Determinants of Portfolio Performance - Essay Example

? Individual Report and Individual Report This task has enabled me to acquire invaluable skills in money management. For the realization of a better result in any venture, regardless of whether it is a business venture or any other venture, there is a need to have a good management to steer the investment to success. Money is one of the essential factors that contribute to the growth of any venture, especially business investment. It should, therefore, be noted that good money management is a sure guarantee of a brighter future to such investment (Stacy and Fuller 2008). Money management is the process of being a custodian of one’s finances by knowing where today’s finances are being spent, and drawing a well thought out plan showing where one wants this money to go. Therefore, it calls for one to be well organized; have set goals, which would gear this investment to success; have a track of one’s spending by putting in place a realistic budget, and above all have a well thought-out savings strategy (Ryan and Deci 2004). Before this course, I was particularly naive and could not have understood how to effectively make an investment decision or understand the significance of making various investment considerations that I have learnt so far. Having known how to make various considerations that affect performance of an investment portfolio, I can now comfortably put up an investment plan (Milevsky 2001). One of the most important principles of investment I have learnt is how to diversify and manage risks. I have become conscious of the essence of the old adage goes “do not put all your eggs in the same basket”, I have realized how risky it can be to concentrate on a single or a few investments especially those whose rate of return is very high in the short-term but very risky. For example, in my individual investment, I combined risky high return stocks with low return but less risky stocks such that it becomes hard to loss substantially when some of the investments perform poorly in the future (Little 2012). In my portfolio, even though Microsoft generated negative returns, I was still able to realize a positive annualized return of 11.52%, primarily because Berkshire Hathaway performed well and watered down that loss (Kapur and Orszag 1999). The idea here is, since investment involves risk, one way of managing this risk is by spreading one’s portfolio across an array of stocks, with different characteristics. The preliminary portfolio that I had selected included a number of companies that operate in different industries, markets and regions as well as dealing with different products; such that each company possessed a distinctive level and nature of risk. Selecting of portfolio from such a diversified field is a way of ensuring the investment plan is well-balanced. In the same measure, I found it important to define the amount of each stock one should buy and hold depending on the company’s current performance, the level of risk and future expectations (Smith 2009). Ideally, in the analysis that I did as well as the one we did as groups, some stocks were clearly generating negative returns. Examples include Microsoft and Kazakhmy among many others. At first, I thought it is completely useless to hold stocks that have negative returns currently, but I have come to change this view because I have learnt to put my eye on the long-term cash flows. Short-term mindset coupled with a lot of trading and market timing is a strategy I would not like to undertake in the future. I have come to realize that I can make profits progressively by focusing on many years to come and by sticking on my stock investment goals. More long-term financial strategies, along proper diversification can be a surprise to an investor because I have come to realize that, even though a certain stock could be generating losses in the short-term, things may change in future hence leading to huge returns. I have actually become more focused on forecasting a company’s future performance rather than dwelling on the current performance. Furthermore, as an investor, I would seek to establish a strategy that matches my risk profile so that I may not be caught off guard should such risks occur. I would, therefore, work towards ensuring that I cushion myself against any short- term loss. This becomes possible if I ensure long-term growth in the value of my investment and by being cautious on inflation (Scott 1975). In the course of our study, I was particularly concerned about some of our group members who were directed by emotions rather than strategy. Sometimes we had stocks whose performance was really bad. Decisions had to be made whether such stocks should be sold or held, but this process was particularly difficult because some members emotionally took stands. In reality, many people abandon their financial plans just because the market has plummeted or when the financial situation has changed significantly. A practical example is what happened following 2007 financial crises, which was instigated by collapse of the real estate and credit crunch. Very many people had made their investment plans, but after the crises, most of them were led by emotions and completely pulled out of the stock market. I have realized that making short-term moves in this manner can make an investor very vulnerable and hence lose a lot of wealth. This includes reacting emotionally to volatility by backing off when the market is low and buying back when it has recovered. So, I have learnt a lesson that, one should be careful when selling low and buying high, because this leads to loss of money (Pekema, 2010). When making these investment decisions, our group was particularly keen on avoiding costly mistakes. This concept is intertwined by the concept of diversification as discussed; however, I have learned that in investment, one cannot completely avoid making mistakes but it is good to put measures to mitigate such mistakes in future. What’s more, making of mistakes is one way of becoming an experienced investor because one becomes aware of what to avoid next time. That said, there are stocks I as well as my group included in the portfolio not knowing well that would lead to incurring of losses, but the experience each one of us went through will help us in making better decisions in the future. Performance of my suggested portfolio My portfolio, which was clearly lean, performed poorer than the group’s portfolio. This is evidence by the analysis of annualized returns as shown in table 1. The annualized return for the group’s portfolio is 26.17%, trailed by my suggested portfolio