Investment and Portfolio Theory - Lab Report Example

Risk Management and Investment Portfolio al Affiliation) Table of Contents Table of Contents 2 Executive Summary 3 What’s Wrong 3 Risk and managers 5 Investment Theory 11 Portfolio Theory 12 New Asset Allocation 13 Detailed Analysis 14 Portfolio Overview 17 Portfolio Reconstruction 17 Reference 20 Executive Summary Twice a year, I checked the portfolio seeing if there are any rebalancing needs that need to be done. I looked at the allocation by the end of April and late October to tally with the beginning of bad months and the beginning of best months (Elton & Gruber 1995). I changed the portfolio by taking the additional step to modify the number of shares I hold in the portfolio. There were few reasons to make the alterations in my portfolio starting with returns and performance of the individual stocks. When I selected the portfolio back in 2012, this means the balance started with a zero balance. I also limited the number of shares because of the fee charges that runs the portfolio. When the portfolio balance grew from the investment returns, I increase the number of shares and changed the investment of the contributions. After passing the initial phase, I planned to tweak the investment so that they spread across the portfolio’s stock. I also gave a concern on the number of shares that strikes a perfect balance between ease management and diversification (Fabozzi 1989). I settled on 10 portfolios because it was easy to manage. The allocation I employed is 20% for each stock. Going through the fund’s list, I avoided investing on unpredictable outcomes like future inflation. What’s Wrong Although the fund’s performance looks good, there still yet there exist many risks in this portfolio that needed to be cared. In this section, the fund’s risk analysis will described and discussed in the order as follows. Standard deviation is an indicator to measure the price’s fluctuation or the return’s volatility. A larger standard deviation means a larger volatility, which contains the bigger risk. As is shown in the overview of the investment fund, the largest standard deviation of price is 252.60 while the smallest is 2.77. Thus DGE is more risky than the others and the bond brings few risks to the portfolio. Moreover, the standard deviation of return ranges from 0.00213 to 0.0198. That demonstrates that PRU has the largest risks and the bond do few contributions to the risk of the fund. In sum, the assets with large standard deviation may prevent the fund’s aims to be achieved. If the confidence level is 95%, then the maximum and minimum VaR of the assets are 415.49 and 4.5593, which means there is 5% chance in a day that DGE and GILT face a loss of over 415.49 and 4.5593. Meanwhile, the portfolio’s VaR is 74189974.39, which means there is 95% possibility that the fund will not suffer a loss more than 74189974.39 in a day. If the confidence level becomes 99%, then the conclusion will be the same apart from the numbers. Therefore, these assets with high VaR will increase the risk of the fund. In consideration of the fund’s strategy of buy and hold, technical analysis will be not so useful to analyze the risk. Furthermore, the effectiveness of technical analysis depends on the efficiency of the market. The theory of EMH points out that technical analysis will be invalid in the weak-form market efficiency. However, this kind of analytical method can provide investors with some reference. The table 3 listed in Appendices show the value of MA (5) and its signal of sell or buy. Apart from DGE, PFG and NG, the remaining assets should be sold due to the results. Some risks brought by the loss of brand reputation or a good manager are very difficult to be measured. Nonetheless these risks may have a huge impact on the return of the portfolio. Therefore, these risks should be identified and analyzed If a company’s reputation was affected by some negative news, then its market value will be cut down due to the jump of its stock price. Some assets in the portfolio may face this kind of risk. Firstly, the event of the Gulf of Mexico Oil Spill occurred in 2010 knocked tens of billions off BP’s stock value since the BP’s technology of offshore oil and gas is immature. This event brought bad reputation and much criticism to BP. So many investors’ confidence was hit and they undersold the company’s stocks. Although the oil spill has been controlled well, yet no one could claim that similar event would never happen again. Therefore, the investment of BP may increase the portfolio’s risk. Secondly, TSCO was caught in the similar situation early this year. The Food Safety Authority of Ireland announced that the beef sold to TSCO contained 29% horse meat by through DNA . The horse meat scandal brought about a two-day