The Process of Portfolio Management for Stock Funds Performance - Research Paper Example

?Introduction This research is aimed at explaining the process of portfolio management for stock funds performance. The portfolio management entails the process that is divided into four stages: they are mentioned by Bodie et al., (2005) that explains “specifying objectives, identifying constraints, formulating policies and later monitoring and updating the portfolio as needed” In specifying portfolio objectives, the main focus is on the trade-off between return requirements and risk tolerance of investors. Hence as an investor, the ability to accept risk in the pursuit of higher rates of return has to be analysed depending on various constraints that include, liquidity needs, time horizon, tax considerations, regulations and unique needs and preference (Bodie et al., 2005). Subsequently, as an investor, the third step of portfolio management is asset allocation that is able to make an attempt of satisfying investors' needs and objectives and at the same time, help in making decision regarding the proportion of wealth invested in each major asset categories (Bodie et al., 2005). As an investor, the main aim of asset allocation and investment is capital appreciation. I intend to make sound investment decisions while maintaining a level of moderate risk tolerance in the pursuit of high return. Hence I will define myself as a moderate investor with a risk aversion of 6 (Bodie et al., 2005). Considering my age, I am a young investment with a long investment horizon, hence my investment decisions will be based on less need for immediate liquidity, long term investment need and at the same time be able to tolerate greater risk in the short time. In the macro level, my investment decisions will be affected by the overall economic growth of the country and region and at the same time government decisions like Tax concerns and regulatory factors. Therefore, considering the objectives and constraints presented above, I would be better off if investing in risky assets in pursuit of higher returns. With a risk aversion of 6, I would invest my wealth in stocks while allocating remainders to treasury bills. The important elements of my investment portfolio strategy is my current assets, time horizon, expected return, tolerable losses, and portfolio benchmarks and they are explained below. Current Assets As an investor, the total net assets available is $10,000,000 in assets.  Time Horizon The investment that is intended has one year time horizon.  Overall Portfolio Expected Annual Return As an investors, I expects a portfolio return that is 5 percentage points above the rate of inflation.  I have arrived at this percentage due to the fact that inflation will vary over time; hence I am using the incremental return over inflation as a determinant of whether I am able to meet my goals. As a guideline, here are the real annual returns (above inflation) that I use:  Large-cap stocks: 6.0% Mid/small-cap stocks: 6.0% International stocks: 7.5%  Bonds: 4.0% By creating a balanced portfolio, I will be able to have a blend of the returns mentioned above based on my asset-allocation mix. Loss Limit as a new investor, I would accept losing not more that 10% in the year of investment. At this rate with my tolerance for risk, I am willing to accept a loss of 10% and if my portfolio falls by more than he prescribed percentage, I will have to re-examine my portfolio and create a new portfolio for investment. Asset Allocation I will set the following lower limits, targets, and upper limits for investment in each asset class.    Asset Allocation Lower Limit ( % ) Target ( % ) Upper Limit ( % ) Large-cap value stocks 30 25 25 Large-cap growth stocks 25 30 35 Mid/small-cap stocks 20 25 25 International stocks 25 20 15 By creating the above asset allocation, it is hoped that the portfolio investment will realise positive growth. If not, then the asset allocation will be rebalanced in the investment horizon. Evaluation Benchmarks It is important to evaluate myself by comparing the total return of each stock with its category, hence I expect to have a return that is above or just at the level of the industrial benchmark for the last two years. Investment Philosophy I will balance the decision of taking on as much risk as possibly while at the same time attempting to achieve a higher long-term rate of return. At the same time, I