An Investor in Bonds Can More Confidently Value Their Investments Than an Investor in Common Stock - Assignment Example

Investment and Portfolio Analysis An investor in bonds can more confidently value their investments than an investor in common stock. Discuss.  There are three types of investments that an investor can choose from; these include stocks, bonds, and short-term investments. Various factors inform the investor’s choice but the general consensus is that bonds are a more stable type of investment than stocks, which are much more volatile, and thus they inspire more confidence than the latter (Graham, 1973). Stocks are also referred to as equity investments and they give an investor the greatest potential for growth. However, in the long term they are accompanied by the risk of short-term changes in the market at a considerably regular rate. They also play a significant role in the investment mix particularly if the investment in long-term. On the other hand, bonds are also known as fixed-income investments and they are significantly less risky than stocks. Investment in bonds ensures that the investor gets a particular fixed return on the bond periodically and the income is not affected by market changes (Fox, 2009). The potential return and risk on bonds is moderate, both the return and the risk are lower than in stocks. The prices of bonds generally rise when interests fall and fall when interests rise. This effect is more pronounced and can be felt by the investor in the case of long-term securities. Based on the characteristics of bonds indicated above, an investor in bonds can more confidently value their investment than an investor in common stock. The main reason is that bonds are generally more stable and less prone to be affected by market fluctuations than common stocks. The return is fixed over a given period of time and the investor can be able to carry out more accurate valuation of the investment than in the case of common stocks which are susceptible to short-term fluctuations. It must however be noted that an investor needs to spread their money over different types investments so as to reduce the investment risk and inflation risk (Graham, 1973). 2. Explain in your own terms how the Markowitz efficient frontier might help a portfolio manager identify appropriate investments. The Markowitz optimizer is also known as the Markowitz mean-variance (MV) efficient frontier and it is a standard theoretical model for normative investment behaviour. As such the model is useful in helping portfolio managers identify portfolio investments. Basically, the model is considered a good method for optimal construction of portfolios, allocation of assets, and rationalization of the value of diversification (Black et al. 1972). The MV optimization model makes the assumption that the average investor prefers a portfolio of securities that will offer maximum expected return for any given level of risk, which should ideally be low. This model simply follows the common laws of investment which aim at maximization of returns while minimizing risks. The risk in this model is measured by the variance of return; this implies that lower returns represent high risk while higher returns correspond to lower risk. The model works by selecting the optimal proportions of wealth that can be invested in each security for potential maximum returns (Durbin and Koopman, 2008). The set of optimal proportions that are selected for each possible portfolio risk level define the MV efficient frontier. The efficient frontier is defined by considering budget constraints and linear constraints lime trading costs. Basically, the MV optimizers aim to estimate how much wealth can be invested in what security for maximum returns over a particular period of time without being exposed to high levels of risk. The optimizers are useful in controlling a portfolio’s exposure to various components of risk (Hull and White, 1998). It is also important for optimal use of information in a total portfolio context where an investor has to make difficult decisions on how to allocate wealth among various portfolios optimally (Black et al. 1972). 3. Does the Capital Asset Pricing Model provide an adequate measure of risk for the portfolio manager? The Capital Asset Pricing Model (CAPM) is still one of the most popular approaches in valuation of assets, however its empirical roots have been found to be increasingly weaker in the recent past (Jafannathan and Wang, 1993). CAPM is an asset-valuation model that mainly tries to explain the relationship between expected risk and expected return. It can be argued that although the CAPM method no longer provides an adequate measure of risk for the portfolio manager, it still provides a significant measure of risk which can be adequate when supplemented by other more current methods. It has also been suggested that the method remains very useful and with a few modifications it can still be adequate in measuring risk (Ferson and Korajczyk, 1995). A number of studies support the assertion that CAPM remains adequate in measuring investment risk. One of the earliest such studies is by Black et al. (1972) which found that their data was consistent with CAPM predictions, especially given the fact that the CAPM methods just like similar models, is an approximation to reality. They had used all the stocks of the NYSE over a period of over 30 years (1931 to 1965) to form 10 different portfolios. There have been studies challenging the usefulness of CAPM in risk measurement but most of them have been challenged in recent years as being inadequate or providing wrong conclusions with regard to CAPM. Farma and French (1992) make a persuasive case against the CAPM but their results have been challenged by various empirical studies as being weak (Jagannathan and Wang, 1993; Ferson and Korajczyk, 1995). Although capital investment decisions have been made before without the use of CAPM and will be made again in future, examination of data from those who have applied it suggests that it has helped them considerably in measurement of risk for portfolio management. 