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Ch 1 Diversification l More Stocks , Less Risk As the number of stocks Ch 1 Diversification l More Stocks , Less Risk As the number of stocks in a portfolio increases, the total risk or volatility of that portfolio decreases .

Benefits of Diversification l Diversification is the act of combining assets with dissimilar behavior Benefits of Diversification l Diversification is the act of combining assets with dissimilar behavior for the purpose of producing a portfolio with an optimal risk/return tradeoff. “NOT PUTTING ALL YOUR EGGS IN ONE BASKET” By diversifying, a deep loss in one asset class may be offset by gains in another. The net result is a more stable portfolio.

Diversification Helps Manage Risk l In an ideal world, investors would find securities that Diversification Helps Manage Risk l In an ideal world, investors would find securities that offer consistently high return with little risk. However in the real world there is no such thing.

International Securities International stocks and bonds are another major asset class to consider. There International Securities International stocks and bonds are another major asset class to consider. There have been some instances when foreign securities have outperformed their U. S. counterparts. The diversification benefits of international securities, have generated high interest in global markets. To reduce the total volatility risk of some portfolios, it would be wise to invest internationally as well.

Asset Allocation The most important investment decision is the asset mix of a portfolio. Asset Allocation The most important investment decision is the asset mix of a portfolio. The five major asset classes investors are concerned with their investment needs are: Day-to-Day, Emergencies, Saving for a Near-Term Purchase, Long-Term Savings, and Retirement. The understanding of five major investment fundamentals aids in a assembling a portfolio are: – – – Tradeoff between risk and return Diversification Benefits Long-Term Investing and Compounding Returns Liquidity and Marketability Considerations Tax Deferral Benefits However the most important decision is the Asset Allocation choice

Ch 2 Modern Portfolio Theory (MPT) Prepared by Alex Au Ch 2 Modern Portfolio Theory (MPT) Prepared by Alex Au

Introduction MPT: takes into account of different possible outcomes, project results with a high Introduction MPT: takes into account of different possible outcomes, project results with a high degree of certainty, have the ability to be fine tuned on a regular basis, stay within selected parameter and reduce your overall risk. l MPT let investors choose their own risk level. l MPT work with proper diversification to reduce risk and increase return. l

The Need for Asset Allocation l Diversification can reduce a portfolio’s risk and improve The Need for Asset Allocation l Diversification can reduce a portfolio’s risk and improve return. l Since each asset class have a different uncertainty it is necessary to consider the range of possible outcome for each asset class.

Portfolio Risk and Return l Investors want a high expected return, but at the Portfolio Risk and Return l Investors want a high expected return, but at the same time they want an asset with low standard deviation. l Expected return and standard deviation are estimated from historical data. l Investors are not concern with holding a asset in isolation, but rather with the risk of the entire portfolio.

(cont’d) Portfolio risk not only depend on the riskiness of its component assets, but (cont’d) Portfolio risk not only depend on the riskiness of its component assets, but also on how the return are related to one another. l Risk that can be eliminated by diversification does not command a risk premium. l A portfolio’s expected rate of return should be easy to determine using the weighted average return of the individual assets. l

(cont’d) Correlation coefficient is the measure of the relationship between the rate of return (cont’d) Correlation coefficient is the measure of the relationship between the rate of return behavior of each asset versus every other asset. l First-order autocorrelations of a return series, is the return in one period that is related to the return in the next period. l Cross correlations show much one series’ returns are related to another. l

(cont’d) l The portfolio’s risk is a function of the individual assets and their (cont’d) l The portfolio’s risk is a function of the individual assets and their correlation to each other.

Portfolio Optimization l Efficient portfolio have a mixture of assets, whereas inefficient portfolio has Portfolio Optimization l Efficient portfolio have a mixture of assets, whereas inefficient portfolio has assets that make higher risk-adjusted incremental contributions to portfolio return than other assets. l Efficient frontier refers to the collection of all efficient portfolios corresponding to the full range of portfolio risk possibilities.

Optimizing the Portfolio Once the expected return, standard deviation, and cross-correlation have been estimated Optimizing the Portfolio Once the expected return, standard deviation, and cross-correlation have been estimated for the asset classes than mathematical calculation to derive the asset allocations for portfolios on the efficient frontier. l Optimal portfolio will always have a subjective dimension because there is no way to directly measure a client’s risk tolerance. l

(cont’d) l Managers’ expectation of return on asset class may not be in line (cont’d) l Managers’ expectation of return on asset class may not be in line with the benchmark return, therefore it is not recommended that the manager’s returns be used in place of benchmark estimates.

