Personal Investment Portfolio Selection - Essay Example

Personal Investment Portfolio Selection Introduction: Background to the exercise This is an exercise in personal finance. It involves a 28-year-old single individual (hereafter referred to as the Investor) who was bequeathed by his late uncle an inheritance which amounted to ₤1,000,000 after taxes. Mindful that such easily-acquired wealth is also easily spent, the Investor sought to put it into worthwhile investments in a portfolio which suits his present lifestyle. The Investor is young, a good earner, and feels that he could be bold with his placements – in fact, he is optimistic about the near-term economy and that the financial markets are bottoming and will soon recover. Also, he feels that he can take on more risk than older people with more permanent financial commitments (family, retirement, etc.). Since he is young and earning, without dependents, and with a rising career, the Investor feels he would be able to absorb losses he may incur by taking a more aggressive investment strategy. After all, if he performs his analysis well, he will likely be able earn above average returns, and he is excited about the challenge of these prospects. Investment allocations The investor has four choices of assets to invest in: stocks (or equity), mutual funds, exchange traded funds (or ETFs), or asset class indexes. He may invest all his money in one asset; however, this is not a wise move. According to Harry Markowitz (1959), investment risk may be reduced by creating a portfolio of securities which tend to move differently from each other – that is, which are not perfectly correlated (p.5). In a portfolio where some securities move up at a time when others move down, then there will never be a time when the entire portfolio will be entirely down, and thus the investment risk is hedged. Diversification according to correlation is not a hard and fast rule, and some experts have taken a modified view from that of Markowitz, for the simple reason that the rise and fall of markets defies prediction (Quinn, et al., 2009). Kiplinger (2011) stated that the portfolio, once set, should not be changed except for an annual rebalancing, to avoid being whipsawed by the intermittent volatility. Updegrave (2012) does not see a problem with investing 90% of one’s funds long-term entirely in equities, as long as the investor is well-versed in his/her stocks and has a clear strategy and target. Since this portfolio is expected to show results in the course of a few months, it will be placed as if it were a short-term fund, and will be fully diversified to take advantage of short-term fluctuations. It is understood that this is a risky strategy but the Investor is agreeable to taking an aggressively (but not recklessly) risky position. It would therefore be permissible to put more of the Investor’s money in reasonably risky securities. Based on the Investor’s profile, the following portfolio allocation will be followed. Stocks (which are riskier than the money market) will comprise 45%, money market will be 35%, mutual fund 10%, and the ETF and asset class index, the two riskiest investments, at 5% each. Asset Class Asset Share Outlay Equities 45% ₤ 450,000 Money Market 35% 350,000 Mutual Fund 10% 100,000 Exchange Traded Fund (ETF) 5% 50,000 Asset Class Index 5% 50,000 Total Investment 100% ₤ 1,000,000 Equities ‘Equities’ refer to common stocks, which are the most popular means of risk (i.e., versus riskless) investment. It is a type of direct investment classified as a capital market instrument, meaning that it has a maturity of more than one year. Common stock represents ownership claim on the corporation’s earnings and assets, with voting rights and limited liability (Elton, et al., 2010, p. 17). An investor in equities may earn from the company’s cash dividends, and by selling stock when the price appreciates above his purchase price. The Investor feels that the economy may recover in the next months, therefore it is possible for banks, who loan out to businesses, will see more robust lending and deposits. Industrial metals may see revenues rise due to industry growth and greater demand for metal supplies. Furthermore, food producers and general retailers are poised to benefit from greater sales due to greater consumer spending. In a recovery, therefore, these sectors are expected to declare higher profits and their stock prices may rise or they may declare cash dividends. Data from Yahoo!Finance, UK & Ireland From these industries, possible investments were chosen on the basis of their high earnings per share, low price-to-earnings, low price-to-earnings growth, and dividend yield. These are shown in the preceding table. High earnings per share (EPS) means that the company is profitable, and it is realizing strong earnings, after interest and tax, for its shareholders. When the market price per share is divided by EPS, it results in the P/E ratio, and a low ratio means that the shareholder pays a lower price for each pound of earnings it makes. Likewise, the price/earnings to growth rate (PEG) is similar to P/E in that it measures price to earnings, but takes into account the growth of the stock. If growth is fast relative to the rise in prices, then the PEG is low, and indicates that the stock is undervalued. When the market takes interest and fully values the stock, then the price may be expected to rise quickly. The choices should also be within the ₤500 million lower limit for market capitalisation specified in this exercise. The higher capitalisation is ideal because it assures a more liquid asset which may be bought and sold more easily and in sufficient volume. The highlights indicate a judgment choice balancing the different factors earlier considered. There are big cap issues (HSBC), medium cap (Associated British and