slump of 1% and TSCO suffered a great loss of market value, which reached up to 300 million pounds. The scandal reduces the customers’ trust for TSCO and the company bears the loss as a result. The bad reputation depressed the performance of TSCO for a long time, thus holding this stock will increase the risk of the fund. Furthermore, AZN fell into illegal marketing and had to pay a large amount of money to bring an end to the charge. As a result, the company’s stock price was deeply affected by the case. In a word, risk of the fund has a strong relationship with the reputation of assets. Risk and managers If a company loses a good manager, then its business will be affected and its prospect faces more certainty. Thus the stock price of this company will fluctuate dramatically and the portfolio containing this security will become more risky. In 2012, AstraZeneca announced that the president Louis who worked for AZN from 2004 would retire in September. Louis is a good manager who helped the company develop rapidly in the eight years and ranked 331 in the global top 500 enterprises. But Louis retirement will make the company’s security more uncertain. Therefore, holding the stock is likely to stop the fund’s aims to be achieved. In this fund, there exist ten stocks and they accounted for a large proportion of the fund’s market value. So it is necessary to analyze the stock specific risks. The larger price volatility is; the larger risk the stock has. Share price volatility can be measured by standard deviation. The section 4.1.1 has discussed the topic, so this section will not discuss it any more. There are three energy stocks in the portfolio. These stocks face many systematic and unsystematic risks. Firstly, owing to the global financial crisis several years ago, almost every country’s economic growth slowed down. Recently, the European economy has recovered from the sovereign debt crisis completely. People’s purchasing power is much weaker than before and that means a falling demand of petroleum, electricity and natural gas. Before getting rid of these crises, it is not wise to hold this kind of security. Secondly, these stocks may face political risk. For example, BP possesses many assets and skilled workers in the several areas of tensions such as Iraq and Iran (BP, 2013). The company will suffer a loss once a war breaks out. Furthermore, these companies may be affected by some other market risks such as exchange rate risk, policy risk and interest rate risk. Therefore, these risks may impact on the fund’s aims if the stock prices jump due to these risks. Apart from the shares mentioned above, there exist four financial stocks and one retail stocks. Just like the energy stocks, the five stocks are also affected by the global economic crisis. However, the financial stocks have some specific risks unique to financial institutions such as credit risk, liquidity risk and operational risk. Furthermore, the retailing was hit seriously by the crisis and there exist fierce competition in this sector. TSCO is the third largest retail enterprise in the world and its expansion in emerging countries was unsuccessful. In sum, its performance was bad over the last two years and its prospect is still not bright. The weighted beta is 0.78, which means that the portfolio’s movement is generally in the same direction but slower as the market. The portfolio whose beta is smaller than one poses less risk but generally offer lower returns (Levinson, 2009). The standard deviation of the portfolio is 9.05E-03, which is calculated by the formula: (Markowitz, 1952). However, the portfolio’s standard deviation is not an ideal risk measure because it penalizes both profits and losses, although its value is low. Asset Allocation Risks The portfolio’s risk has a strong link to the asset allocation and an inappropriate allocation may lead to a high risk. As is shown in the table below, there are four financial stocks and three energy stocks in this fund. The financial stocks account for 36.36 per cent of total number and 37.39 per cent of market value. And the energy stocks also account much. Therefore, the portfolio’s asset allocation has problems. If the financial sector was hit by some negative events, then the fund would suffer a great loss. Table 2: sector heavy Industry Number Weight of number Weight of market value Financial 4 36.36% 37.39% Energy 3 27.27% 27.85% Total 7 63.64% 65.25% Apart from the sector heavy problems, the portfolio also faces the risk caused by asset class heavy. In this fund, there are ten stocks and only one bond. The single variety of asset class may bring many risks to the fund. When large volatility occurred in the stock market, the fund’s income would fluctuate wildly. Therefore, the asset class heavy also stops the fund’s goal to be