The portfolio management processThe portfolio management process

The portfolio management processThe portfolio management process

• Set objective and policy goals

• Examine and understand the environment

• Construct the portfolio: asset allocation & security selectionasset allocation & security selection

• Monitor and update

Individual investment objectives? Individual investment objectives?

Popular belief:

Investments are aimed at “making money”

Suggested strategies for “making money”Suggested strategies for “making money”

Put $1 in the bank at 3%.

Eventually you will become a billionaire

Put all of your earnings in the lottery.

Eventually you’ll hit the jackpot

Goals vs. objectivesGoals vs. objectives

Financial Goals

Broad financial ends, such as, buying a home, paying for children’s education, etc.

Investment objectives

Stated in terms of risk and return - a function of goals, investment horizon etc.

Investment objectivesInvestment objectives

Are dictated by risk tolerance and time horizon

• Capital preservation• Income • Growth

Individual investment objectivesIndividual investment objectives

Age considerations

Risk consideration

Individual investor life cycleIndividual investor life cycle

• Accumulation phase

• Consolidation phase

• Spending phase

• Gifting phase

Accumulation phaseAccumulation phase

Long-term goals• Retirement• Children’s education• Etc

Short-term goals• Car• House

Consolidation phaseConsolidation phase

Long-term goals• Retirement

Short-term goals• Children’s education• Vacation • Etc.

Spending phaseSpending phase

Long-term goals• Estate planning

Short-term• Life style• Gifts

Gifting phaseGifting phase

Long-term goals• Estate planning

Short-term• Life style• Gifts

Risk considerationsRisk considerations

Factors:

• Psychological makeup

• Family situation

• Income

• Age

Investment constraintsInvestment constraints

• Liquidity needs

• Tax concerns

• Regulations

• Unique needs

Liquidity needsLiquidity needs

Related to investment horizon & age

Longer horizons = accept less liquidity & more risk

Tax concernsTax concerns

Investors think in terms of after-tax return

RegulationsRegulations

Impose restrictions and constraints

Ex:

RRSP: Foreign content rule

Unique needsUnique needs

A function of each individual

Asset classesAsset classes

Classification according to risk and expected return characteristics

• Stocks• Bonds• Risk-free investments

Asset classesAsset classes

Each class can be further divided into subclasses

Bonds:• Long-term corporate bonds• Long-term government bonds• Medium-term corporate bonds• Medium -term government bonds

Etc.

Historical record: 1926-1998 (US)Historical record: 1926-1998 (US)

Geometricmean

Arithmeticmean

Standarddeviation

Large stocks 11.2% 13.2% 20.3%

Small stocks 12.4% 17.4% 33.8%

Long-term corporate bonds 5.8% 6.1% 8.6%

Long-term government bonds 5.3% 5.7% 9.25

US T-bills 3.8% 3.8% 3.25

Inflation 3.1% 3.2 4.5%

Inflation

Historical record: 1948 -1998 (Canada)Historical record: 1948 -1998 (Canada)

Arithmeticmean

Risk premium Standarddeviation

Large stocks 13.2% 7.16% 16.6%

Small stocks 14.8% 8.75% 23.68%

Long-term bonds 7.6% 1.6% 10.6%

T-bills 6% 0 4%

Inflation 4.25% -1.8% 3.5%Inflation

Returns from investing $1: 1948-1999Returns from investing $1: 1948-1999

1945 1975 2000

TSE300

$ 357.3

$ 36.4Bonds

$ 20.4T-bills

Inflation$ 8.4

Asset allocation: Various countriesAsset allocation: Various countries

US & Canada UK Germany Japan

Equity (domestic) 41% 54% 9% 22%

Equity (foreign) 4% 18% 2% 2%

Bonds 29% 12% 45% 22%

Real Estate 8% 9% 5% 6%

Cash 10% 5% 4% 6%

Other 8% 2% 35% 42%

27%

22%

17%

12%

7%

Return

Standard deviation20% 30%

World stock markets annual rates of return and risk in local currency 1986-1997World stock markets annual rates of return and risk in local currency 1986-1997