Accountant Money Management Issues - Essay Example

? Finance and Accounting Money Management Table of Contents Introduction 3 Analyzing Risk Profile 3 Investment Experience 4 Risk Tolerance 4 Investment Goals and Objectives 4 Investment Time Horizon 5 Liquidity 5 Age and Income 5 Analyzed: Moderate Risk Profile 5 Asset Allocation 6 Difference between Mutual Funds and Exchange Traded Funds (ETFs) 6 Benefits of Investing in Mutual Funds 7 Risk Management 9 Role and Influence of main actors in Financial Markets 10 Relationship between Macro-economic Forces and Financial Market 11 Financial Instrument: Risk and Benefit 12 Conclusion 13 Bibliography 15 Appendices 16 17 Introduction The initial point in investment strategy is individual risk profile. In order to make investments, first of all it is required to examine own risk profile in order to evaluate overall acceptance to take risk which is influenced by numerous factors such as current financial situation, personal needs and goals, time horizon, structure of my current investment, risk tolerance attitude, investment goals and objectives, liquidity, age and income and degree of familiarity with investment issues. After analyzing own risk profile, the investment decisions will be made, that in which investment vehicle I need to invest. This report will focus on the investment strategy and objectives need to be adopted, difference between ETFs and the mutual funds and how to manage the portfolio risk in order to experience good flow in investing. Further, it will also take into consideration the financial instruments which are accessible for investments, the role and influence of the main players in the financial markets, relationship between the financial markets and the macroeconomic forces and the benefits and risks of investing in different investment vehicle. Analyzing Risk Profile All investors have contradictory attitudes towards risk, so when it comes to investing, it is essential that we need to judge our own risk profile including that the returns on my investments could fluctuate broadly from year to year and also how comfortable I am with the likelihood of losing money. Understanding personal risk tolerance will provide assistance in selecting a suitable asset allocation. My asset allocation includes stock, mutual fund, cash and property. It depends broadly on the time horizon and my risk tolerance ability. So, in order to judge own risk profile, following points need to be taken into consideration: Investment Experience The investment experience will indicate my understanding of financial markets such as just started investing or know the basics of investing or investing for several years or have enough knowledge of financial markets and have been making investment decisions boldly (See Appendix A). So, my experience is that I understand the fundamentals of investing. Risk Tolerance In order to ascertain an investment strategy that suits my risk profile, first I need to think about the likelihood that my investment value may decline although this may be temporary and must be prepared to admit the probability of negative return at any time for the purpose of likely higher long term returns. It will focus on the factors that whether I will neglect short term losses or interested in collecting regular income from investment or long term growth in investment value or want protection against inflation. So, I consider neglecting any short term losses and if in any case, the investment value fell by 20% in a short time then I would like to hold the investment and sell nothing (See Appendix B). Investment Goals and Objectives The investment goals include capital growth, purchase of new car, to purchase a new plot of land, to get a house and a young child’s education in future. My investment goals are for long term, so I afford to take some risk for a higher return. My investment objectives include investing in mutual funds because of its diversification benefits, property and stocks because they offer higher returns than fixed interests. It also includes investing in cash because it is highly liquid and considered safe in comparison to other asset classes and it also gives stable return with low capital loss possibility. Investment Time Horizon Usually the investment timeframe involves less than one year or two year; two to five years; six to ten years or over ten years (See Appendix C). My investment time horizon is six to ten years. Liquidity It is necessary to keep some amount of money with myself for emergencies without relying on credit cards. The amount of emergency funds depends on current expenses and lifestyle but the general rule is that we should have at least three months of income with ourselves in order to meet emergencies. Age and Income The age and income is also an important factor which should be taken into consideration when establishing the investment profile. As I am a youngster and receive property rent from three different houses and have gold and also will receive certain amount from debtor in terms of income, so, I afford to take short term losses and a longer term view. Analyzed: Moderate Risk Profile So, based on the above criteria, it is considered that my risk profile is moderate because my main investment goal is capital growth and I can afford some fluctuations in my investment value in the expectation of higher return. Moreover, I can consider neglecting short term losses as it is a part of