Personal Financial Management

Semester 2 2008 – 2009

Gareth Myles g.d.myles@ex.ac.uk

Paul Collier p.a.collier@ex.ac.uk

Reading

Callaghan: Chapter 5McRae: Chapter 2

Investing in Financial Assets

There are many financial assets available

Some are accessible to private investors Some are primarily for institutions We will focus on the former but mention some

of the latter Investment funds allow access to all assets

Portfolio Choice

The basic investment issue is to construct a portfolio of investments

This should have return and risk characteristics that match the investor’s needs

Example 1. An investor aged 25 in full-time employment may feel safe to “take a chance” and aim for a high risk/high return portfolio

Example 2. An investor aged 65 who is retired may want primarily to protect their capital in a low return/low risk portfolio

Portfolio Choice

Example 3. (Annuitisation)A private pension is invested in a range of

assets during working lifeUpon retirement the majority of the fund is

used to buy an annuityAn annuity pays a fixed income for

remainder of lifeThis represents transfer from risky to safe

assets

Portfolio Choice

The basic issue in portfolio design is to choose the assets to match risk preference

We need to know The risk and return characteristics of

individual assets How they interact with other assets

But first we need to know the available assets

Assets

Non-Marketable Assets which cannot be sold to someone else (e.g.

bank accounts) Marketable

Assets which can be traded Included here are bonds and stocks

Derivatives A specialised group of assets for institutions or very

sophisticated private investors Indirect Investments

Simplify portfolio construction and reduce costs

Non-Marketable Assets

The most important assets within this category areBank and building society accounts

Royal Bank of ScotlandGovernment savings bonds

National Savings and Investments

To purchase these private information must be revealedName, age, address, employment status,

even source of income

Marketable Assets

Shares (common stock, equity) Issued by companies to fund investmentHolder receives a dividend (share of profit), Holder has ownership rights (voting)To trade must open an account at a broker

On-line Broker Information is readily available

Yahoo Finance

Bonds (government or corporate)Promise a flow of payments (coupon

payments – equivalent to interest)Pay face value on maturityMaturity (at issue) from 3 months to many

yearsReturn depends on market assessment of

risk (default)Example

Marketable Assets

Marketable Assets

DerivativesAssets based on the price of other

“underlying assets”Call option: the right to buyPut option: the right to sellFutures: contracts in advance of delivery

Marketable Assets

Indirect InvestingPurchase of a share in a portfolioChoice of portfolio (ethical, trackers)Allows diversification at low cost

Abbey

Trading

Going long: holding a positive quantity of an asset This is the typical investment

Selling short: holding a negative quantity of an asset Takes advantage of expected price falls

Buying on the margin: borrowing money to invest Increases expected return and risk

Portfolio

A set of assets and the proportion of the portfolio in value terms they constituteExample ICI shares (20%), BP shares

(10%), Deposit account (30%), Bonds (30%), Unit trust (10%)

The return on a portfolio is the weighted average of that on the assets in the portfolio

The risk is more complex to compute

Effect of Covariance

Consider the returns on two assets in the two possible events next year

Consider the return on a portfolio: 1/3 of asset A, 2/3 of asset B

Asset A B

Rain 8 1

Sun 2 4

Effect of Covariance

Rain Sun

Return (1/3)8+(2/3)1=10/3 (1/3)2+(2/3)4=10/3

In this example the risk in the individual assets cancels when they are combined

Each asset does well in a different state

Effect of Covariance

This is an example of negative covariance

Because of the strong influence of market factors most assets have returns with positive covariance

But some combinations of assets have lower risk than other combinations with the same return

Portfolio Risk

When assets are combined into a portfolio it is possible to trade risk for return

There are some portfolios which are efficient (maximum return for given risk)

Some portfolios are inefficientThere is always a portfolio will least risk

(the minimum variance portfolio)

Return and Riskpr

p

mvpr

mvp

Efficient Frontier

Asset A only

Asset B only

Market Model

Consider the entire set of financial assets: these form the “market”

The riskiness of each individual asset can then be measured relative to the market

This gives an asset’s “beta”Portfolio risk is then proportional to

weighted average beta plus asset-specific risk

Beta

Return onMarket

Return onAsset

The slope of this line is for the asset

Return onMarket

Return onAsset

A risk-free assethas a of 0

Introducing Risk-free Asset

Return onMarket

Return onAsset

The of this asset is less than 1

Defensive Asset

45o

Return onMarket

Return onAsset

The of this asset is more than 1

Aggressive Asset

45o

Beta

Company Betas

Company Beta

AstraZeneca 0.8573

Barclays Bank 1.5259

BP 1.0082

HSBC Holdings 0.6071

Imperial Tobacco 0.5053

Portfolio Return and Risk

Let be the proportion of asset i in the portfolio

Portfolio return is The of the portfolio is

The portfolio variance is

So larger , larger variance

nnXXX 2211

iX

nnrXrXrXr 2211

2222eM

Portfolio Return and Risk

Portfolio

Portfolio Return

Risk-freeAsset

= 1

MarketReturn Choice of

efficientportfolios

Idiosyncratic Risk

What has happened to the idiosyncratic risk (risk not due to market) ? this is eliminated by diversificationas the number of assets held rises, the

individual variations cancelHow can we diversify economically?

by buying a tracker fund

2e

Practical Observations

Risk is reduced by diversificationHigher returns bring higher riskRisk can be assessed by using By altering ratio of risk-free and market,

can run through all feasible returnsA return higher than the market can be

obtained by going short in the risk-free: borrowing to invest (yes, this is risky)