Economics, V. I, No. 2 Kaplan, R.S. (1982), Advanced Management Accounting, Englewood Cliffs, N.J., Prentice-Hall. Drury, D. H. and C. S. McWatters. 1998. Management accounting paradigms in transition. Journal of Cost Management (May/June): 32-40. Ebben, J and Johnson A (2006). Bootstrapping in small firms; An empirical analysis of change overtime. Journal of business venturing, Vol 21 issue 6 851-865. Van Auken, H (2005). A small firm capital acquisition decisions, international entrepreneurship and management journal vol 1;335-352 Winborg, J & Landstrom,H (2001) financial bootstrapping in small business managers resource acquisition Behaviour, Journal of business venturing vol 16; 235-254 Bhabatosh Banjerjee (2005).financial policy & management accounting. Prentice hall of India. Michael J. Lambert and Alicia M (2006); Management Accounting. Sage publication Press. Websites interactiveinvestortradingltd@http://www.iii.co.uk riskgradesTM@http://www.riskgrades.com Accessed 11.05.07 Appendix Performance Evaluation Performance by line between 2nd April and 11th May 2007. Cabot Micro Electronics 37.5 37.0 36.5 36.0 35.5 35.0 34.5 34.0 33.5 33.0 32.5 32.0 0 13 16 17 18 19 20 23 24 25 26 27 30 1 2 3 4 7 8 9 10 11 Parker Drilling Company 11.8 11.7 11.6 11.5 11.4 11.3 11.2 11.1 11.0 10.9 10.8 10.7 10.6 10.5 10.4 0 13 16 17 18 19 20 23 24 25 26 27 30 1 2 3 4 7 8 9 10 11 Peabody Energy Corporation 51.0 50.5 50.0 49.5 49.0 48.5 48.0 47.5 47.0 46.5 46.0 45.5 45.0 0 13 16 17 18 19 20 23 24 25 26 27 30 1 2 3 4 5 6 7 8 9 10 11 Read More