at 11.52%. However, I have based this performance on returns alone, and hence I did not pay attention to the risk that led to attainment of those returns (Kapur & Orszag, 1999). While my portfolio was diversified into only three stocks, the group’s portfolio was diversified into more than 10 stocks, a factor which perhaps led to the better performance of the group’s portfolio. Henceforth, I have learnt that it advisable to invest in as many stocks as possible, because this seemingly spreads the risk more and hence increasing the chances of the portfolio performing better. What’s more, if just a few stocks are selected, like the way I did, the investor is likely to incur losses if the few companies perform poorly, but when there are many companies invested in, the chances of almost all of the companies performing poorly is significantly low. For instance, in the group’s portfolio, 3 stocks performed significantly poorly while the remaining 8 were not badly off, hence the good performing stocks comfortably bailed the few that flopped and the overall results were somewhat remarkable. This scenario is very different in the case of my portfolio, where 1 stock performed poorly hence making it difficult to get enough bail out from the remaining 2 portfolios, which also did not perform extremely well (Merton, 1969). When I research deeper into this area, with the aim of finding out whether there was a better way of quantifying and measuring the performance of a portfolio, I found a set of three techniques that considers both risk and return together. These include Sharpe, Treynor and Jensen ratios (Merton, 1969). In this section, I will illustrate how treynor is used to measure performance, and the reasons why it is better than using returns or risk only. Figure1: Individual Annualized Returns Berkshire Hathaway (NYSE) Microsoft (NASDAQ) General Electric (NYSE) Original share value 147,113.09USD 27.93USD 22.62USD Share value 150,247.79 USD 27.74 USD 23.28 USD Return 0.021(2) -0.19(3) 0.029 (1) %+1 1.021 0.993 1.029 [1.021*0.993*1.029]*12= 12.52-1=11.52 The annualized return = 11.52% Annualised Fund Return (dividends excluded)  ((1+0.3168)12 - 1)=26.1793% Treynor shows the relationship between market rates of returns and portfolio returns, where by the beta measures the volatility between the market and the portfolio. The best risk-return tradeoff is the one where the line’s slope is highest. The Treynor is defined as follows: Treynor = In this formula, the denominator represents the risk of the portfolio while the numerator identifies the risk premium. The resulting figure is the portfolio’s return per unit risk. To illustrate the return per unit risk of my suggested portfolio, we shall assume a 10-year annual return for the market portfolio to be 10%, while the average annual returns on T-Bills to be 5%. So, assuming the already discussed annualized returns for my suggested portfolio, the following is computed: Portfolio Average annual returns beta Berkshire Hathaway (NYSE) 0.021 0.53 Microsoft (NASDAQ) 0.993 0.79 General Electric (NYSE) 0.029 1.61 T (market) = (0.10-0.05)/1 = 0.05 T (Berkshire Hathaway (NYSE) = (0.021-0.05) = -0.029(2) T (Microsoft (NASDAQ) = (-0.007-0.05) = -0.057(3) T (General Electric (NYSE) = (0.029-0.05) = -0.021(1) The best portfolio is the one with the highest Treynor, which in this case is General Electric. When the portfolios are evaluated on the basis of performance alone, the same results which are the same as these are found, which led me to the conclusion that beta may not introduce significant effect in my analysis and hence increasing my confidence of ranking the stocks on the basis of performance alone. Similarly, with the assumption that beta has no significant effect, I have confidently presumed that my suggested portfolio performed poorer than that of the group. This metric only applies systematic risk because it assumes that the investor hold sufficiently diversified portfolio. Therefore, unsystematic risk is not put into account in this computation (Brinson, Randolph HL & Gilbert, 1986). In view of this analysis, the groups failed to follow my suggestions but at the same time I support their idea of ditching it because it could have led to inadvertent investment, as evidenced by the poor performance of my portfolio. An annualized return of 11.52 % for my portfolio compared to 26.17% for the group portfolio is a clearly a big difference that cannot be ignored. Apparently, the group was somewhat right in failing to follow my suggestion, though I could argue that the fact that my portfolio performed poorly in the short-term is not a guarantee that it will perform poorly in the long-term. However, I strongly support the group’s idea because probably adopting my lean portfolio is a big gamble that is too risky (Ryan and Deci, 2004). Conclusion This course has taught me a lot of investment management skills. I have highly understood the importance of using different concepts such as risky profile, diversification, and portfolio performance in determining the best investment that guarantees the optimum returns while minimizing the level of risk (Lachance, 2003). Most importantly, it has been noted that evaluation of personal risk profile is a very important consideration that should be made before deciding the most appropriate investment for a particular individual. The fact that my focus is having a long-term mind set means that the numerous volatiles situations that take place in the short-term should not lead me to emotional actions that can results to massive loss. Reference Brinson, GP., Randolph HL., & Gilbert, LB 1986. ‘Determinants of Portfolio Performance.’ Financial Analysts Journal, July/August, pp. 39–44. Kapur, S & Orszag, M 1999, A portfolio approach to investment and annuitization during retirement, Birkbeck College press, London. Lachance, M 2003, Optimal investment behavior as retirement looms, Wharton School, University of Pensylvania, Philadelphia. Little, K 2012, Major Types of Risks for Stock Investors, viewed 30 May 2012, Merton, R 1969, ‘Lifetime portfolio selection under uncertainty: The continuous time case’, Review of Economics and Statistics, vol. 51 no.3, pp.247-257, Milevsky, M 2001, ‘Optimal annuitization policies: analysis of the options’, North American Actuarial Journal, vol. 5 no.1, pp.57-69. Pekema, D 2010, Understanding the benefits of investment, Boston University Press, Boston. Review of Economics Studies, Vol. 32 no. 2, pp.137-150. Ryan, RM. and Deci, EL., 2004, Handbook of Self-Determination Research, SAGE, London. Smith, A 2009, 5 Benefits prudent investment, University of Trinidad Press, Trinidad. Read More