Money Management - Exchange on Trade Fund - Assignment Example

? Money Management and Money Management Introduction For the realization of a better result in any venture, regardless of whether it is a business venture or any other venture, there is a need to have a good management to steer the investment to success. Money is one of the essential factors that contribute to the growth of any venture, especially business investment. It should, therefore, be noted that good money management is a sure guarantee of a brighter future to such investment (Stacy & Fuller 2008). Money management is the process of being a custodian of one’s finances by knowing where today’s finances are being spent, and drawing a well thought out plan showing where one wants this money to go. Therefore, it calls for one to be well organized; have set goals, which would gear this investment to success; have a track of one’s spending by putting in place a realistic budget, and above all have a well thought-out savings strategy. The paper takes cognizance of the Exchange on Trade Fund (ETF), which is associated with the stock market. Carrel (2008) explains that ETF is an investment fund or security that is entrusted with the stock exchange market. ETFs resemble a commodity, an index or a basket like an index fund; thus it is designed to trade like a stock on an exchange market. The paper would, therefore, discuss the aspects surrounding the financial market as far as ETF is concerned (Carrel 2008). My risk profile evaluation reflection As an investor, I would seek to establish a strategy that matches my risk profile so that I may not be caught off guard should such risks occur. I would, therefore, work towards ensuring that I cushion myself against any short- term loss. This becomes possible if I ensure long-term growth in the value of my investment and by being cautious on inflation. My investment objectives would only be pegged on the long-term investment; therefore, I will have to take risks in order to get higher returns (Scott 1975). To demonstrate my risk profile and asset allocation, I will use the model shown in the appendix III. Under this profile, my risk profile falls under 44-58 score, which means that my risk taking profile is moderate. This will inspire my selection for passive participant portfolio that will be explained later. In view of this, my portfolio selection will depend on my key objectives including time horizon, risk tolerance, and other assets held out of the plan. The original amount or the principal investment is not assured at any time, including the proposed year of allocation. I will seek to establish my risk tolerance, so I can know my level of investment risk, with which I am comfortable. I will do this through the investor profile quiz as shown in Appendix I (Milevsky 2001; Milevsky 1998). ETFs verses Mutual funds In this study, I will prefer ETF to mutual funds, because ETF has some potential advantages compared with mutual funds. Most importantly, my aim is to choose an investment that will improve my rate of return on investment, while minimizing the risk profile as much as possible. ETFs are operated at low expenses because they are passively invested unlike mutual funds, hence improving my rate of return. In addition, I will prefer ETFs to mutual funds because of their tax efficiency, due to their structure that makes them avoid capital gain tax. The following are some specific advantages of ETFs. Condensed Risk Hedging Vehicles Hedging is an effective risk diversification technique employed by buying an investment that is inversely associated with other assets in a group. An Inverse ETF is designed to shift in the reverse direction of a particular index. A portfolio manager, with the use of Inverse ETF, can reduce the market threat of an entire group or precise part of a group. Increased Diversification When circumstances are in need of a basket of stocks, ETFs helps in diversification. Diversification is the situation of being in possession of enough personal investments in an asset category or class such as stocks, bonds, foreign stocks, and real estate with the aim of minimizing the specific or unsystematic risk. Several attributes, including the size of allocation to the asset class, can influence the decision on whether to employ individual stocks or ETFs. Ability to Target Precise Investment Sections ETFs make Asset allocation management easier because they have an array of products available for the investors to choose from. For the U.S domestic investors, the range is almost infinite. This enables a portfolio manager to expand into precise market sectors and niches with a minor, but diversified position. For instance, if an investor hopes that investing in water is a wise investment, of course, there are many water ETFs to be selected for investment. Nearly any sector conceivable is now covered in ETF portfolios. The choices are nearly as good internationally. Investing in individual international stocks may be more precarious, particularly in small, developing, and frontier markets. ETFs grant instant low cost variation in diverse classifications such as frontier and emerging markets, sector funds, small-cap country funds and foreign large cap dividend growth. Passive participant portfolio In view of my situation and risk profile, I would go for a passive participant portfolio, which involves use of hybrid/lifestyle and index funds. This is a simple lifestyle funds asset allocation strategy and index funds investment management strategy, which suits investors who want to get instant diversification through by investing in asset allocation fund and/or by tracking the market performance benchmark. An index fund, in this case, is a mutual fund that moves in the same direction with the performance Dow Jones Industrial Average among other major key market index. This behavior is achieved by investing in the companies that match the average and in an identical ratio, in such a way that it precisely corresponds to the index. This implies that the fund will drop when the average drops and vice versa. The following are some of the benefits that inspire me to invest in passive participant portfolio (Brinson et al. 1986). 