investment and is natural and don’t require an income and also ready to invest for six years or more. Asset Allocation My asset allocation includes dividing investment portfolio between various asset categories such as stock, mutual fund, cash and property. I chose following categories because of the following reason: Stocks have greater risk as it is highly volatile but it provides the highest return. Those who are capable to ride out the unstable returns of stock have generally been compensated with strong positive returns. Allocating asset in mutual funds will help in minimizing the risk of losing money through its diversification specialty. Cash includes saving deposits which is the safest investment though it offers low return. The benefit is that the probability of losing money on an investment is usually extremely low. Last is property, because it is less volatile in comparison to shares and the minimum timeframe is three to five years. Difference between Mutual Funds and Exchange Traded Funds (ETFs) Exchange traded funds are like mutual funds because both instruments pull together securities to provide investors diversified portfolios. But, there are many differences between the two which are as follows: Exchange traded funds are bought and sold through a brokerage house through online or phone and their prices change all over the trading day. Whereas, the mutual fund orders takes place during the day, but the real trading does not take place until after the markets close. ETFs are passively managed i.e. they tend to symbolize market segments, indexes and the managers of exchange traded funds apt to do little securities trading in the ETF. Whereas, the mutual fund are actively managed. Exchange traded funds have no sales loads or investment minimums but the mutual funds have both, the sales loads and investment minimums. ETFs generate and redeem shares with in-kind operations that are not regarded as sales and therefore the taxable events are not generated. Redemptions do not create tax events in exchange traded funds but they create tax events in mutual funds. When a vigorous sale of stock takes place, mutual funds allocate higher level of capital gains as compared to ETFs. Moreover, ETFs have better tax efficiency as compared to mutual funds because of the structure that permits them to reduce or evade capital gains distributions altogether (Wild, 2011, p.27). Exchange traded funds have lower overhead expenses as compared to most mutual funds because of the reason that they don’t have to manage staff call centers or customer accounts. But the risk in ETFs is that it is not as diversified as mutual funds. So, it can involve more risk (Gitman, Joehnk and Billingsley, 2010, p.440). Benefits of Investing in Mutual Funds There are many benefits of investing in mutual funds which make it most attractive when capital markets are abnormally volatile and thus allow the investors to choose mutual funds over ETFs. These benefits are as follows: Liquidity intermediation: It means that it provides the benefits to investors to convert their investments into cash promptly and also at a low cost. It permits investors to buy and redeem in any amount and at any time. Some funds are considered mainly to meet short term transaction requirements and also involve no fees related with redemption. Other funds which are designed to meet long term transaction requirement may involve redemption fees if they are held only a short time. Denomination intermediation: It permits small investors right to have access to securities which they are not able to purchase without the mutual fund. These securities can be bought by mutual funds on behalf of investor (Mishkin and Eakins, 1998, p.538). Diversification: The most significant benefit to investing in mutual funds is the diversification advantage. It helps to avoid some of the risk which is engrossed in investing in individual bonds or stocks by giving the shares in various assets. It also minimizes the cost of diversifying by allocating transaction costs with other shareholders (Garrett, 2008, pp.90-91). Cost advantage: It also provides the benefit of cost advantage. Major cost benefit may accumulate to mutual fund investors. Institutional investors bargain lower transaction fees than are accessible to individual investors. By purchasing securities through a mutual fund, it will be possible for investors that they can share in these lower fees (Mishkin and Eakins, 1998, pp.538-539). Marketability: It signifies that one can effortlessly buy or sell mutual fund shares. It provides the flexibility to generate and maintain a diversified portfolio (Garrett, 2008, p.91) High returns: In observation of professional management taking the correct investment decisions, and effectiveness in operations of mutual funds, investors are suppose to get better returns on the investments. Pooling advantage: Since the savings are pooled and invested, so the small investors can also obtain the advantage of a large-sized investment (Siddaiah, 2011, p.273). The benefits provided by mutual funds encourage me to invest in it rather than in ETFs. Risk Management Risk management is a vibrant process that permits portfolio managers to recognize; measure and evaluate the current risk aspects of a portfolio and to assess the potential gains from taking the risk. Moreover, it involves managing the causes that can have an unfavorable impact on the targeted rate of return. Equity