Next), and small cap (Ferrexpo and Brown). The smaller capitalised stocks are to provide the Investor the possibility of some speculation, since small capitalised stocks are more volatile and move up and down more frequently (Amberger, 2006, p.117; Burns, 2010, p.78). The exercise requires that stock investments should be limited to five choices. The five stocks chosen from the previous list are shown in the next table below, with the corresponding symbols, shares, purchase price, and capital outlay. The total outlay should be equal to or less than the ₤450,000, pursuant to the portfolio allocations earlier worked out. Stock Symbol Price Shares Amount HSBC Holdings (Bank) HSBA.L 589.42 p 10,000 ₤ 58,942 Associated British Foods (Food Producers) ABF.L 1,321.96 p 10,000 132,196 Ferrexpo (Industrial Metals & Mining) FXPO.L 188.60 p 20,000 37,720 Brown (N.) Group BWNG.L 265.74 p 20,000 53,148 Next NXT.L 3,564.04 p 4,700 167,510 Total investment ₤ 449,516 Money Market The second-largest allocation in the portfolio is placed in the money market. This accounts for 35% of the million-pound portfolio, or ₤350,000. The way the portfolio tracker is programmed, however, shows that the money market placement will be a catchment of sorts for funds that are not invested in the other assets. This means whatever balance is left over after investing in stocks, EFTs, mutual funds and asset class indexes will be invested in the money market. In truth, the money market is more than just a receptacle where funds not invested in other securities are to be lodged. The size of the money market placement indicates the degree to which the riskier investments may be hedged. Like stocks and derivatives, money market instruments are also direct investments, characterised as short-term debt instruments which may be issued by governments, financial institutions, and private corporations (Elton, et al., 2010, p. 12). The most marketable money market securities are Treasury Bills, which is considered almost riskless because they are backed by the government and has minimal default risk. Because of its small risk and the fact that these are debt placements, the Investor is assured that he may expect asset preservation from it, meaning that his capital will remain intact and returned with the corresponding interest income. On the other hand, placing too much money in the money market is safe but not very profitable because interest rates are low (The Telegraph, 2012). Thus, if the financial markets collapse and the risky investments in the portfolio fail, the money market placement remains intact and may be recovered by the Investor. Mutual Funds In the portfolio, 10% or ₤100,000 of the funds is allocated for investment in mutual funds. Mutual funds are indirect investments wherein the funds of several small investors are pooled together and are managed by a professional fund manager. Some mutual funds hold a small set of securities while others are placed in broader classes of securities (Elton, et al., 2010, p.18). There are several advantages to investing in mutual funds, most important of which is the mutual funds allow access to the services of professional portfolio managers who are highly educated and trained, have extensive experience, and are professionally accredited. A second advantage is the relatively low amount of money needed to purchase shares in a mutual fund. Since the funds of small investors are pooled together, the small investors are afforded the opportunity to rely on a professional manager that would normally have been affordable only by rich investors. Also, the pooled funds have sufficient scale to purchase data and resources to make fund management more efficient, which small investors could normally not purchase. Highly trained staff can better monitor economic events and individual companies. Most importantly, larger pooled funds could be better diversified with lower transaction costs because of economies of scale (Janjigian, et al., 2011). However, there are also disadvantages of investing in mutual funds. At some point, the incremental reduction in risk as new securities are added to the portfolio is exceeded by the incremental cost required in managing that security. Thus, it is likely that very broadly diversified funds would be less profitable than less diversified funds. Another disadvantage is that several mutual funds do not perform as well as the market indexes, even before expenses are deducted, because there is no guarantee that the fund manager could do better than individual investors looking after their own funds. Some investors prefer having greater control of their own placements rather than relegating this to a third person. Some funds are also not tax-efficient because of placement decisions by fund managers. Therefore, it may just happen that directly invested funds which follow on the index may do better than mutual funds (Janjigian, et al., 2011). Exchange Traded Funds and Asset Class Index The portfolio also stated that ETFs and Asset Class Indexes are each to be allocated 5% of the Investor’s money. Therefore the portfolio shall invested ₤50,000 for ETFs and ₤50,000 for Asset Class Indexes. An ETF is a basket of stocks that mimics or duplicates a stock index. This basket is traded on the exchange much as other stocks are, but since its risk is the weighted average of all stocks in the index, this provides special advantage for the ETF. Theoretically, it cannot trade higher or lower than the index, and therefore exposes the Investor to less volatility risk. ETFs also have few taxable capital gains and good transparency since one can see what one is buying. They also have no minimum investment, no fees or sales charges, and the only transaction costs involved are normal brokerages commissions (Lofton, 2007). Technically, ETFs are a kind of Asset Class Index. An index of an asset class is an average of the underlying assets in that class. The asset-class index therefore resembles a broad-based index for the market where the assets are traded. It may be considered a passive investment portfolio much the same as an indexed fund of that market. The asset-class index is implicitly ‘a long-only, buy-and hold strategy for investing in the underlying assets.’ If the Investor therefore feels that a particular asset class is poised to rise in a particular market, then it makes sense to position a portion of the fund in the asset-class index pertaining to that asset class (Jaeger, 2004, p.73). The table below shows the four investments chosen for the Investor, with one mutual fund amounting to approximately ₤100,000, two exchange traded funds totalling about ₤50,000, and the Asset Class Index on BRIC (Brazil, Russia, India and China), amounting to no more than ₤50,000. The choice of funds was made with the advice of an investment analyst, because these funds were derivatives that derived their value from underlying assets, and their analysis required advanced knowledge. As for the asset class index, since the Investor is of the opinion that global recovery is imminent, there is a greater chance for emergent economies to surge forward, and these countries shall have an advantage ahead of other emerging economies. Data from Yahoo Finance, UK & Ireland These investments, together with the stocks and money market investments earlier mentioned, were placed on the 15th of October and their progress was tracked through the 15th of December. The results of these investments for the Investor are presented in the tracking Excel spread sheet provided for the exercise, discussed below. Conclusion: Results of the exercise The results of the investment portfolio of the Investor as formulated in this exercise is shown in the following table, based on the calculations of the tracking spread sheet provided for the exercise. Two types of rates of returns are calculated, the two-month return (from October 15 to December 15), and the annualized return which assumes that the two-month return prevails over the span of one year. Symbol Asset type Returns Two Months Annualized HSBC.L Stock 10.48% 81.83% ABF.L Stock 15.99% 143.53% FXPO.L Stock 23.93% 262.14% BWNG.L Stock 40.48% 668.64% NXT.L Stock 5.52% 38.00% AT2:LN Mutual Fund 4.71% 31.84% SUK2.L ETF -6.33% -32.44% ISEM.L ETF 6.91% 49.29% EM(BRIC)MSCI Asset Class Index 1.24% 7.67% Money Market 0.08% 0.50% Portfolio 7.26% 52.25% The table shows that all the choices of investments made for the portfolio were profitable, except for one EFT, that of SUK2.L. Considering that this is a comparatively higher risk portfolio because it has more funds placed in risky instruments (65%, including all assets except for Money Market), one placement that suffers a loss is not at all unexpected. It will be noticed in the spread sheet that this ETF was positive in November, but one stock placement, Next, and the other ETF and the BRIC Index were tracking negative returns for the two-month period. These negative returns recovered and rose higher before the December 15th liquidation date, which is testimony to the volatility of the markets. As for the stocks, true to form, it is the small capitalised stocks which realized the highest price appreciation in the span of a short period of time. Since the Investor is willing to take risks, he has the option to recognize profits on these stocks at present because of their above-average short-term gains. Profit-taking may bring the prices back down at which point he could once again buy into the same funds. The portfolio is therefore successful because it earned more than 7% (or 52%) gain for the Investor. This is likely more than the economy can grow in the span of one year. References Amberger, J C 2006 J. Christoph Amberger’s Hot Trading Secrets: How to Get In and Out of the Market with Huge Gains in Any Climate. Hoboken, NJ: John Wiley & Sons Burns, R 2010 The Naked Trader’s Guide to Spread Betting: How to Make Money from Shares in Up or Down Markets. Petersfield, Hampshire: Harriman House Ltd. Elton, E.J. et al. 2010 Modern Portfolio Theory and Investment Analysis, 8th Edition, Wiley [ISBN: 0470505842] Francis, J. C. and R. G. Ibbotson 2002 Investments: A Global Perspective, Pearson Education [ISBN 0130758760] How to Build a Better Portfolio 2011, Kiplingers Personal Finance, 65, 11, p. 27, Business Source Complete, EBSCOhost, viewed 5 January 2013. Jaeger, L 2004 The New Generation of Risk Management for Hedge Funds and Private Equity Investments. New York, NY: Institutional Investor Books Janjigian, V; Horan, S M; & Trzcinka, C 2011 The Forbes/CFA Institute Investment Course: Timeless Principles for Building Wealth. Hoboken, NJ: John Wiley & Sons, Inc. Lofton, T 2007 Getting Started in Exchange Traded Funds. Hoboken, NJ: John Wiley & Sons, Inc. Markowitz, H 1959 Portfolio Selection: Efficient Diversification of Investments. Hoboken, NJ: John Wiley & Sons Mishkin, F. 2008 The Economics of Money, Banking and Financial Markets: International Edition, 9th Edition, Pearson Education [ISBN 1408245809] Quinn, D, & Voth, H 2009, Free Flows, Limited Diversification: Openness and the Fall and Rise of Stock Market Correlations, 1890-2001, NBER International Seminar On Macroeconomics, 6, 1, pp. 7-39, Business Source Complete, EBSCOhost, viewed 5 January 2013. The Telegraph 2012 ‘Bank holds UK interest rates at record low: reaction’ The Telegraph. 8 Nov 2012. Retrieved 5 January 2012 from http://www.telegraph.co.uk/finance/economics/9663999/Bank-holds-UK-interest-rates-at-record-low-reaction.html Updegrave, W 2012, The Easy Way To Stay On Track. (cover story), Money, pp. 82-87, Business Source Complete, EBSCOhost, viewed 4 January 2013. . 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