will diversify our portfolio investment across a wide range of investment opportunities. It is hoped that this move will help me benefit in the upside of most asset-class performance while reducing the probability of suffering losses due to our investment choices. I will also strive to control costs by limiting expense ratios, fees, and brokerage costs. Data and methodology The research conducted is chronological in nature. Hence the report provided begins by defining terms and concepts and show the methodology used in research analysis, sources of data and finally it shows how my portfolio is constructed and evaluated during the period of investment based on the stock chosen from the Forbes list provided. Portfolio diversification Any investor recognizes the importance of maintaining a diversification strategy as he/she strives to reduce the portfolio deviation by adding more stocks into the portfolio until all unsystematic risk are eliminated and only risks that are attributable to systematic risk remains. As a result, Portfolio diversification is a strategy that is able to achieve the above and at the same time moderate the short-term effects of individual asset class performance on portfolio value at a minimal cost in terms of expected return. These underlying principals apply to all types of investments in the financial market. Treynor/Black (TB) method The Treynor–Black model is a mathematical model for making asset allocation decisions in an investment portfolio based on securities' systematic and unsystematic risk, that was postulated by Jack Treynor and Fischer Black. The model is used when assuming that an investor who through his investigation assumes that his securities are price sensitive, will try to use information to predict abnormal movements in prices to find the optimum portfolio as he tries to create a tradeoff between diversification and benefiting from price changes by other investors (Bodie et al., 2005). The model while being used has several underlying assumptions. They include the fact that only a limited number of stocks will be analyzed. Hence, Mispricing is considered to be the guiding factor when choosing active portfolio will at the same time, and the market index portfolio is treated as the passive portfolio. Coupled with, macro forecasting that provides information that entails the expected return and variance of the passive portfolio. Lastly, a combination of the active and passive portfolio is the ultimate optimal risky portfolio (Bodie et al., 2005). The essence of Treynor/ Black method lies in the optimization process with the active and passive portfolios. By definition, the market index (passive portfolio) is the tangency point of the capital market line (CML) with the efficient frontier representing the universe of all securities assumed to be fairly priced. However, in practice, the market-index portfolio has been proved to be inefficient as a result of superior analysis identifying mispricing. Therefore, the active portfolio, with its positive alpha value, must lie above the CML. So far, the optimization problem has become a simple application of the construction of optimal risky portfolio from two component assets: active portfolio constructed at first and the passive portfolio represented by market index portfolio. Considering that the active portfolio is not perfectly correlated with market index portfolio, the efficient frontier consisting of these two components would be a curve as well, similarly to but above the one from the universe of all securities. The optimal capital allocation line (CAL), passing through the risk-free rate and tangent to the new efficient frontier can be obtained by now. The optimal risky portfolio, which combines the active and passive portfolio, locates at the tangency point of the CAL to the efficient frontier. Hence, TB method has successfully exploited mispriced opportunities, while achieving optimal diversification. Data analysis To achieve diversification, I have selected 10 stocks from different indexes but listed in the Forbes to companies in the world from March 02, 2012 and collected monthly returns for this 3-month period till May 08, 2012. Table 1 reveals the companies and the weekly movement of the stock prices for the period under investigation. Date ROCHE WALT DISNEY DAIMLER PTR CHINA MOBILE WAL-MART STORES BHP JNJ MICROSOFT RIO TINTO 5/7/2012 42.47 45.02 38.35 136.29 56.67 59.03 69.33 64.28 30.76 