Portfolio Theory and Investment Analysis

Group Members :
Afdal Syarif Alvin Putra Dedet Afrinata Sandisa Putra

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Chapter 1
Understanding Investments

Investments Defined
Investments is the study of the process of committing funds to one or more assets
Emphasis on holding financial assets and marketable securities Concepts also apply to real assets Foreign financial assets should not be ignored

Investment Objectives
Primary Objectives
Safety of principal Income Growth of capital

Secondary Objectives
Liquidity Tax minimization

Investment Constraints
Possible constraints for investors include:

Legal Moral / Ethical Emotional including investment knowledge and risk tolerance Basic minimum income to be provided by the portfolio Realism an understanding that some objectives are unrealistic (e.g., high returns with low risk) Other (e.g., illness, pending divorce, etc.)

Primary and Secondary Objectives

Objectives and constraints must be related to the three primary investment objectives of safety, income, and growth, and to the secondary objectives of liquidity and tax minimization.

The importance of safety relates to: risk, market timing, inflation, return, and emotion The importance of income relates to: taxation, return, risk, inflation, and basic minimum income The importance of growth relates to: taxation, risk, return, market timing, and emotional considerations

The Investment Process

A description of the process is:

1. Set investment policy

Objectives Amount Choice of assets Examine securities (identify those which are mispriced?) a. Technical analysis the examination of past prices for trends b. Fundamental analysis true value based on future expected returns

2. Conduct security analysis

Use

The Investment Process

3. Portfolio Construction

Identify assets Choose extent of diversification Assess the performance of portfolio Repeat previous three steps

4. Portfolio Evaluation

5. Portfolio Revision

Why Study Investments?

Most individuals make investment decisions sometime

Individuals need sound framework for managing and increasing wealth Security analyst, portfolio manager, investment advisor, financial planner, Chartered Financial Analyst

Essential part of a career in the field

Investment Decisions
Underlying investment decisions: the tradeoff between expected return and risk Return: expected return is not usually the same as realized return Risk: the possibility that the realized return will be different than the expected return

The Tradeoff Between ER and Risk

Investors manage risk at a cost lower expected returns (ER) Any level of expected return and risk can be attained

Stocks ER Bonds

Risk-free Rate Risk

Typical Chart
RT

RISK- EXPECTED RETURN RELATIONSHIPS

12

RELATION

RISQUE-RENDEME

High
10

Options/Futures Art objects Coins and stamps Real estate (commercial) Common shares Real estate (residential) Preferred shares Corporate bonds Government bonds Treasury bills
Rendement

Expected Return 6
4

0 Low

Risk

10

12

High

The Investment Decision Process

Two-step process:

Security analysis

Necessary to understand security characteristics and applied to these securities to estimate their price or value Selected securities viewed as a single unit How and when should it be revised? How should portfolio performance be measured?

Portfolio management

Factors Affecting the Process

Uncertainty in ex post returns dominates decision process

Future unknown and must be estimated

Foreign financial assets opportunity to enhance return and/or reduce risk Investors must now cope with a changed investing environment Internet changes investments environment Institutional investors are important How efficient are financial markets in processing new information?

Return and Risk

The risk inherent in holding a security is the variability, or the uncertainty, of its return Factors that affect risk are

1. Maturity

Underlying factors have more chance to change over a longer horizon Maturity value of the security may be eroded by inflation or currency fluctuations Increased chance of the issuer defaulting the longer is the time horizon

Return and Risk

2. Creditworthiness

The governments of the US, UK and other developed countries are all judged as safe since they have no history of default in the payment of their liabilities Some other countries have defaulted in the recent past Corporations vary even more in their creditworthiness. Some are so lacking in creditworthiness that an active ''junk bond'' market exists for high return, high risk corporate bonds that are judged very likely to default

Return and Risk

3. Priority

Bond holders have the first claim on the assets of a liquidated firm Bond holders are also able to put the corporation into bankruptcy if it defaults on payment Liquidity relates to how easy it is to sell an asset The existence of a highly developed and active secondary market raises liquidity A security's risk is raised if it is lacking liquidity

4. Liquidity

Risk and Return

5. Underlying Activities

The economic activities of the issuer of the security can affect how risky it is Stock in small firms and in firms operating in hightechnology sectors are on average more risky than those of large firms in traditional sectors

Return and Risk

The greater the risk of a security, the higher is expected return Return is the compensation that has to be paid to induce investors to accept risk Success in investing is about balancing risk and return to achieve an optimal combination The risk always remains because of unpredictable variability in the returns on assets