Symmetrical vs. Asymmetrical Risk Distribution l Symmetrical risk distribution uses all the optimization software Symmetrical vs. Asymmetrical Risk Distribution l Symmetrical risk distribution uses all the optimization software to minimize risk, whereas asymmetrical is where the investors are more concerned with losses.

Why MPT Hasn’t Been More Widely Used l The software is expensive (from $50, Why MPT Hasn’t Been More Widely Used l The software is expensive (from $50, 000 to $200, 000 per year). l Index funds and foreign funds were not widely accessible. l Most planners do not have theoretical and practical education to implement MPT. l Asset allocation and MPT did not receive mainstream press coverage.

(cont’d) l MPT calculates different combinations of assets that yield the maximum expected return (cont’d) l MPT calculates different combinations of assets that yield the maximum expected return at each level of risk, as measured by standard deviation. l It is important to understand that the expected return, standard deviation and correlation of the assets in the portfolio are merely forecasts based on past performance.

Ch 3 Structuring A Portfolio By Yihui Yu Ch 3 Structuring A Portfolio By Yihui Yu

Diversification l Objective: to add investments to the client’s portfolio that are not closely Diversification l Objective: to add investments to the client’s portfolio that are not closely related to his other investments l Measurement: correlation coefficients. - coefficient = 0 (no direct relationship) - coefficient = 1 (perfect positive relation) - coefficient = -1 (perfect negative relation)

The Correlation Matrix Concept: compare one investment o another and report the correlation coefficient The Correlation Matrix Concept: compare one investment o another and report the correlation coefficient l Investment categories for the matrix: - domestic stock - foreign stock - bonds - cash equivalents - real assets l

Selecting Assets For a Portfolio The assets that the client refuses to get rid Selecting Assets For a Portfolio The assets that the client refuses to get rid of should be included. 2. Several investment categories are represented. 3. Each category should comprise at least 5% of the portfolio. 4. Recommended weightings should be rounded off to the nearest whole number. 1.

Other Factors The type of mutual fund or annuity chosen should depend on the Other Factors The type of mutual fund or annuity chosen should depend on the following factors: l Client’s time horizon l Any existing investment the client already owns l Client’s goals and objectives l Client’s risk tolerance level

Ch 4 Asset Allocation Ch 4 Asset Allocation

Definition l Asset allocation is the process of distributing portfolio investments among the various Definition l Asset allocation is the process of distributing portfolio investments among the various available investment categories. l Process involves three decisions: 1. Which types of investments should be included or excluded? 2. How much weight should be given to each asset? 3. Which vehicles should be used?

Importance of Asset Allocation l If you should have x% of a portfolio’s holdings Importance of Asset Allocation l If you should have x% of a portfolio’s holdings in growth and income funds versus some other percentage figure is much more important than trying to gauge if ht investment should be made now or in six months.

Approaches to Asset Allocation l Strategic asset allocation is a passive approach that focuses Approaches to Asset Allocation l Strategic asset allocation is a passive approach that focuses on long-range policy decisions to determine the appropriate asset mix. It does not attempt to predict or time the market. The portfolio is fully invested at all times. Risk is reduced by using several different investment categories.

Approaches to Asset Allocation l Tactical asset allocation is an active approach that generally Approaches to Asset Allocation l Tactical asset allocation is an active approach that generally uses market predictions to change the asset mix in order to exploit superior predictive ability through such techniques. This strategy believes that market inefficiencies can constantly be found and that short-term trading can take advantage of such inefficiencies.

Approaches to Asset Allocation l Dynamic asset allocation is an active technique that reacts Approaches to Asset Allocation l Dynamic asset allocation is an active technique that reacts to changing market conditions by making relatively frequent changes in the asset mix with the goal of providing downside protection in addition to upside participation.