achieved. Performance of the investment The stocks and assets put in the following are as shown below. The portfolio was picked on the basis of their performance, dividend, and profitability. Therefore, it’s overall performance is as shown in table 1. Just as is shown is the table above the coriance between assets are almost positive. The largest covariance coefficient is 1.21E043 and the smallest one is -9.11E-06.. Ceteris paribus, the portfolio’s risk measured by standard deviation will be larger if covariance coefficients between assets are positive and closed to 1.Therefore, the current portfolio has some risks caused by the positive covariance. The new portfolio is expected to meet the aims of the portfolio by prioritizing the portfolio management and positioning them as value added. The management will be prioritizing the portfolio through investment and communication (Williams & Findlay 2004). This is the most effective way of shifting the portfolio mandate from the mandate to value addition. Additionally, more resources will dedicate to portfolio management based on time dedicated in managing the portfolio. The overview of the new portfolio is as shown in the figure below: Additionally, inflation risks need to be reduced. When the investments are allocated to stocks, there is likelihood to minimize exposure to inflation risk. In general, the inflation risk is a concern when investment is made on the fixed income securities in economies that have lower interest rates (Williams & Findlay 2004). When the interest rates continue to raise in future, the portfolio will face two problems; when the yields rises, the price of the stocks will reduce. Secondly, the investment will continue receiving similar coupon payments despite the interest payment purchasing power will continue declining as the rate of inflation rises. Therefore, the present interest rate condition and future expectation d the inflation needs to play a crucial role in finding the better asset allocation. Generally, the portfolios need to focus on asset classes that are growth oriented to minimize the inflation risk exposure and the opportunity cost of the future. However, the exposure of the portfolio need to be diversified across the assets, with a higher concern on valued securities. Investment Theory I took the top-down approach, where the individual stock was selected and bought with an additional step in the process. The final stage for the step involved analysis of the individual stock from various perspectives (Elton & Gruber 2005). The fundamental analysis involved various measurements like dividend yield, return on equity, and P/E growth ratio to the ratio of growth. The crucial aspect of the individual analysis will be the firm’s growth potential over a certain period of time. Ideally, the investment will have to own stocks with higher growth potential since it will lead to a higher stock price. The technical analysis concentrated on the long term weekly performance, for the entry price. At this point, the stocks were chosen and the process of buying began ((Elton & Gruber 2005). The approach was important because it helped determining the ideal location for the portfolio. The approach uncovered the situation that looked appropriate for larger investments into equities. The ability of maintaining the investment from overinvesting in stocks during the drought market was a higher plus for the system. When the market was lower, the probability of selecting the winning investment went down dramatically despite the stocks meeting the required conditions (DeFusco 2007). Assuming the bottom-up system was used, the investment determined the kind of stock to be bought even before taking note of the market condition. This kind of approach could easily lead to over exposure to equities, and the selected portfolio will greatly be affected. Other benefits of the approach include the diversification among the top sectors and foreign markets. This is normally referred to as conversification since it is a mixture of diversification and concentration. Therefore, the top-down approach was used where the individual stock was selected and bought with an additional step in the process. Additionally, the fundamental analysis involved various measurements like dividend yield, return on equity, and P/E growth ratio to the ratio of growth (DeFusco 2007). Portfolio Theory Majority of investments revolves around the growth of the company in terms of their earnings. When the earning of the firm is not growing, there is a lower possibility for the company to survive. The method is used in determining the portfolio was earnings growth. The selected companies have histories of growth in their earnings through every economic condition and stock market. From the statistics, the companies have recorded