Financial Resource Management at Personal Level: Risk and Return - Essay Example

Personal Finance Personal Finance is nothing more than the management of your financial resources to meet your needs and achieve your desired goals. It is personal; that is, it's about you and your family, and your household. It is finance; that is, it concerns money - that which you have, that which you will have, that which you need. It does not concern things - things are what you buy with your money. It concerns how money is acquired, stored and used (Peter Sander, p.4-5). The happy phrase "make it, spend, keep it, grow it" summarizes the major quadrants of personal finance. Personal Finance requires attention to all four aspects in balance. Making money accomplishes little if it spent frivolously. Consuming more than one produces is not viable in the long term. A household that makes and spends but does not save will achieve immediate gratification, but will be caught short at some point in the future. A household that makes it, spends it and manages to save some is on the right track but without growing it may fall short of achieving goals (Peter Sander, p.4-5). Personal finance involves planning both for today and for the future. The toady part is managing current income, expenses, and savings. Planning covers aspirational goals and the many of what-ifs of life (Peter Sander, p.4-5). The quadrant model of personal finance popularized by Robert T. Kiyasaki's Raich Dad, Poor Dad series is a good reference. The four quadrants are Income, Expenses, Assets and Liabilities. The difference between Income and Expenses (net savings) builds Assets (good) or Debt (bad). The difference between Assets and Liabilities is net worth, which, of course, is good if positive and bad if negative (Peter Sander, p.4-5). Personal Finance essentially comes down to managing the four quadrants of ones financial life (Peter Sander, p.4-5). 1. Justification of the Strategy The total amount available for investing is GBP 100,000.00. The investment goal is to earn an amount of GBP 5,000.00. The period in which to generate an investment income of GBP 5,000.00 is one month. Considering the lead time the amount must be invested in high yielding securities in order to achieve the objective. The decision has been made to invest in shares of Tesco Plc and BP Plc. Tesco Plc's shares has peaked to 470p in mid of May 2007 and again in mid October 2007 463.25p. BP Plc shares have commenced an upward trend at 562p from 04th October 2007 and peaked at 580.5 on 09th October 2007. The shares had been purchased at the price 579.25p. It is the expectation that the appreciation of the share prices will continue further appears to have been basis of the decision to purchase these two shares. The two companies are in diverse sectors. This diversification assists in minimizing the impact of adverse results in one area. This would complement the composition of the portfolio. No data is available to differentiate whether that stock were purchased based on Sector selection or economic forecasts. 2. Calculation of Portfolio Risk Portfolio Theory Modern portfolio theory (MPT) proposes how rational investors will use diversification to optimize their portfolios, and how a risky asset should be priced. The basic concepts of the theory are Markowitz diversification, the efficient frontier, capital asset pricing model, the alpha and beta coefficients, the Capital Market Line and the Securities Market Line. MPT models an asset's return as a random variable, and models a portfolio as a weighted combination of assets; the return of a portfolio is thus the weighted combination of the assets' returns. Moreover, a portfolio's return is a random variable, and consequently has an expected value and a variance. Risk, in this model, is the standard deviation of the portfolio's return.(http://en.wikipedia.org/wiki/Modern_portfolio_theory) Risk and Return The model assumes that investors are rational, meaning that given two assets that offer the same expected return, investors will prefer the less risky one. Thus, an investor will take on increased risk only if compensated by higher expected returns. Conversely, an investor who wants higher returns must accept more risk. The exact trade-off will differ by investor based on individual risk aversion characteristics. The implication is that a rational investor will not invest in a portfolio if a second portfolio exists with a more favourable risk-return profile - i.e. if for that level of risk an alternative portfolio exists which has better expected returns.(http://en.wikipedia.org/wiki/Modern_portfolio_theory) Figure: Capital Market Line Source: .(http://en.wikipedia.org/wiki/Modern_portfolio_theory) 3. Efficient Market Hypothesis An investment theorythat states that it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, this means that stocks always trade at their fair value on stock exchanges, and thus it is impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. Thus, the crux of the EMHis that it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments. Although it is a cornerstone of modern financial theory, the EMH is highly controversial and often disputed.Believers argueit is pointless to search for undervalued stocks or to try to predict trends in the market through either fundamental or technical analysis. Meanwhile, academics point to a large body of evidence in support of EMH, an equal amount of dissension also exists.For example, investors such as Warren Buffett have consistently beaten the market over long periods of time, which by definition is an impossibility according to the EMH. Detractors of the EMH also point to events such as the 1987 stock market crash (when the DJIA fell by over 20% in a single day) as evidence that stock prices can seriously deviate from their fair values. (http://www.investopedia.com/terms/e/efficientmarkethypothesis.asp). 4. Portfolio Performance In evaluating the personal portfolio performance, the consideration is to compute the gains on disposal of the shares in the portfolio. This is, the difference between the net sales proceeds with the grossed total purchase cost. The total of net gains could be compared with the expected outcome of GBP 5,000.00, i.e., the initial expectation at the outset when purchasing shares in the portfolio. The variance will evaluate the personal portfolio performance. On the returns, the net gain on each share could be evaluated on the following basis. Calculation for each share - Net gain x 100 Total Purchase cost will provide the percentage of earning from that cash investment for a period of 30 days. When you annualized this percentage, one could compare with the return from an alternative option. The same formula could be compared with the total net gains to overall performance and the rate of return. The following figure provides the composition in a conservative portfolio. (Source: http://www.investopedia.com/articles/pf/05/060805.asp) (Source: http://www.investopedia.com/articles/pf/05/060805.asp) The above figures demonstrate the investment decisions in respect of allocation assigned in the percentage for each different components of the portfolio in line with the associated risk. The performance evaluation of the portfolio will be computed for each different segment and then overall. 5. Tax Considerations The implication of tax in this investment stems from the net gain in the disposal of shares and any dividend income. On the dividend income, tax credit will be given for the amount taxed at source. On his personal status, the receipt of GBP 100,000, which he inherited, is free from inheritance tax as the amount is below the threshold. He earns an annual GBP 20,000. His personal allowance for 2007/2008 is GBP 5225. His personal tax rate will be at the basic rate. He will have paid PAYE on his employment income. 6. Conclusion The overall performance will be evaluated taking into the tax consideration, average annualized return the portfolio has earned given the risk characteristics in the portfolio and the comparative analysis to expected return which includes respective beta and the Risk free Return. References: 1. http://www.greekshares.com/educate.php 2. http://www.investmentu.com/resources/investmentadvice.html 3. Peter J. Sander, The 250 Personal Finance Questions that everyone should ask, (USA, Adams Media, 2005) 4. http://en.wikipedia.org/wiki/Modern_portfolio_theory 5. http://en.wikipedia.org/wiki/Modern_portfolio_theory#Risk_and_return 6. http://www.investopedia.com/terms/e/efficientmarkethypothesis.asp 7. http://www.investopedia.com/articles/pf/05/060805.asp Read More