Ch 5 Market Timing Ch 5 Market Timing

Introduction l Essence of market timing in any investment is to buy low and Introduction l Essence of market timing in any investment is to buy low and sell high – Use of leading indicators – A blending of business analysis with technical projections – Reaction to leading indicators sometimes opposite of expectations – Investors take advantage of market inefficiencies – Switching of portfolios of high/low betas according to market conditions

Methodology: Moving Averages l Straight or simple moving average is the sum of a Methodology: Moving Averages l Straight or simple moving average is the sum of a data series divided by the total units involved – Commonly used: 30 and 60 day moving averages l Exponential moving average is a weighted moving average – Smoothes out minor fluctuations in trends – More reliable

Moving Averages (Continued) l Two basic rules: – Buy signals rendered whenever price of Moving Averages (Continued) l Two basic rules: – Buy signals rendered whenever price of fund rises above level of moving averages employed – Sell signals rendered when price level falls below level of moving averages employed

Methodology: Cash Flow Indicator l Based on the concept of contrary thinking – Buy Methodology: Cash Flow Indicator l Based on the concept of contrary thinking – Buy at peak pessimism; sell at peak optimism of market l Example: Mutual fund cash position – Large increase/decrease may indicate bear/bull market expectations – Historically, rise above 10% leads to major upward market move; converse at 8%; normal at 9%

Drawbacks to Short-term Trading l Market timers have to be right twice: when they Drawbacks to Short-term Trading l Market timers have to be right twice: when they are getting in and again when they are exiting the market l The more moves, the greater the chance for mistakes l May lose advantage of deferred taxation

Studies: Trinity Study l Observations on nine peak-to-peak cycles since WWII: May 29, 1946 Studies: Trinity Study l Observations on nine peak-to-peak cycles since WWII: May 29, 1946 through Aug. 25, 1987 – About 1. 7 times more up months than down: 309 vs. – – 187 Average bull market up 104. 8% vs. Average bear market drop of 28% Bull markets last three times as long as bear markets: 41 up months vs. 14 down months Even in bear markets, on average 3 to 4 months out of 10 are up months On average, 8 of 41 -month bull market duration accounted for 60% of total returns

Charles D. Ellis Study l All 100 pension funds engaged in some market timing Charles D. Ellis Study l All 100 pension funds engaged in some market timing – Not one improved rate of return – 89 of 100 lost as a result of “timing”

William F. Sharpe Study l Market study from 1934 to 1972 – Market timer William F. Sharpe Study l Market study from 1934 to 1972 – Market timer with 2% in trading costs, choosing once a year between stocks and cash, would have to be right at least 82% of the time to do as well as a buy-and-hold stock investor

Chua and Woodward Study l To be successful at market timing, investors require forecast Chua and Woodward Study l To be successful at market timing, investors require forecast accuracy for at least: – 80% of all bull markets, 50 % of all bear markets; – 70% of all bull markets, 80% of all bear markets; or – 60% of all bull markets, 90% of all bear markets

Robert H. Jeffrey Study l If market timing is only accurate 50% of the Robert H. Jeffrey Study l If market timing is only accurate 50% of the time, probable outcomes: – Best-case real dollar return, only two times greater than from continuous investment in S&P – Worst-case produces 100 times less.

Roy D. Henrikson Study l Study on 116 mutual funds from 1968 to 1980 Roy D. Henrikson Study l Study on 116 mutual funds from 1968 to 1980 – Virtually all fund managers showed no significant ability to time purchases for superior performance

Ibbotson Study l Study on security returns from 1949 to 1998 – If investor Ibbotson Study l Study on security returns from 1949 to 1998 – If investor missed 5 best years for common stocks and invested in T-bills instead, $1 in stocks at end of 1925 would only become $127, instead of $578 if invested continuously in S&P 500 – Point: market timer has tremendous natural odds to overcome; odds increase geometrically with length of timeframe and frequency of timing interval

Timing Services l Many investors rely on newsletters or timing services for timing signals Timing Services l Many investors rely on newsletters or timing services for timing signals l Timing services also track fund performance and recommend specific funds to buy – Minimum account: $25, 000 – Plus 2% annual management fee

Timing vs. Buy-and-Hold l Q: Which does better? l A: It depends – Performance Timing vs. Buy-and-Hold l Q: Which does better? l A: It depends – Performance measurements strongly influenced by period of comparison Buy-and-hold is better in upward trend markets l Timing is better in declining markets l In good markets, all can do well. Therefore, timing services may help cut losses l

Ch 6 FORMULA TIMING INDICATORS Introductionl Offers a mechanical timing approach l Commonly used Ch 6 FORMULA TIMING INDICATORS Introductionl Offers a mechanical timing approach l Commonly used substitutes for subjective buy-and-sell timing decisions. l Requires investor input

3 Types of formula plans includes: l Constant Dollar Plans- requires investor to set 3 Types of formula plans includes: l Constant Dollar Plans- requires investor to set the dollar value of the aggressive portfolio. l Constant Ratio Plan- maintains the value of the aggressive portfolio relative to the value of the conservative portfolio. l Variable Ratio Plan- mechanical portfolio management plan that requires extensive forecasting.