consistent results thus giving investment a different economic and market scenarios (Reilly & Brown 2007). The analysis focused on the financial ratios and other important information about the business as shown in the diagram below. New Asset Allocation The main objective of new asset allocation is to maximize the investment’s returns. Higher stocks were prioritized based on the dividends performance as shown in the table below: In the new portfolio, some of the investment funds were added and some removed from the portfolio. Some new assets should be added to the portfolio for the sake of the fund’s aims to be realized. The first one is TUI Travel (TT) from travel industry. Firstly, its annual return reaches up to 18.11% while its standard deviation of return is 0.021. Secondly, its pre-tax profit and ROE is increasing in these years. That shows a good profitability. Thirdly, the number of tourists increased not decreased in the context of global crisis. Finally, the company lies in another sector and that will increase the sector number. BT 5.75% 2028 Bond (BT) is also added. Firstly, the fund is a type of income fund, which means bonds should account more in the portfolio. So the fund needs more bond in order to gain stable income with low risks. Secondly, this bond’s annual return is 15.28, which is much higher than the market return. Thirdly, the bond has hardly any credit risk since its issuer British Communications’ financial is healthy. Apart from the two assets, the portfolio will accept two another assets Barclays PLC (BARC) and ETFS Gold (BULP). The former stock’s annual return is better than HSBA and is a blue chip with a good financial performance. The latter one is a kind of ETF. Although its risk is large, yet it will performance better since the demand of gold increases and contribute to the diversification of the asset class Detailed Analysis Using the top down approach, the new portfolio as based on the dividend the companies received ((Reilly & Brown 2007). The overview of the new portfolio is as shown in the figure below: The Covariance and Correlation for the new portfolio is as shown below. Just as is shown is the table above the covariance between assets are almost negative. The largest covariance coefficient is 1.05E-05 and the smallest one is -9.11E-06.. Ceteris paribus, the portfolio’s risk measured by standard deviation will be larger if covariance coefficients between assets are negatice and far from 1.Therefore, the new portfolio has less risks caused by the negative covariance. Holdings that recorded a higher dividend performance, recorded an increase in the size of holding in the new portfolio. This was based on the top down approach. . The fundamental analysis involved various measurements like dividend yield, return on equity, and P/E growth ratio to the ratio of growth. The crucial aspect of the individual analysis will be the firm’s growth potential over a certain period of time (Bowyer 2002). Ideally, the investment will have to own stocks with higher growth potential since it will lead to a higher stock price. The technical analysis concentrated on the long term weekly performance, for the entry price. At this point, the stocks were chosen and the process of buying began. The approach was important because it helped determining the ideal allocation he asset for the portfolio. The approach uncovered the situation that looked appropriate for larger investments into the equities. The ability of maintaining the investment from over-investing in stocks during the drought market was a higher plus for the system (“Investment analysis” 2006). Portfolio Overview Due to the large number of specific portfolios the recommendation will be generic. Assuming the that the effects of charges are ignored, nil commission, nil taxes, and nil trading costs the new portfolio will record new profitability statistics as shown below The adjustments have been made to avoid the risks that are associated with the portfolio allocation. The new portfolio meets the aims of the portfolio by prioritizing the portfolio management and positioning them as value added (Bentley 2002). The management will be prioritizing the portfolio through investment and communication. This is the most effective way of shifting the portfolio mandate from the mandate to value addition. Additionally, more resources will dedicate to portfolio management based on time dedicated in managing the portfolio. I changed the portfolio by taking the additional step to modify the number of shares I hold in the portfolio. There were few reasons to make the alterations in my portfolio starting with returns and performance of the individual stocks. When I selected the portfolio back in 2012, this means the balance started with a zero balance. I also limited the number of shares