1. Low cost: Unlike active management funds, these funds are less expensive to operate because the investor does not need to employ traders, analysts, fund managers and other specialists. Since the index funds follows the average, little expenses is spent in running them, hence the returns are high. 2. The investment strategy is regular: Since humans are not involved in the running of these funds, then the investment strategy is not likely to change. Lifestyle funds are run up to a specific year of retirement as specified in the fund name, with each fund having a combination of bonds and stocks, which are distributed as the fund nears the planned date of retirement. Before and after the retirement date, the funds continue to change asset classes. With time, the allocation of these funds become more conservative, hence the participants are not required to keep rebalancing them. The following table illustrated my portfolio of choice: Sample Passive participant portfolio Core Investment Categories Tickers Stable Value Invesco Stable Asset Fund Class ADP 85 N/A Large Cap Blend SSgA S&P® 500 Index Fund N/A Small Cap Blend SSgA Russell® Small Cap Index Fund N/A Intermediate Term Bond SSgA U.S. Bond Index Fund N/A Foreign Large Cap Blend SSgA International Index Fund N/A Non-Core Investment Categories Life Style Target Funds T.Rowe Price Retirement Income, RRTIX, RRTAX, RRTMX Mid Cap Blend SSgA S&P® MidCap Index Fund N/A Risk management/hedging While passive portfolio is essentially less exposed to risk, its returns are potentially low. Even though the risk profile for passive investment is low, this does not whatsoever weigh down the need to apply hedging as a risk management strategy. Hedging is whereby a particular investment is maintained with the aim of reducing negative impacts that result from price swings in a portfolio. To hedge my portfolio, I can use financial derivatives such as futures and options to reduce losses. For example, whenever I am worried about short-term sways in my portfolio, I can purchase put options, which will guard my investment against loss in case the value of my portfolio declines. This hedging will come at a cost; therefore, I will have to weigh that cost against the benefit. Asset allocation and diversification One of the most important steps for creating a successful portfolio is efficiently dividing assets within scores of different investment types. Some of the most important classes of assets are bonds, stocks and cash. The performance of these investments depends on the prevailing conditions of the economy. Therefore, a good balance is required to maintain the portfolio strong in different economic situations. Accordingly, the allocation of assets becomes the most important way of diversification. More so, classes of assets carry different amounts of risks. This means that the best an allocation will depend on various factors relating to my investment profile (Yaari 1965). While compiling a plan for asset allocation, it is very important to consider risk tolerance, time horizons, and investing goals. These factors are closely related. They will allow me to determine the amount of money that I will need at certain stages of my life. They will also determine the amount of uncertainty that I can tolerate in moving from one stage of life to the next. Family situations and age are closely linked to investing goals. Generally, I am quite young and can tolerate moderate risks in my investments; since I can manage to wait for bad times to wade off and compensate for the difference during the better times. Time horizons simply refer to the duration of time that the money that has been invested will be required. Some common examples include the time that a child takes to start college or the time that I will work before retiring. Again, time horizons that are longer, allow for investments that are more risky because a short downturn cannot adversely affect the long term plan (Merton 1969). Once I have decided my time horizons and the corresponding risk level that I am comfortable with, I will have to establish investment options that are best for my profile. Risks that are high pave way for greater rewards. However, these rewards are not of any value if they are not available when the money is required. Stocks provide investors with the best growth prospectus in the long run. Stocks do better than all other investments in the long run. However, stocks are quite volatile, hence making them very risky. Within a short time span, stocks can lose a lot of value. More so, the profitable stock performance is based on entire consideration of the stocks. Stocks that are individual may not be able to be at par with the entire market. At the same time; they may completely lose value, for instance, if the bank is declared bankrupt. Bonds constitute a safer investment opportunity even though they have fewer returns over time. These low return assets represent the cost of doing away with a high level of volatility. Investments in cash, such as money markets constitute the safest methods of investments. Just as expected, they deliver the least returns. In order to get assistance with allocation of assets without hiring the services of a financial expert, I will prefer investing in ETFs. Funds for