Focus on the Individual Investor - Coursework Example

INVESTMENT MANAGEMENT Focus on the Individual Investor Introduction Much of the study of investments, as a field, is centered on corporate portfolio analysis and management. Many of the more recent and sophisticated financial instruments were designed with the returns enhancement and risk mitigation of business organizations in general, and financial institutions in particular. However, this is not to say that individual investors (sometimes obscurely termed the “household sector” vis-à-vis the business and government sectors) are not entitled to the same protection and consideration as his corporate counterpart. While the simpler personal portfolio does not demand the rigor and complexity devoted to institutional investments, its mismanagement will nevertheless have severe repercussions were one to consider the welfare of the portfolio’s beneficiaries. This treatment will thus be on the recommendations for an individual investor. The selected subject is a retired widower, 70 years of age and with no dependents relying on him for support. The subject receives a small pension from his previous employer, and his entitled pension from the state. He has no debts nor mortgage. Finally, he has £80,000 to invest. Relevant Theoretical Framework The analysis will be conducted along the lines of the Modern Portfolio Theory as applied to individual investment. According to Bodie et al (1996, p. 3-4) the main organizing principle of the MPT is what is termed efficient diversification. “The basic idea is that any investor who is averse to risk, that is, who requires a higher expected return in order to increase exposure to risk, will be made better off by reorganizing the portfolio so as to increase its expected return without taking on additional risk.” (Bodie et al 1996, p. 3). The issue prevailing in efficient diversification is asset allocation, or the choice of how much is to be invested in broad asset classes defined by peculiar qualifying characteristics, in order that the best possible portfolio is achieved to meet the investors’ meet the investors’ goals within the limits of his constraints. Significant parameters that would determine portfolio restrictions are grounded in the practical decisions the investor is to make. First is the determination whether the resort to passive or active management. The former – passive management – is the strategy of maintaining a well-diversified portfolio of generic security types in order to attain average market returns. In such a case, no attempt is made to outperform the market through the use of analysis and forecasting. The latter – active management – makes it a goal to obtain returns superior to the market through the dual use of studied security selection (fundamental analysis) and predictive market timing (technical analysis). Other considerations are financial intermediation and the costs they entail, financial innovations and derivatives as hedging tools, and the response to taxation and regulation. The Investor As previously stated, the Investor is a 70-year-old retiree; as such, he is unemployed and no longer supports himself through his labour. He thus relies exclusively on his investments’ yield for his subsistence (food, clothing and shelter), his medical and health maintenance expenses (which expectedly will tend to increase over time), and to maintain the comfort and lifestyle to which the investor is accustomed. As the Investor’s needs are regular and consistent if not increasing, then likewise should the yield from his investment be regular and consistent or, perhaps, increasing in the same degree as his needs. The requirement of regularity and sustainability of the cash yield from investments indicates that investor cannot tolerate huge and unforeseen losses that would compromise his cashflows. Neither has he the luxury of liquidating his investments given the insufficiency of cash income as such would erode the capital base from which the income flows. Furthermore, since he no longer is engaged in employment or practice, the Investor has little or no ability nor time to regenerate wealth from sources other than his nest egg. It should be pointed out here that a necessary assumption is for the Investor to be free of familiar responsibilities such as the support of a relative or dependent. Only his needs are to be met by his placements. It is also implied that the Investor owns his home and is free from debt as he has no mortgage obligations. There is also a need for a high level of certainty of cash income for him. Since risk is otherwise defined as the variability of returns about the expected means (statistically measured by the standard deviation or variance), this is to say that the desired portfolio must have a statistical variation as close as possible to zero. Possible Investments As a general rule, there are three components to an actively managed financial portfolio, namely cash, debt instruments or fixed-income securities, and equity investments or “risk” assets. Cash may be funds that are invested in a bank account or money market placement., characterized as short-term and easily liquidated. Debt instruments, which yield periodic interest and the guaranteed return of principal, includes among others gilts, commercial paper and bonds. Equity, on the other hand, are investments in the nature of ownership of entities engaged in business. Equity are in the form of common stocks, whose owners absorb the risk and thus are entitled to the rewards of the business; preferred shares of stock, while so named, have the nature of debt because of a fixed return. Other possible securities would be in the nature of derivatives, or contracts based on an underlying debt or equity asset, although strictly speaking the Investor would consider such as hedging instruments rather than speculative prospects. Selected Portfolio Assets As earlier defined, the Investor must be benefited by a portfolio that guarantees safety of capital and resists the erosion of its value, yields a regular cash income at regular intervals, has a high level of liquidity and flexibility, and maintains a relative consistency value in the face of market volatility. The Investor must possess sufficient cash in the bank to meet his needs as they are incurred. This may be placed in savings or demand deposit account, and since its purpose is mainly to meet current or impending needs returns are not a major consideration here. Of the £80,000, 5% to 10% or should be a sufficient balance in the bank. For fixed income instruments, it is recommended that this comprise the major portion of the Investor’s portfolio – if possible an appropriate 60% to 70% of the £80,000. This may consist of short-term money market placements with a year’s duration or less, as well as government securities or gilts, bonds, investment grade commercial paper, and so forth. Gilts, invested either directly or in a fund, are also an important part of the Investor’s portfolio. The advantages of this instrument are low risk, safety of capital, the security of government backing