because of the fee charges that runs the portfolio. When the portfolio balance grew from the investment returns, I increase the number of shares and changed the investment of the contributions. After passing the initial phase, I planned to tweak the investment so that they spread across the portfolio’s stock. I also gave a concern on the number of shares that strikes a perfect balance between ease management and diversification (Briston 2000)  Portfolio Reconstruction After considering the investment goal and financial situation, the future needs came after. During the reconstruction process, I maintained the diversification above all every scenario. It is not only important to own the securities from every class of assets; they must also be diversified within every class. I ensured that the holdings within the asset class are properly spread across the industry sector and their subclasses array. The investment can attain excellent diversification through the use of ETF and mutual funds. Those investment vehicles enabled the investment to obtain economies of scale that mangers enjoy. Generally, a portfolio that is well diversified is the best for long term growth of investments (Holmes 2002). It protects the assets from structural changes and large declines in the economy over a given period of time. The diversification of the portfolio was monitored, making the appropriate adjustment where needed. Therefore, for a successful reconstruction, appropriate asset allocation need to be determined, the second step is achieved the portfolio designed during the asset allocation. Then the portfolio weighting is reassessed. Here analysis and periodic rebalancing is done since the movements of the marker can cause the initial weightings to change. Assessing the actual asset allocation involves categorizing the investments and determining the values proportion to whole (Krause 2006).  The factors that are prone to change over time are the current financial situation, risk tolerance, and future needs. When the parameters changes, the amount of stock held will reduce. Or perhaps someone is willing to take risk and allocation of the assets need that a smaller proportion of the assets be held in riskier small cap stock. Basically, rebalancing needs to determine the kind of positions that are overweighed and those that are underweighted. The last stage is rebalancing strategically, ones the securities that require reduction are determined, and the securities that will be underweighted will be bought from the securities that will be overweighed. When the assets are sold to rebalance the portfolio, moments need to be considered on the implication of readjusting the portfolio (Cohen & Zinbarg 1967). Assuming the growth stocks’ investment has grown strongly over the past periods, significant capital gains of the taxes will be incurred. In this scenario it will be profitable to not invest funds on the asset class in future while continue contributing to asset classes. This will tend to reduce the growth stock weighing in the portfolio overtime without incurring the taxes of capital gains. Similarly, the security outlook needs to be considered. If it is suspected that the same overweighed stocks are ready to fall, selling will be the better option despite the implication of the taxes (Brentani 2004). Reference Bentley, R. (2002). Investment analysis. Paterson, N.S.W.: NSW Agriculture, Home Study Program. Bowyer, J. W. (2002). Investment analysis and management (4th ed.). Homewood, Ill.: R.D. Irwin. Brentani, C. (2004). Portfolio management in practice. Oxford [England: Burlington, MA :. Briston, R. J. (2000). The Stock Exchange and investment analysis,. London: Allen & Unwin. Cohen, J. B., & Zinbarg, E. D. (1967).Investment analysis and portfolio management. Homewood, Ill.: R.D. Irwin. DeFusco, R. A. (2007). Quantitative investment analysis (2nd ed.). Hoboken, N.J.: Wiley. Elton, E. J., & Gruber, M. J. (2005).Modern portfolio theory and investment analysis (5th ed.). New York: Wiley. Fabozzi, F. J. (1989). Portfolio & investment management: state-of-the-art research, analysis, and strategies. Chicago, Ill.: Probus Pub. Co. Holmes, A. (2002). Risk management. Oxford, U.K.: Capstone Pub.. Investment analysis. (2006). Lincoln] N.Z.: Kellogg Farm Management Unit, Lincoln College. Krause, A. (2006). Risk management. Bradford, England: Emerald Group Pub.. Prime, J. H. (2007). Investment analysis(4th ed.). Englewood Cliffs, N.J.: Prentice-Hall.s Reilly, F. K., & Brown, K. C. (2007).Investment analysis and portfolio management (5th ed.). Fort Worth, Tex.: Dryden Press. Weaver, D. (2001). Investment analysis;. London: Longman [for] the Society of Investment Analysts. Williams, E. E., & Findlay, M. C. (2004).Investment analysis. Englewood Cliffs, N.J.: Prentice-Hall. Read More