derivatives play an important role in risk management process. It shift the frontier in support of the investor through applying a strategy at a lower risk, lower cost, and higher returns or to gain the right to use an investment that was unavailable because of some regulatory or other restriction. Therefore, the management of equity portfolios can be regarded as a complicated exercise in risk management (Collins and Fabozzi, 1999, p5). Stock index futures provide portfolio managers the facility to hedge systematic risk and take benefit of advanced stock selection capability that will generate a positive return even in declining markets. It is used to separate the non-market element of total risk. This characteristic benefits the active managers who possess the capability to select high performance stocks, but who do not essentially like the market. It is used to hedge an equity position in various ways such as: lock in a price of a predicted stock purchase, hedge risk of an expected market decline, minimize systematic risk of the overall portfolio and defend the sale charge of a diversified portfolio (Collins and Fabozzi, 1999, p.135). Immunization is a method which is designed in order to eradicate interest rate risk inbuilt in a bond portfolio. The real meaning of immunization is converting long term securities into security equivalents or short term securities. A mutual fund minimizes risk through portfolio diversification strategy. In future markets, some bond mutual funds try to minimize interest rate risk through taking positions in interest rate future contracts. In swap markets also some bond mutual funds employ in interest rate swaps to reduce interest rate risk. The option and future market are utilized to hedge against market risk and interest rate risk. Some mutual funds sponsored by Merrill Lynch, Morgan Stanley and other securities firms take tentative position in future markets (Madura, 2008, p.645). Role and Influence of main actors in Financial Markets The major actors in the financial markets are businesses, households and government. Businessmen attempt to increase money in order to finance their investment in such type of enterprises which are productive, when their personal internal funds are inadequate. They can perform this by debt incurred through borrowing from issuing corporate bonds or financial institutions or by taking new equity owners in the firm. Households diversify their risk through a portfolio with both financial assets such as stocks, bank saving account and bonds; and real assets such as land and houses. Claims in opposition to future income can be held directly by financial intermediaries such as mutual funds, banks and pension funds; or through households. Governments must borrow money in order to raise funds when expenditures of tax revenue are not covered by tax revenue as they are insufficient to cover them. Equity shares cannot be sold by them. They may be proficient to stimulate or induce bank funding which is same as printing money. Though, this action is narrowed by inflationary implications. They can have access to money from domestic savers or from abroad, but this too is limited. In order to raise revenue, a non-inflationary way is by selling government bonds to the non bank public. Financial markets consist of individuals and group of institutions who work to generate and trade financial assets. Financial markets main function is to move excess savings from households to government and business that are not able to finance all of their activities from their own savings. Still, businesses can finance a lot of their investment out of their own saving. Thus, the financial markets intermediate only part of a total investment of country. If financial markets do this effectively then they would be able to minimize the cost of intermediation i.e. relocating resources from savers to investors. This efficiently minimizes the cost to investors and amplifies the return to savers (McLindon, 1996, pp.42-43). Relationship between Macro-economic Forces and Financial Market The five important macro-economic forces are the interest rate, inflation, real economy, money supply and exchange rate. The relationship between the macroeconomic forces and the stock prices is well explained below. An equity share current prices is more or less equal to the present value of all future cash flows; therefore an economic variable affecting required rate of return and cash flows also influences the share value. Relationship between stock price and interest rate: There is negative relationship between stock price and interest rates. If interest rates rise, the risk free rate will also increase but this will result in the fall of stock price due to increase in rate of return. On the contrary, if interest rate decreases, the stock price will increase due to decrease in the required rate of return. Relationship between stock price and inflation: A negative link is found between stock prices and inflation. High inflation is related with the high equity risk premium and therefore falling stock prices and also leads to high required rate of return. Relationship between stock price and real economy: The stock returns volatility increases at the time of economic contractions and falls during recoveries. Relationship between stock price and money supply: An increase in monetary growth signifies surplus liquidity accessible for buying stocks, therefore resulting in