allocating assets give different bond, stock mixes and other investments that fit different profiles as shown in the appendices models. In the same case, ETFs can be used for the provision of diversification in different classes of assets. This means that I can easily divide my money among bond funds, money market funds and stock funds in correct ratios. The main actors in the financial market The main actors in the capital market can be singled out as the issuers, the investors and the intermediaries. In any normal setup, issuers are the source point. They are, therefore, the companies that flaunt the market shares to the public or the investors. Normally, intermediaries facilitate the transactions between the issuers and the investors. They make the shares available to the investors after having sourced them from the issuers. This is because many people who would want to buy shares from a given company or the issuer may be located at a distance; thus the intermediaries serve to bridge the gap. Investors are individuals or private entities that buy share, which are made available to them to increase their stake in a given company. In the general market outlook, the stock market is often counted as one of the actors. This is where the prices of the shares of various companies are decided and announced. The central bank is also an actor as it dictates the amount of money in circulation, by regulating the interest rates to other commercial banks. This act contributes to the economic worth of a country, in regard to the amount of money in circulation (Pekema 2010). The links between the macroeconomic forces and the financial markets Amadeo (2012) asserts that economic forces can be defined as the factors that determine the economic status of a given country. These factors, more often, contribute to the amount of money in circulation. The forces include the monetary and fiscal policies, rate of interests, the level of employment, environment in which a firm operates the level of investment, and the rate of inflation. Given that the above discussed forces influence the financial market, it is imperative to note that a financial market is an environment, which allows the transaction to take place. Financial market is, therefore, a transaction that helps businesses to grow and the potential investors to make money and improve their financial wellbeing (Smith 2009). Most often, the term financial market has been used to represent the stock exchange market or bonds and commodities. Apparently, there is a mutual relationship between the financial market and the macroeconomic forces. In fact, there would be no financial market without the macro-economic forces. This calls for analyses of some of the notable links between the macroeconomic forces and the financial market as follows: a) Interest rates One of the mandates of the central bank is to regulate the interest rates. This compels the commercial banks to operate as per the set rates of interest. Therefore, the interest rate is one of the market forces that are operational. These interest rate influences the lending rates by the commercial banks. Whenever the interest rates go high, it is natural that the financial markets will suffer the consequences. d) Fiscal and monetary policies Mishkin (1995) observes that it is the role of the government to make financial policies. It is therefore important for the government to come up with policies that support investment for the economic growth of the country to be realized. As such, the government can control the flow of money in the country through various policies, one of them being through the central bank as have been mentioned above, and another example could be through exchange rate. There are two types of exchange rate; the floating and fixed exchange rates. The government can decide to adopt either of the two, and each has its effects. Floating exchange rate is where the government allows the market forces to determine its exchange rate whereas the fixed exchange rate is where the government decides to set the rate at a certain level (Mishkin 1995). If the government decides to fix its exchange rate, it means that its exports would be more compared to its imports - this means that many investors would be lured by such situation, thus improving on the economy of that country. c) Level of employment It should be noted that a population that has attained the age of employment is only empowered through the provision of that employment. If a population has employment, then it means that the population has money, which is as a result of earnings in terms of salaries and wages (Jones 2012). This would imply that there would be quite a substantial amount of money in circulation. This is the point at which the level of employment as one of the macroeconomic forces influences the financial market. d) Rate of inflation This is the rate at which level of prices of goods and services are rising, therefore having a subsequent impact in the purchasing power. The purchasing power in this case is bound to fall if the level of prices continues to fall. High inflation would mean that there would be less circulation of money in the money market; thus as a macroeconomic force, it just links directly to the financial market. e) Competitive environment It is worth mentioning that no meaningful growth could be achieved in an environment devoid of competition. It is indeed worth mentioning that competition is a factor of production as it reduces laxity in any venture, thus promoting business. This facilitates the exchange of goods and services, thereby promoting circulation of money (Jones 2012). This is actually the link of this macroeconomic force, with the financial market. This because, whenever