TIMING INDICATORS Bear Market Endings 6 indicators that tell investors when it is time TIMING INDICATORS Bear Market Endings 6 indicators that tell investors when it is time to start buying stocks again: l Investment Sentiment l Market P/E l Dividend Yield l Interest Rates l Market Volume l Advances and Declines

Stocks in a recession 1973 -1975 l In 1973 -75 during the beginning of Stocks in a recession 1973 -1975 l In 1973 -75 during the beginning of the recession, there was a 7. 8% growth in the S & P 500. l In 1980 there was a 14. 6% growth l In 1981 -82 there was a 16. 5% growth.

Markets in a recession 1948 -1991 l There have been 9 business recessions since Markets in a recession 1948 -1991 l There have been 9 business recessions since the end of World War II. 1. First Postwar Recession 1948 -1949 2. Second Postwar Recession 1953 -1954 3. Third Postwar Recession 1957 -1958 4. Fourth Postwar Recession 1960 -1961 5. Fifth Postwar Recession 1969 -1970 6. Sixth Postwar Recession 1973 -1975 7. Seventh Postwar Recession Jan 1980 -June 1980 8. Eighth Postwar Recession 1981 -1982 9. Ninth Postwar Recession 1990 -1991

PREDICTABILITY l Businesses tend to occur in most major nations about twice in each PREDICTABILITY l Businesses tend to occur in most major nations about twice in each 10 -year period. l National Bureau of Economic Research is one of the most respected economic organizations to study business cycles.

BEARS l Bear markets is any market when share prices reach a two-year low. BEARS l Bear markets is any market when share prices reach a two-year low. l Bear markets occur about twice every 10 years l The best way to predict a bear market may be to realize bear markets end when least expected

BULLS l. A bull market is defined any time when share prices reach a BULLS l. A bull market is defined any time when share prices reach a two-year high.

Ch 7 Timing Indicators Ch 7 Timing Indicators

Bear Market Endings l A list of some indicators to call a market turn. Bear Market Endings l A list of some indicators to call a market turn. 1. Investment Sentiment. Market P/E. Dividend Yield Interest Rates Market Volume Advances and Declines 2. 3. 4. 5. 6.

Stock and Markets in a Recession l First Postwar Recession- Nov 1948 - Sep. Stock and Markets in a Recession l First Postwar Recession- Nov 1948 - Sep. 1949 ( 11 months) l Second Postwar Recession- July 1053 - April 1954 ( 10 months) l Third Postwar Recession- August 1957 March 1958 ( 8 months) l Fourth Postwar Recession- April 1960 - Jan. 1961 ( 10 months)

Stock and Markets in a Recession l l l Fifth Postwar Recession- Dec. 1969 Stock and Markets in a Recession l l l Fifth Postwar Recession- Dec. 1969 to Oct 1970 ( 11 months) Sixth Postwar Recession- Nov. 1973 to Feb. 1975 ( 16 months) Seventh Postwar Recession – Jan. 1980 to June 1980 ( 6 months) Eighth Postwar Recession- July 1981 to Oct 1982 ( 16 months) Ninth Postwar Recession- July 1990 to March 1991 (9 months)

Predictability l Business recession tend to occur in most major nations about twice in Predictability l Business recession tend to occur in most major nations about twice in each 10 -year period, but we have never been able to find any person or organization who could correctly predict either bear markets or business recessions.

Bears and Bulls l. A bear market is defines as any market when share Bears and Bulls l. A bear market is defines as any market when share prices reach a two-year low. l A bull market is defined any time when share prices reach a two-year high.

Ch 8 Security Analysis Ch 8 Security Analysis

Introduction l The capital asset pricing model and efficient markets theory has been demonstrated Introduction l The capital asset pricing model and efficient markets theory has been demonstrated both theoretically and empirically that diversification reduces the risk of a portfolio.

Modern Portfolio Theory l Markowitz showed that investor should hold diversified portfolios containing financial Modern Portfolio Theory l Markowitz showed that investor should hold diversified portfolios containing financial assets that are less than positively correlated with each other. l William Sharpe, John Lintner and Jan Mossin extended this theory called Capitail Asset Pricing Model.

CAPM l CAPM provides a theory of the relationship between securities and portfolio rates CAPM l CAPM provides a theory of the relationship between securities and portfolio rates of returns and those of a representative market index that is a proxy for the overall stock market. l Betas are calculated using past security and portfolio data and hence are simply estimates of future relationships.