4. Describe briefly the four main asset allocation strategies and discuss the merits of each. The four main asset allocation strategies that are most commonly applied in investment include the conservative mix, the balanced mix, the growth mix, and the aggressive growth mix. These hypothetical investment mixes represent the asset allocation strategies that different investors utilize. The mixes balance between long-term mutual funds; directly-held corporate equity shares; deposits and money market funds; and directly held bonds (Holden and VanDerhei, 2005). The conservative mix: In this asset allocation strategy, the investor allocates about a half of the assets in bonds and the remaining half is shared between domestic stocks and short-term investments. The advantage of this strategy is that it provides steadier performance over an extended period of time with some opportunity for growth. The balanced mix: This strategy emphasizes domestic stocks and bonds which constitute about 85% of the total investment (45% domestic stocks and 40% bonds). The remaining assets are divided between foreign stocks (about 5%) and short-term investments (about 10%). The mix is advantageous when the investor wants an opportunity for growth. It also enables the investor to be tolerant to some fluctuations in portfolio value. The growth mix: The growth mix strategy for asset allocation places greater emphasis on domestic stocks, these typically consist of about 60% of total investment. About 25% is allocated to bonds while 10% is allocated to foreign stocks. The remaining 5% is allocated to short-term investments. The strategy is advantageous for growth and it can be tolerant to fluctuations in the value of the portfolio. The aggressive growth mix: This asset allocation strategy places greater emphasis on domestic stocks but eliminates any short-term investments because it is mainly focused on growth. Domestic stocks typically consist of about 70% of the total asset allocation. The remaining 30% is shared approximately equally between foreign stocks and bonds. For an investor who has strong preference for growth, this strategy is preferred. The main advantage associated with the aggressive growth mix strategy is that it can tolerate wide, and even sudden, fluctuations in the value of the portfolio. 5. Discuss the range of portfolio performance measurements available to portfolio managers. What are the major differences and what do you think should be the most appropriate measure to evaluate performance. There are a number of existing methods that measure performance of investment mutual funds. Most of the existent methods are based on mean-variance frameworks which underlie popular factor models. However, the most useful way of categorizing existing performance measures is determining whether or not they reward positive skew (Malevergne and Sornetter, 2006). Thus only measures that go beyond mean and variance of returns can effectively demonstrate the full impact of option strategies on mutual fund performance. Mean-variance measures like Sharpe’s ratio and Jensen’s alpha are more appropriate only when the investors trying to measure performance restrict attention to mean and variance of returns. The alternative performance measures which reward positive skewness are preferable. Some of these methods include; Market Timing: This refers to allocation of capital among several broad classes of investments restricted to equities and government bonds. A successful market timer increases portfolio weight on equities before a general rise in the market index, and shifts the capital to government securities before the market index falls (Shefrin and Statman, 2000). Market timing induces a non-linear portfolio return distribution and successful market timing generally generates a positively skewed distribution whereas an unsuccessful one generates a negatively skewed distribution. This method is identical to the CAPM regression. Market timing models generally capture asymmetries in a portfolio’s return distribution. It is noted by Jagannthan and Korajczyk (1986) that investment options also generate a skewed distribution that are detected by market timing regressions. This method has its disadvantages including the fact that it is impossible to distinguish between the effect of market timing and the effect of investments in options. Performance Analysis Options Asset pricing models can be used to measure performance when investments have option-like features. The general idea is to include the sensitivity of the option’s return to the stock’s return mainly as an explanatory variable. Value at Risk (VaR) In contemporary risk management, skewness preference is addressed by focusing on the probability of various levels of downside outcomes. The option is generally know as Value at Risk (Hull and White, 1998). The method involves determination that an investor is X% confident that they will not lose Y amount of dollars in a given number of days (N). The Y is determined by the distribution of underlying variables and associated payoff function. VaR is useful as a corporate risk management tool as it assigns a probability to important outcomes such as the level of cash imbalance which triggers financial distress. 