there is stiff and healthy competition between the players in one sector, there would be active exchanges of money as far as buying and selling is concerned (Ferri 2009; Lachance 2003). Conclusion A passive participant portfolio has been selected in this study, due to its potential advantages, notably, its low running cost, which increases the rate of return on investment. Unlike active management funds, these funds are less expensive to operate because the investor does not need to employ traders, analysts, fund managers and other specialists. Most importantly, it has been noted that evaluation of personal risk profile is a very important consideration that should be made before deciding the most appropriate investment for a particular individual. For examples, a risk averse investor should go for investments that are less risky. References Amadeo, K 2012, An Introduction to the Financial Markets, viewed on 30 May 2012, Brinson, GP., Randolph HL., & Gilbert, LB 1986. ‘Determinants of Portfolio Performance.’ Financial Analysts Journal, July/August, pp. 39–44. Carrel, L 2008, ETFs for the Long Run, John Wiley & Sons, New York. Economics, vol. 2 no.3, pp.187-203. Ferri, T 2009, The ETF book: All you need about Exchange trade Funds, Wiley, New York. Jones, D 2012, ‘Macro Forces in Market Confound Stock Pickers’, The Wall street Journal, viewed on 30 May 2012, < https://nr 011.appspot.com/online.wsj.com/article/SB20001424052748704190704575489743387052652.html> Kapur, S & Orszag, M 1999, A portfolio approach to investment and annuitization during retirement, Birkbeck College press, London. Lachance, M 2003, Optimal investment behavior as retirement looms, Wharton School, University of Pensylvania, Philadelphia. Little, K 2012, Major Types of Risks for Stock Investors, viewed 30 May 2012, Merton, R 1969, ‘Lifetime portfolio selection under uncertainty: The continuous time case’, Review of Economics and Statistics, vol. 51 no.3, pp.247-257, Milevsky, M 1998, Optimal asset allocation towards the end of the life cycle: to annuitize or not to annuitize?, The Journal of Risk and Insurance, vol 65 no.3, pp.401-426. Milevsky, M 2001, ‘Optimal annuitization policies: analysis of the options’, North American Actuarial Journal, vol. 5 no.1, pp.57-69. Mishkin, S 1995, ‘Symposium on the Monetary Transmission Mechanism’, Journal of Economic Perspectives, vol. 9 no. 4, pp. 12-19. Pekema, D 2010, Understanding the benefits of investment, Boston University Press, Boston. Review of Economics Studies, Vol. 32 no. 2, pp.137-150. Scott, R 1975, optimal consumption, portfolio and life insurance rules for an uncertain lived individual in a continuous time model, The Journal of Financial Smith, A 2009, 5 Benefits prudent investment, University of Trinidad Press, Trinidad. Stacy, L & Fuller 2008, The Evolution of Actively Managed Exchange-Traded Funds, Review of Securities & Commodities Regulation, New York, SAGE. Yaari, M 1965, Uncertain Lifetime, Life Insurance and the theory of the Consumer, Review of Economics Studies, Vol. 32 no. 2, pp.137-150. APPENDICES: Appendix I: Investor profile cross-examination 1 The time when I plan to embark on the distribution of assets Within 5 yrs 2 Pts 6–10 yrs 6 Pts 11–15 yrs 10 Pts 16–20 yrs 14 Pts 20+ yrs 20 Pts 6 The amount of money I have saved for retirements and emergencies and other expenses I have not saved anything 2pts I have saved something 8pts I have saved adequately 14pts I have saved substantially 20pts 3 The maximum loss I can stand for in a duration if 1 year. -4% 2 pts -9% 6pts -18% 10pts -28% 14 pts -35% 20pts 4 My perception on investment plans. Hold the principal amount constant or close to constant through all market circumstances 2pts put up with some risk, but seeking out capital and current income appreciation 8pts Put up with the better part of risk and hope for loss of principal from time to time 14 pts High risk put up with and be aware of the fact that loss of principal is likely sometimes 20 pts 5 My general awareness regarding investments None 2 pts Low 8 pts Medium 14 pts High 20 pts 6 My tolerance for risk can be described best by which statement? I cannot put up with risk 2pts Low forbearance 8 pts Medium forbearance 14 pts High forbearance 20 pts Appendix II: Risk Return model Potential Return Risk Appendix III: asset allocation model based on risk 28 pts or less Model 1 29-43 pts Model 2 44-58 Model 3 59 – 78 pts Model 4 78 – 95 pts Model 5 96 pts or more Model 6 If my score is 28 points or less, then my risk profile is best matched with model 1, which cushions me from the stock market risks. If my score is 29-43 pts, then my investment risk profile is best matched with model 2, which has below average risk and offers potential growth If my score is 44-58 pts, then my investment risk profile is best matched with model 3, which provides potential growth when the amount of risk is average If my score is 59-78 pts, then my investment risk profile is best matched with model 4, Which provides potential growth when the amount of risk is above average If my score is 7895 pts, then my investment risk profile is best matched with model 5, Which provides potential growth when the amount of risk is high If my score is 96 pts or more, then my investment risk profile is best matched with model 6,which is focused on aggressive growth and provides the highest potential for growth though very risky Model 1 12% Stock-based 14% 74% Bond-based Model 2 57% Bond-based 26% Stock-based 17% Specialty/Alts Model 3 46% Bond-based 34% Stock-based 20% Specialty/Alts. Model 4 30% Bond-based 50% Stock-based 20% Specialty/Alts. Model 5 12% Bond-based 68% Stock-based 20% Specialty/Alts. Model 6 0% Bond-based 92% Stock-based 18% Specialty/Alts. Read More