Stock Selection l Neither chart reading (technical analysis) nor analysis of corporate financial statements Stock Selection l Neither chart reading (technical analysis) nor analysis of corporate financial statements (fundamental analysis) can provide above-average investment returns on a risk-adjusted basis.

Fundamental Analysis l The fundamental analyst’s tools indlude macro-economic data, corporate financial reports, industry Fundamental Analysis l The fundamental analyst’s tools indlude macro-economic data, corporate financial reports, industry data, and comments from corporate officers and company memoranda. looking to determine whether a specific company’s stock is undervalued or overvalued.

Technical Analysis l Technical approach involves the use of past price and volume and Technical Analysis l Technical approach involves the use of past price and volume and other external data to assess the crowd’s attitude toward the market and specific stocks.

Chapter 9 Rebalancing the Portfolio § The Need for Rebalancing -if the portfolio is Chapter 9 Rebalancing the Portfolio § The Need for Rebalancing -if the portfolio is not rebalanced one asset could achieve dominance -Rebalancing keeps the portfolio diversified

§ Approaches to Reevaluation -buy-and-hold strategy- do nothing at all -calendar approach- rebalance the § Approaches to Reevaluation -buy-and-hold strategy- do nothing at all -calendar approach- rebalance the portfolio back to its original allocations i. e. monthly, quarterly annually -contingent approach- make changes based on pre-specified percentage change in allocations from o. g. policy

§ Rebalancing Experimentation -”Let it Ride” Study --study performed without transaction costs or industry § Rebalancing Experimentation -”Let it Ride” Study --study performed without transaction costs or industry fees --rebalancing doesn’t help the portfolio on either a return or risk basis

-Stine and Lewis Study --considered transaction costs --rebalancing does lower risk, while sacrificing little -Stine and Lewis Study --considered transaction costs --rebalancing does lower risk, while sacrificing little return in exchange --annual rebalancing makes more sense than quarterly rebalancing --the best option is the contingent strategy, with the asset varying more than 7. 5 to 10% from o. g. position

-Clifton Study --considered all costs --annually rebalanced outperformed buy-and-hold and contingent strategies on a -Clifton Study --considered all costs --annually rebalanced outperformed buy-and-hold and contingent strategies on a risk-to-reward basis

-Short Holding Period Study --transaction costs included --contingent strategy, with asset varying 7 -10% -Short Holding Period Study --transaction costs included --contingent strategy, with asset varying 7 -10% from o. g. position produces less risk than annual rebalancing, requires fewer rebalances and lower transaction costs

§ Conclusions -rebalance only when a portfolio reaches a predetermined level of risk exposure § Conclusions -rebalance only when a portfolio reaches a predetermined level of risk exposure -because the contingent strategy is easy to monitor and requires no sophisticated programming, management costs are minimal -if the portfolio manager does elect a calendar strategy, annual balancing produces the best results

§ Compensation -a portfolio manager should regularly bill clients for re-optimization, even if it’s § Compensation -a portfolio manager should regularly bill clients for re-optimization, even if it’s infrequent -if a manager is monitoring clients’ investments and communicating regularly, they should be paid

Ch 10 Asset Allocation Sensitivity Ch 10 Asset Allocation Sensitivity

Introduction l Overall, U. S. equities had excellent return in the 1980 s and Introduction l Overall, U. S. equities had excellent return in the 1980 s and 1990 s. Foreign equities performed fairly well during these two decades. l It is well known by MPT followers that of the three components that comprise the model program (historical returns, standard deviations and correlation coefficients)

Sensitivity to Expected Returns Although managed futures, venture capital, oil and gas, and other Sensitivity to Expected Returns Although managed futures, venture capital, oil and gas, and other limited partnerships have very good historical returns, they still have some shortcoming of each of these investments. -guru, bank brokerage firm, insurance company, or financial planning group had such information , they certainly wouldn’t share it with you. Also industry users and insiders know more about you or any trader knows in future market or other market.

Review Individual Asset Statistics l Whenever or wherever you see a return or standard Review Individual Asset Statistics l Whenever or wherever you see a return or standard deviation figure that you strongly doubt, note it. But it assumes that you have done research not just based on experience or recent history.

The 5/25 Strategy l By selecting at least 5 different asset categories and investing The 5/25 Strategy l By selecting at least 5 different asset categories and investing at least 5%, but no more 25%. l Don’t rely entirely on the program that suggests a large investment in one of these categories.