and, of course, regular yield. Gilts would fall in the nature of riskless instruments. There are disadvantages, however; this would include relatively low returns because of the practical absence of risk. The following graph shows how low the yields on the 10-year gilt have gotten, particularly in the light of the present financial crisis. (Ferguson 2008) Long-term (non-zero coupon) bonds and high quality commercial papers, with a regular pay-out are also attractive during a time of crisis. Along the same line, Individual Savings Account (ISA) could be placed at least five years before maturity. The ISA has the advantages of being tax favoured, and to foster safety of capital and a regular yield. However, it is at a relatively small spread to government securities, and thus also has more or less a low to modest yield. Bank and building society accounts are also considerations; its attractiveness lies in the fact that the 20% tax normally imposed on it may be waived in certain qualified cases and upon proper registration. Its disadvantage is its relative illiquidity of placement. The remainder of the portfolio should be invested in equity or equity-based funds. The Investor should be discriminating as to the type of stock he should invest in. It is recommended that he makes his selection from the blue-chip FTSE 100 index stocks. The blue chips normally have a track record of dividend declarations, and being large-capital stocks the bigger market float ensures low liquidity risk and ease of entry and exit at prices advantageous to the Investor. Advantages to investing in common stocks are, firstly, that there is no income tax associated with the returns from trading, at least not to the degree income from employment is taxed. Tax is incurred on the capital gains only when the stock is sold; however, there are circumstances wherein the Investor may legally pay less or no capital gains tax at all. There is also a minor tax imposed during the purchase of the shares of stock, a tax in the form of a stamp duty. At 0.5% of the acquisition price, the tax is far from burdensome. And where the share of stock has been received without cost (such as in stock dividends and rights), there is no duty. The disadvantages normally associated with equity investing is its high risk of loss on of the capital investment. As long as the Investor does not cash in his investment (sell the stock), then the loss remains on paper and no actual loss is incurred. However, in case of the need for untimely liquidation, actual losses may prove detrimental to the Investor. It is possible that the Investor would opt for the passive management of his equity investment. He may do this through the purchase of shares of an equity-based mutual fund. However, the recent downturn in the financial markets have brought the prices of stocks so low that low-risk bargain prices are inevitable for the Investor who actively manages his fund. In the figure below, the FTSE 100 index shows the deep market correction stock prices have undergone in the latter part of 2007. The moving average indicators show, however, the development of the possible reversal in the market as well as what is likely a bottoming out. The faster MA has already made a cross-over of the intermediate MA, awaiting confirmation upon the expected break above the long-term MA. This is a possible signal of a recovery. (Moneyweek 2008) In the selection of stocks, fundamental analysis should seek out those defensive stocks. These are companies which, during period of crisis, show resilience in a falling market. They may be: companies in critical industries with regular demand – food and beverage, utility companies, pharmaceuticals companies with less financial leverage (less debt), companies which are cash rich (retailers) companies in industries with fast inventory turnover or high asset liquidity The choice of stocks having been made, the use of technical analysis should indicate those stocks that have descended heavily in the market, those that tread oversold levels, that show reversal patterns (similar to the chart above), those that have consolidated and those that have low beta (relative risk to market portfolio). The Investor, in order to maintain consistent returns and low risk, should avoid speculative stocks due to the difficulty in determining asset values and earnings prospects if the company’s business is vague or resists analysis as a result of uncertainty and volatility in defining parameters. The Investor should likewise avoid trading in derivatives. The Investor does not assume unnecessary risk for which hedging would have been needed. The valuation and assessment risk of derivatives is particularly unreliable because of difficulty in determining prospects for gain in the underlying asset during a time of crisis. Summary and conclusion This presentation was made with the purpose of determining an appropriate portfolio for a retiree Investor of advance age and needs typical of that age. The portfolio proposed includes some money in cash (5% to 10% of the portfolio), investment in fixed income instruments (60% to 70%), and the remainder in equities, in dividend-yielding blue chip stocks and defensive counters. It is expected, giving the times, that such a portfolio will provide the Investor with a safe and regular income in his retirement years. References Bodie Z, Kane A. and Marcus A.J. (1996) Investments, 3rd Edition, Richard D. Irwin, Chicago. Brealey R., Myers S. and Marcus A. (1999) Fundamentals of Corporate Finance, McGraw-Hill, New York Brigham E. and Gapenski L. (2004) Intermediate Financial Management, Dryden Press, Fort Worth, TX Damodaran A. (1994) Damodaran on Valuation, John Wiley and Sons, Canada Ferguson J. (2008), “The banking crisis tells us its time to buy gifts”, Moneyweek Dec 05, 2008, as retrieved on January 6, 2009 from mhttp://www.moneyweek.com/investments/the-banking-crisis-tells-us-its-time-to-buy-gilts-14231.aspx “Fixed Income Investment Funds”. Retrieved on January 6, 2009 from https://www.fidelityinstitutional.com/defined_benefits/fixed_income/fixed_income_fund_range.html Helfert E. (2003) Techniques of Financial Analysis, A Guide to Value Creation. McGraw-Hill, New York Lau, D. (2009) “FTSE starts 2009 on high”, Reuters Published: January 2, 2009 Mishkin, F.S. and Eakins, S.G. (2003) Financial Markets and Institutions, 4th Edition. Addison-Wesley, Montreal. Palepu, K.G., Bernard, V.L. and Healy, P.M. (1996), Business Analysis and Valuation, South-Western Publishing, Cincinnati, Ohio Reilly, F.K. and Brown, K.C. (2006) Investment Analysis and Portfolio Management, 8th Edition, Thomson South-Western, Mason, OH Shim, J.K. and Siegel, J. G. (1988) Handbook of Financial Analysis, Forecasting and Modeling, Prentice Hall, New Jersey Steinherr, A. (1998) Derivatives: The Wild Beast of Finance, John Wiley and Sons, New York http://www.moneyweek.com/news-and-charts/market-data/ftse.aspx . Retrieved on January 6, 2009. http://www.barclayswealth.com/individuals/products-services/execution-only-online-products/fixed-income.htm. Retrieved on January 6, 2009. Read More