50.67 4/30/2012 44.95 42.93 39.28 144.45 56.47 58.3 71.73 64.74 30.98 51.91 4/23/2012 45.6 43.35 42.08 149.89 54.52 58.63 74.25 64.84 31.98 56.96 4/16/2012 46.28 42.35 41.23 146.18 56 62.03 73.41 63.71 32.42 57.12 4/9/2012 42.7 41.85 40.29 140.75 54.47 59.37 70.45 63.54 30.81 54.88 4/2/2012 42.85 43.08 42.85 140.97 53.93 60.26 70.04 65.34 31.52 54.24 3/26/2012 43.64 43.78 45.21 140.53 55.08 60.79 72.4 65.96 32.26 55.59 3/19/2012 43.4 43.65 45.49 142.37 53.21 60.34 71.58 64.55 32.01 53.74 3/12/2012 43.75 43.19 47.23 147.84 53.56 60.43 74.69 65.12 32.6 56.82 3/5/2012 43.13 42.24 46.94 147.65 55.35 59.68 74.14 64.74 31.99 54.67 2/27/2012 41.27 42.36 46.24 150.06 52.68 58.22 76.01 64.77 32.08 56.42 2/21/2012 42.37 41.31 47.44 150.13 52.42 58.01 76.7 64.46 31.48 57.4 2/13/2012 42.2 41.75 47.78 150.35 52.92 61.65 75.05 64.42 31.25 56.55 2/6/2012 42.36 41.45 46.35 146.63 50.6 61.07 76.02 64.03 30.3 58.42 1/30/2012 41 40 45.46 149.47 51.18 61.2 81 65.07 30.04 61.74 1/23/2012 41.29 39.25 42.7 147.07 50.8 59.9 79.03 64.99 29.04 59.07 1/17/2012 41.89 39.31 41.96 145.58 49.28 60.2 77.06 64.7 29.52 56.46 1/9/2012 40.97 38.4 37.97 140.1 49.01 58.75 73.9 64.69 28.07 53.47 1/3/2012 41.22 39.91 36.47 137.31 48.62 58.21 71.44 64.26 27.93 50.46 With the purpose of obtaining an overall understanding of those stocks I am going to use in the portfolio construction, I am employing an exploratory data analysis, including descriptive statistics, autocorrelation and correlation analysis. Descriptive statistics Date ROCHE WALT DISNEY DAIMLER PTR CHINA MOBILE WAL-MART STORES BHP JNJ MICROSOFT RIO TINTO 4/30/2012 0.058394 -0.04642 0.02425 0.059872 -0.00353 -0.01237 0.034617 0.007156 0.007152 0.024472 4/23/2012 0.014461 0.009783 0.071283 0.03766 -0.03453 0.00566 0.035132 0.001545 0.032279 0.097284 4/16/2012 0.014912 -0.02307 -0.0202 -0.02475 0.027146 0.057991 -0.01131 -0.01743 0.013759 0.002809 4/9/2012 -0.07736 -0.01181 -0.0228 -0.03715 -0.02732 -0.04288 -0.04032 -0.00267 -0.04966 -0.03922 4/2/2012 0.003513 0.029391 0.063539 0.001563 -0.00991 0.014991 -0.00582 0.028329 0.023044 -0.01166 3/26/2012 0.018436 0.016249 0.055076 -0.00312 0.021324 0.008795 0.033695 0.009489 0.023477 0.024889 3/19/2012 -0.0055 -0.00297 0.006193 0.013093 -0.03395 -0.0074 -0.01133 -0.02138 -0.00775 -0.03328 3/12/2012 0.008065 -0.01054 0.03825 0.038421 0.006578 0.001492 0.043448 0.00883 0.018432 0.057313 3/5/2012 -0.01417 -0.022 -0.00614 -0.00129 0.03342 -0.01241 -0.00736 -0.00584 -0.01871 -0.03784 2/27/2012 -0.04313 0.002841 -0.01491 0.016322 -0.04824 -0.02446 0.025223 0.000463 0.002813 0.03201 2/21/2012 0.026654 -0.02479 0.025952 0.000466 -0.00494 -0.00361 0.009078 -0.00479 -0.0187 0.01737 2/13/2012 -0.00401 0.010651 0.007167 0.001465 0.009538 0.062748 -0.02151 -0.00062 -0.00731 -0.01481 2/6/2012 0.003791 -0.00719 -0.02993 -0.02474 -0.04384 -0.00941 0.012925 -0.00605 -0.0304 0.033068 1/30/2012 -0.03211 -0.03498 -0.0192 0.019368 0.011462 0.002129 0.065509 0.016242 -0.00858 0.05683 1/23/2012 0.007073 -0.01875 -0.06071 -0.01606 -0.00742 -0.02124 -0.02432 -0.00123 -0.03329 -0.04325 1/17/2012 0.014531 0.001529 -0.01733 -0.01013 -0.02992 0.005008 -0.02493 -0.00446 0.016529 -0.04418 1/9/2012 -0.02196 -0.02315 -0.09509 -0.03764 -0.00548 -0.02409 -0.04101 -0.00015 -0.04912 -0.05296 1/3/2012 0.006102 0.039323 -0.0395 -0.01991 -0.00796 -0.00919 -0.03329 -0.00665 -0.00499 -0.05629 From table 2, it is observed that all the 10 stocks have a relatively low average return in the three month period, accompanied by low or medium risks, the standard deviation below 0.1 for most stocks. As shown in the table below.   ROCHE WALT D DAIMLER PTR CHINA M. WAL-MART BHP JNJ MICROSOFT RIO TINTO beta 0.416925 0.440027 0.401956 0.036178 0.274195 0.213758 0.138145 0.183099 0.799967 0.244535 Autocorrelation Correlation analysis Correlation analysis is important in investigating the portfolio of assets and find out whether the assets move in the same or opposite directions. Correlation value of 1 means two assets are moving in the same direction to the same extent. Correlation value of -1 would mean perfect opposing movement--one asset increases, the other correspondingly decreases. The table for the overall correlation coefficients can be found in table 3. It can be seen that only MICROSOFT and RIO-TINTO are negatively correlated. ROCHE WALT DISNEY DAIMLER PTR CHINA MOBILE WAL-MART STORES BHP JNJ MICROSOFT RIO TINTO 0.61 0.18 0.72 -0.03 0.07 0.22 0.19 0.16 0.16 -0.53 Portfolio construction and comparison In constructing the optimum level of portfolio selection, it is important to use the Markowitz portfolio for comparison and use. This is explained below. The Markowitz portfolio To construct optimal portfolios based on Markowitz methodology, hence initially, I will construct efficient frontier from the set of risky assets through the process of minimizing the portfolio variance for any given returns. With our portfolio having 10 stocks for diversification. And given the fact that we hope to achieve a positive return to investment, the efficient frontier will depend on the historical returns of the 10 stocks showing the lowest and the highest returns. At the same time, in drawing the graph, I am making assumptions based on the expected return in the market. At the same time, I am using the 10-year treasury yield by the Federal Reserve Bank (FRB) publishes updated treasury rates once a month. The current rate on a 10-year treasury is 1.89 percent (CNN, 2012). In analysing the expected return of the market, according to the S & P, the average return is 10.8 percent a year, compounded, since 1926 (CNN, 2012). Hence for analysis, it is important to use it as a basis for the expected return of the market. Hence, the market risk premium equals the average expected return from the market (10.3 percent) minus the risk free rate (1.89 percent). The risk premium = 8.41 percent. Sharp ratio measurement Sharp ratio measures the risk premium return earned per unit of total risk. It is an equation to calculate risk-adjusted performance of a stock portfolio in which it is able to evaluate investment portfolio while creating a trade of between rate of return and diversification (Reilly and Brown, 2003). The higher the ratio, the better the portfolio has performed after being adjusted for risk. The calculation for sharp ratio is shown below: The sharp ratio equation = (rate of portfolio return - risk free rate) / portfolio standard deviation Hence = (-0.35392-1.89%)/ (0.151115) = -2.46716 The answer shows that the portfolio of investment is not very wise since it is less than zero, if it was greater than zero and above it would have been better off. Hence it is important for the investor to create another asset class that would bring a better return on investor with less risk in the market. Evaluation of performance When analysing the portfolio of investment, there were six stocks that did perform moderately well in the period of three month. They included ROCHE HOLDING AG, WALT DISNEY, DAIMLER, CHINA MOBILE, WAL-MART STORES and MICROSOFT. Their overall rate of return was positive attributed to the average rate of return in the market. For ROCHE HOLDING AG it performance can be seen in the below graph and chart. For the last 52 weeks, the stock has been fluctuating between 36.50 - 46.40. It has not been able to fully realise its true value that analysts predict should be targeted at 50.55. According to the analysts it is a strong buy however, due to subdued market activities, the stock value has been quite till when the market becomes bullish again. CHINA MOBILE with an increase 14.75% rate of return stock chart has been rising steadily for the last three months. According to the analysts, the wireless communication market is still bullish with an expected growth in return on asset invested. Most analysts believe that the investors should buy and hold the shares. Its chart is shown below in which for the last three month, the value of the shares has been steadily rising. For MICROSOFT SHARES, its share price had been rising initially before it corrected itself, most analysts believe it is a strong share with them recommending to the investors to buy and hold since its value is expected to rise in the near future by more than 20%. The graph for Microsoft is shown below. Despite the fact that JOHNSON AND JOHNSON is a strong company, its share for the last three month has been almost at the same spot. Trading at around $ 64 as shown in the graph below. The company is heavily capitalized with a strong balance sheet and analysts are of the opinion that its share is one the you can buy and hold for long period of time. DAIMLER shares were also moving positively with its shares prices moving by more than 3% for the period being analysed. However, its shares started going on a downward trend from the month of March and this affected the overall rate of return for the