chapter 4 investment analysis and portfolio management

ISLAMIC INVESTMENT

Mahyuddin Khalidemkay@

salam.uitm

.edu.my

Investment Analysis and Portfolio Management

Chapter Outline

Individual Investor Life Cycle The Portfolio Management Process The Need for Policy Statement Constructing the Policy Statement The Importance of Asset Allocation

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What is asset allocation?

Asset Allocation

•Process of deciding how to distribute an investor’s wealth among different countries and asset classes for investment purposes

Asset Class

•Group of securities that have similar characteristics, attributes, and risk/return relationships

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Managing Risk

Since risk drives

expected return,

investing involves

managing risk rather than managing

return.

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Risk Management Strategies

Risk Avoidance

• Can avoid any real chances of loss• Generally a poor strategy except for

a part of an overall portfolio

Risk Anticipation

• Position part of your portfolio to protect against anticipated risk factors

• For example, maintain a cash reserve

Risk Transfer

• Insurance and other investment vehicles can allow for the transfer of risk, often at a price, to another investor who is willing to bear the risk

Risk Reduction

• Effective diversification and asset allocation strategies can reduce risk, sometimes without sacrificing expected return.

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Individual Investor Life Cycle

The individual investors life

cycle can often be

described using four separate phases or

stages

Accumulation Phase

Consolidation Phase

Spending Phase

Gifting Phase

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Phases of an Investor’s Life Cycle7

Accumulation Phase

Early to middle years of careers

Attempting to satisfy

intermediate and long-term goals

Net worth is usually small, debt

may be heavyLong-term

investment horizon means usually willing to take

moderately high risks in order to

make above-average returns

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Consolidation Phase

Past career midpoi

nt

Have paid off much of their accumulated

debt

Earnings now exceed living expenses, so

the balance can be invested Time horizon is

still long-term, so moderately

high risk investments

are still attractive

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Spending Phase

Usually begins at retiremen

t

Saving before, prudent spending

now

Living expenses covered by Social

Security and retirement plans

Changing emphasis toward preservation of capital, but still

want investment values to keep

pace with inflation

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Gifting Phase

Can be concurren

t with spending

phase

If resources allow, individuals

can now use excess assets to provide gifts to

other individuals or organizations

Estate planning becomes

important, especially tax considerations

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The Portfolio Management Process

4 step process:Construct a

policy statement

Study current financial

conditions and forecast future

trends

Construct a portfolio

Monitor needs and

conditions

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Portfolio Management Process13


Specifies investmen

t goals and

acceptable risk levels

Should be reviewed periodicall

y

The “road map” that guides all investment decisions

Policy stateme

nt

14


Study current financial and

economic conditions and forecast future

trends

Determine strategies that

should meet goals within the expected

environment

Requires monitoring and updates since financial markets are ever-changing

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Allocate available

funds to meet goals while

managing risk

Given the policy

statement and the

expected conditions, go

about investing

Construct the portfolio

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Monitor and update

Revise policy

statement as needed

Monitor changing financial

and economic conditions

Evaluate portfolio

performance

Modify portfolio

investments

accordingly

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The Policy Statement

Understand and articulate realistic investment objectives and constraints Know yourself Know the risks and potential rewards from investments

Learn about standards for evaluating portfolio performance Know how to judge average performance Adjust for risk

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The Policy Statement

Don’t try to navigate without a map! Begins with:

Profile analysis Investor’s current and future financial situations

Important Inputs: Investment Objectives Investment Constraints

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Investment Objectives

Need to specify return and risk

objectives

Need to consider the risk

tolerance of the

investor

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Investment Objectives

Capital preservatio

n• Maintain purchasing power• Minimize the risk of loss

Capital appreciatio

n

• Achieve portfolio growth through capital gains

• Accept greater risk

Current income

• Look to generate income rather than capital gains

• May be preferred in “spending phase”

• Relatively low risk Total

return• Combining income returns and

reinvestment with capital gains• Moderate risk

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Investment Constraints

These factors may limit or at least impact the investment choices

• How soon will the money be needed?Liquidity needs

• Influences liquidity needs and risk tolerance

• Longer investment horizons generally requires less liquidity and more risk tolerance

Time horizon

• Limitations or penalties on withdrawals• Fiduciary responsibilities• Retirement regulations

Legal and Regulatory

Factors

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Investment Constraints

• Unrealized capital gains: Reflect price appreciation of currently held assets that have not yet been sold

• Realized capital gains: When the asset has been sold at a profit

• Trade-off between taxes and diversification: Tax consequences of selling company stock for diversification purposes

Tax and Zakat

Concerns

• Personal preferences such as socially conscious investments could influence investment choice

• Perhaps the investor wishes to avoid types of investments for ethical reasons

Unique needs and preferenc

es

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Investment Education

The bottom line

If you do not plan for the future, you will likely not be prepared for it.

Data indicates that many Malaysians have greatly under-invested for the future.

The type of information necessary to construct a good policy statement is neither “common sense” or “common knowledge.”

Many investors fail to diversify. Many fail to plan completely.

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Asset Allocation Decisions

What asset classes

should be considered?

What should be the normal

weight for each asset

class?

What are the

allowable ranges for

the weights?

What specific

securities should be

purchased?

Four decisions in an investment strategy

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The Importance of Asset Allocation

The asset allocation decision (which classes and at what

weights) is very important. Using fund data:

About 90% of return

variability over time can be explained by

asset allocation.

About 40% of the differences

between returns can be explained by differences in

asset allocation.

Asset allocation is

thus the major factor that

drives portfolio risk and return.

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Risk/Return History and Asset Allocation

Looking at return data on various asset classes indicate some important factors for investors• Even apparent low-risk investments like T-bills can have

considerable reinvestment risk

Over long time horizons, stocks have always outperformed low-risk investments.• So the additional risk over shorter time horizons seems to all

but disappear over time.The only way to maintain purchasing power, net of taxes and inflation, is by investing in proper investment instruments like common stock, unit trust etc.

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Asset Allocation and Cultural Differences

Differences in social, political, and tax environments influence asset allocation.For instance, 38% of pension fund assets of Kumpulan Wang Amanah Pencen (KWAP) are invested in equities.• 79% in equities in United Kingdom, where high average inflation

impacts this choice• 8% in equities in Germany, where generous government

pensions and greater risk aversion seem to play a strong role

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Summary

In this chapter

you have learned about:

Individual Investor Life

Cycle

The Portfolio Management

ProcessThe

Importance of Asset

Allocation

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30 Thank You