6. In your opinion, are markets in the UK and US semi-strong efficient? Discuss with reference to the empirical studies which challenge this. Market efficiency as a concept was developed in the 1950s ad 1960s through the market research of various scholars. Fama (1970) was able to assemble a comprehensive review of theory and evidence of market efficiency. The theory of market efficiency defines an efficient market as one in which trading on available information does not produce an abnormal profit. Therefore a market can be assumed to be efficient only if the efficiency is modelled in terms of returns. The weak form of an efficient market is the form whereby prices fully reflect the information implicit in the sequence of past prices. On the other hand, the semi-strong form of market efficiency is the situation whereby prices reflect all relevant information that is publicly available. The strong form of market efficiency asserts that information known to any participant in the market is reflected in the market prices. In my opinion, the markets in the UK and US are semi-strong efficient because it can be generally observed through most of the market data available that prices reflect all relevant information that is publicly available. This can be attributed to the competitive nature of the markets whereby companies compete on the basis of current market information, which influences their pricing. No investor has the ability to earn consistent abnormal profits trading on any public information including prices that reflect historic prices as well as additional public information. This can be observed through the constant changes in prices in the market with frequent changes in all sorts of information available including earning announcements and dividends. All the information involved in price determination in this case is publicly available and is used appropriately by competitive investors. 7. Explain why proponents of behavioural finance regard modern finance theory as being somewhat incomplete.  The traditional portfolio Theory, on which modern financial theory is built works on the basis of efficient markets, meaning that prices of securities coincide with the fundamental value. The modern efficient market school of financial theory postulates that investors are rational and that their investment decisions are made on the basis of their risk aversion which can be measured by mean and variance of the returns on investment (Kent, 2002). Behavioral finance proponents indicate that this approach has been proved to be incomplete because over three decades of research indicates that the major factors driving portfolio selection are much more complex than the efficient market postulations and the mean and variance future of returns. They indicate that it has been discovered through empirical findings that market returns are not determined according to the efficient market theory (Shefrin and Statman, 2000). It has been established that portfolio managers not only consider statistical measures such as return and risk but also consider psychological factors such as overreaction, overconfidence, and sentiment. The main reason they propose Behavioural Finance (BF) is that it makes the modern financial theory more complete by applying psychological analysis to financial behaviour. Behavioural finance asserts that investors are rational in the decision-making, however their rationality does not follow the linear mathematical sense that is based on mean and variance returns. The BF indicates that investors respond to natural psychological factors such as fear, hope, pessimism, and optimism. This may result to asset values deviating from their fundamental value and thus the modern theory of market efficiency will suffer. On the view of this, proponents of BF assert that modern financial theory is not complete without integration of the behavioural aspect in the market efficiency theory to reflect the real conditions surrounding decision-making in the financial market. 8. Explain the concepts of systematic and unsystematic risk, variance, covariance, standard deviation and beta as each of these relate to investment management. Systematic and unsystematic risk: Unsystematic risk is described as the type of volatility that does not covary with the market as a whole but is merely the additional random “moise” that is present in a specific asset’s returns. Since it is well established that this type of random noise has an expected return of zero, it can be diversified away through addition of more securities to the portfolio. On the other hand, systematic risk refers to the risk that cannot be diversified away (Bodie et al., 2010). Variance: This is a measure of variability; it represents the mean of the squared deviations from the mean or the expected value. Covariance: this is the covariance between the return on the market and the return of the asset. Standard deviation: This is the square root of the variance. Beta: Beta is a parameter that was conceived as a measure of the risk contribution of an individual security to a well diversified portfolio. This parameter was created to measure the volatility of the asset that is considered systematic, which is measured by the degree to which its returns vary in relation to those of the overall market. 