shares. For BHP BILLITON LTD, its share value reduced steadily for the whole period of analysis. According to the analysts, it is a buy and hold. However, the shares have been overweight and were downgraded with the median term projections showing that the shares might fall to a low of $ 52.01. Its downward movement in the value of the shares by around 38% greatly contributed towards the portfolio value reducing. RIO TINTO shares were steady for the period of analysis, oscillating in the range of $ 50. It is a strong buy according to the analysts the price in the median term might rise to $ 88.40 hence it is a stock that an investor can buy for the long term. Its chart can be observed below. For WALT DISNEY Company, the shares have been on an upward trend with its share value climbing steadily from $ 39.91 in January to $ 45.02 in May. The company is a strong company with its revenue stream coming from animation movies and other block buster’s that have positively contributed towards its economic health. With its P/E ratio being at 16.22 the company is poised to continue growing with analysts predicting that in the median term its share should rise to $ 48.50. And on the higher side, the shares might rise to $ 57.00. its chart is shown below showing the steady rise in the value of the shares. PETROCHINA CO. LTD is a Chinese company that is involved in exploration and trading of fuel in the world and in chine. When analysing its share movement for the period under scrutiny, its shares has been oscillating between $ 137 and $ 149. These are big movement considering the value of the shares and the size of the company. Analysts predict that the company’s shares have the potential of rising to $ 169.33 in the future due to increased trading and economic outlook. Finally for BHP BILLITON Ltd. Its shares have been steadily maintaining its position between $ 71 and $ 69 for the period of investment. According to analysts, its share is overweight and it is predicted that it will reduce to $ 66.04. it chart can be observed below. As seen below, since the beginning of the year, the shares have been steadily on the positive side with no significant movement on either side. Compared to the overall performance of the major indexes, its main index has been at the range of, 10,362.30 - 13,359.60 for the last 52 weeks showing a less than significant movement in the market. Its graph is presented below and it shows the average index moving in a positive direction showing that the market is recovering from it last year’s poor performance. Conclusion This research briefly reviewed the foundations of portfolio selection. It then applied and extended the MPI model of Grauer & Hakansson [1986] to construct and rebalance portfolios composed of equities, long-term government bonds, a risk-free asset, over the period three month between January and March 2012. Returns were assumed to be normally distributed and transaction costs were ignored. Portfolios were then generated, using three month of past realised returns to forecast future returns. On a risk-adjusted basis it still provided a substantial improvement in performance when compared to investment in financial assets alone. The results that were discovered suggested that, if a high proportion of assets are held in stocks, as investors, we should diversify company risk by investing cash balances designated for long-term capital expenditure in a diversified equity portfolio, or index fund, or in a bonds that would help reduce the probability of less return. We had invested all the assets in risky assets and did not hedge against probability of failure in a portfolio investment. Another important lesson that was derived from the investment portfolio is ensuring that as investors, we expanding the investment horizon, to other markets that are less volatile and at the same time invest in growth stock for a long period of time to be able to realise positive return on our investment. At the same time, it is important to hold increasing number of individual stocks to be able to fully diversify while putting into consideration other systemic and unsystemic risk factors that might end up reducing the effect of diversification. References: 1. Bodie, Z., Kane, A., & Marcus, A. J. (2005). Investments. 6th edn, Singapore: Mc Graw Hill 2. Reilly, F.K. & Brown, K.C. (2003). Investment Analysis and Portfolio Management. 7th edn. Ohio: Thomson South-Western Read More