increased stock prices because of an increase of demand to both real good markets and common stocks. Relationship between stock price and exchange rate: On the stock market, the impact of exchange rate fluctuations depends on both the degree of trade imbalance and the degree of openness of domestic economy. Goods market model signifies a positive relationship between exchange rates and stock prices from the hypothesis of employing exchange rate quotation. Whereas, the portfolio balances models put more emphasis on the function of capital account transaction. Therefore, it signifies negative relationship between exchange rates and stock prices. Financial Instrument: Risk and Benefit Financial instruments can be regarded as easily tradable, each having unique features and structure. In today’s marketplace, the broad range of financial instruments allows for the proficient capital flow among the investors. Various types of financial instruments available for investments are as follows: Money market instruments: There are several types of money market instrument such as certificate of deposit, commercial paper and banker’s acceptance. The appearance of money market mutual fund gives access to the individual investors to participate in the rates of return of money market, which are higher than saving account. The benefit of investing in money market funds is that they are broadly used as protective investments when the stock markets are going down. The risks associated with these instruments are inflation risk and currency risk because they are debt-based instruments. Investment funds: It is comprised of a pool of funds which is assembled from various investors to invest in securities such as money market securities, bonds, stocks and similar assets. It is managed by money managers who generate income and capital gains for the fund’s investors. Open-ended funds are also known as mutual funds which provide small investors entrance to a well diversified portfolio of bonds, equities and other securities, which could be not possible to generate with small amount of capital which is most important benefit of investing in mutual funds. Foreign exchange market: Currencies are traded in foreign exchange market. The advantage is that any firm, person or country can participate and is also regarded as the most liquid market in the world. For currency exchange, there is no central place; rather trade is carried out over-the-counter. One more benefit is that it is open 24 hours a day, with currencies being traded worldwide. UK government bond: Government promises to pay the holder a coupon i.e. a fixed cash payment every six month till the date of maturity, at which point the holder collects the principal and the final coupon payment. As it is used by the UK government, so the benefit is that it is regarded as free of credit risk. The difficulty is that there are not much government bonds with short maturities. Conclusion Money management is an act of managing one’s personal finances. It is a combination of risk management and financial planning of investment. In order to make investments, first of all it is required to examine own risk profile and after analyzing self risk profile the result comes that mine is moderate risk profile because my main investment goal is capital growth and I can afford some fluctuations in my investment value in the expectation of higher return. After asset allocation, differences between the ETFs and mutual funds have been indicated and also the benefits of investing in mutual funds are shown. This paper has focused on the different process of risk management and the role and influence of the main actors in the financial market. Further it takes into consideration the relationship between the macroeconomic forces and financial market and risk and benefits associated with different financial instruments. Based on the risk and benefits of the financial instruments it is decided to invest in mutual funds because of its several benefits like liquidity, cost advantage, marketability, higher returns, pooling advantage and most important diversification benefit; and in foreign exchange market because it is open 24 hours a day and is regarded as the most liquid market. Bibliography Collins, B.M. and Fabozzi, F.J., 1999. Derivatives and Equity Portfolio Management. New Jersey: John Wiley & Sons. Garrett, S., 2008. Investing in an Uncertain Economy for Dummies. New Jersey: John Wiley & Sons. Gitman, L.J. Joehnk, M.D. and Billingsley, R.S., 2010. Personal Financial Planning. 12th Edn. United States of America: Cengage Learning. Madure, J., 2008. Financial Institutions and Markets. 8th Edn. United States of America: Cengage Learning EMEA. McLindon, M.P., 1996. Privatization and Capital Market Development: Strategies to Promote Economic Growth. United States: Greenwood Publishing Group. Mishkin, F.S. and Eakins, S.G., 1998. Financial Market and Institutions. 2nd Edn. New Delhi: Pearson Education India. Siddaiah, T., 2011. Financial Services. New Delhi: Pearson Education India. Wild, R., 2011. Exchange-Traded Funds for Dummies. 2nd Edn. New Jersey: John Wiley & Sons. Appendices Appendix A Investment Experience: How do I express my investment experience and understanding of financial markets? Appendix B Risk Tolerance: Which of the following is important to me? If I have an investment that fell by 20% in a short time period, then I would: Appendix C Investment Time Horizon: Read More