9. Discuss the security valuation techniques available to investors; are these approaches competitive or complementary? A number of valuation techniques are available for measuring the value of securities. These methods are distinguished by the type of valuation approach they employ. The main approaches used include market approach, cost approach, and income approach. There are a number of main techniques commonly applied including price of recent investment multiples, net assets, discounted cash flows or earnings, discounted cash flows, and industrial valuation benchmarks (Wright, 2000). Price of recent investment: When the investment or security being valued was made recently, its cost may be a good indication of its fair value. The value of such valuation depreciates over time; this is because the price of the securities at the time of investment reflects the conditions that existed at the time of the transaction. In most dynamic environments, the changes in market conditions and other factors associated with passage of time act to diminish the appropriateness of the technique. It must also be noted that in a situation where the price at which a third party has invested is being considered, the background of the transaction must be taken into account (Charles and Darne, 2009). This is a complementary approach and can be used together with at least one other approach particularly in the short term after investment. Multiples: This security valuation technique involves the application of an ‘earnings multiple’ to the earnings of the security being valued so as to derive a value for the security. The technique is appropriate for securities in a stable market (Alvarez-Ramirez et al. 2008). A revenue multiple is commonly established on the basis of an assumption as to the ‘normalised’ level of earnings that can be generated from the security. The valuation technique and its conditions apply if a multiple of revenue is utilized and the technique is competitive, it cannot be applied alongside a different approach. Discounted Cash Flows or Earnings: This is a valuation technique that involves the derivation of the value of a security by calculating its present value of the expected future cash flows. The cash flows and ‘terminal value’ are those of the investment. The technique enables the valuation of investment to be applied in situations that other techniques may not be capable of addressing, this makes it a competitive approach. Net Asset Value Method: A security’s Net Asset Value (NAV) is derived from the fair value of the underlying investment and is usually of the same measurement date as that applied by the valuer of the fund interest. Investors in securities must value their interest in an underlying fund at a regular interval so as to support their financial reporting. Traditionally, the NAV has been applied as the basis for estimation of the fair value of an interest in an underlying fund. Fair value for an underlying fund interest is equivalent to the summation of the estimated value of underlying investments. Therefore, NAV when well determined in accordance with the principles of fair valuation guidelines gives the best estimates upon which a security’s fair value can be determined. NAV is a complementary technique especially because it can be applied after a another valuation technique has been used so as to give more accurate estimate of a security’s fair value. 10. Why might investors choose to favour investment in common stock over corporate bonds?  Bonds are basically debt investments. They represent a loan that an investor makes to an institution, a corporation or a government so as to earn interest during a specified period on top of repayment of the principle (Lo, 2004). Bonds are considered fixed income investments because the income received from them is generally fixed at the time of the bond agreement. Bonds generate money in two ways, through interest or through capital gains. Interests provide the investor with a fixed source of income for the bond’s term while capital gains can be earned by selling the bonds before maturity at a higher price than was paid for it. On the other hand, investment in stocks involves buying of ownership shares in the company, known as equity shares. The return on investment for the investor depends on the performance of the company. If the company succeeds and makes money then the investor can get good dividends from the investment. Like bonds, stock makes money both in terms of dividends and capital gains. While dividends depend on the company’s earnings, capital gains are based on the investor’s demand for the stock. Most investors favour investment on common stock precisely because they represent two situations. First, stocks can be very profitable when a company performs well and pays out good dividends. This means that the investor can be able to earn dividends annually if the company is successful. The difference between stocks and bonds is that while in the case of bonds interest on the principle is pre-determined, stocks may earn an investor a greater dividend if a company performs very well (Lim and Brooks, 2011). Secondly, common stocks represent a status of ownership for the investor. The investor owns a part of the company through common stock and therefore can contribute in different decisions through annual general meetings. However the most important aspect about the ownership is that the investor can be able to get a share of the company in case of dissolution. 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