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Historical Performance of Financial Assets. What are our investment alternatives? How have stocks, bonds, cash, and other financial assets performed in terms of risk and return? Why is a global perspective on investing important?

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Historical Performance of Financial Assets

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Historical performance of financial assets l.jpg

Historical Performance of Financial Assets

  • What are our investment alternatives?

  • How have stocks, bonds, cash, and other financial assets performed in terms of risk and return?

  • Why is a global perspective on investing important?

  • How does historical performance influence the asset allocation decision?


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Historical Performance of Financial Assets

  • Investment alternatives?

    • Real vs. financial?

    • Capital Market vs. Money Market?

    • Equity:

      • US

      • Foreign (ADRs)

      • Mutual Funds


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Historical Performance of Financial Assets

  • Investment alternatives?

    • Fixed Income:

      • US Treasury securities (notes, bonds)

      • US Agency Securities (FNMA, FHLB, FHA)

      • Municipal Bonds (GO vs. Revenue, tax issues)

      • Corporate Bonds (collateral, subordination, etc.)

      • Preferred Stock (tax issues)

      • International Bonds (domestic, Euro, Yankee)


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Historical Performance of Financial Assets

  • Investment alternatives?

    • Cash Equivalents

      • Savings Accounts

      • CDs

      • T-bills

      • Commercial Paper

      • MMMF


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Historical Performance of Financial Assets

  • Investment alternatives?

    • Derivatives

      • Options (calls, puts, warrants)

      • Futures (financial, commodity, index)

    • Real Estate

    • Precious Metals

    • Art


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Historical Performance of Financial Assets

  • Issues which should matter in return performance

    • Risk!

      • Seniority of claim (bonds vs. stock)

      • Business risk

      • Financial risk

    • Liquidity!

      • Secondary market issues


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Historical Performance of Financial Assets

  • Ibbotson and Sinquefield (I&S) examined nominal and real rates of return for seven major classes of assets in the United States

    • 1. Large-company common stocks

    • 2. Small-capitalization common stocks

    • 3. Long-term U.S. government bonds

    • 4. Long-term corporate bonds

    • 5. Intermediate-term U.S. Treasury bills

    • 6. U.S. Treasury bills

    • 7. Consumer goods (inflation)


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Basic Series: Historical Highlights (1926 - 1998)

  • GEOMETRIC RORARITHMETIC RORSTANDARD DEVIATION

  • Large Stocks11.2%13.2%20.3%

  • Small Stocks12.417.433.8

  • LT Corporate Bonds 5.8 6.1 8.6

  • LT US Gov’t Bonds 5.3 5.7 9.2

  • US Tbills 3.8 3.8 3.2

  • CPI 3.1 3.2 4.5

  • Other markets?


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Importance of the Global Perspective

  • 1. Absolute and relative sizes of U.S. and foreign markets for stocks and bonds

    • U.S. = about 52% of total value of securities

    • More opportunities globally

  • 2. Rates of return available on non-U.S. securities often exceed U.S. Securities

    • Higher returns on equities are justified by higher growth rates for the countries where they are issued

  • 3. Diversification with foreign securities can reduce portfolio risk


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Importance of the Global Perspective: Market Size, $2.3 Trillion in 1969


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Importance of the Global Perspective: Market Size, $49.1 Trillion in 1997


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Importance of the Global Perspective: Better Returns in Bonds? (1987-1996)


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Importance of the Global Perspective: Better Equity Returns? (1986-1997)

Table 3.2


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Importance of the Global Perspective: Diversification of Risk

  • Returns from risky assets can stabilize one another when held together.

  • Why?

    • Some sources of risk are different (unsystematic)

    • Some sources of risk are common (systematic)

  • Unsystematic sources of risk tend to offset. Only systematic risk matters in a well diversified portfolio.


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Importance of the Global Perspective: Diversification of Risk (Correlation!)


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Importance of the Global Perspective: Diversification of Risk

Correlation Coefficients for Equity Markets

CNFRDMJPSWUKUS

FR.533

DM.193.700

JP.409.452.319

SW.353.715.907.359

U.K. .428.460.392.262.568

U.S. .618.490.386.334.505.616

W.652.687.516.698.631.686.818


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Diversification of Risk: Computing Covariance and Correlation

  • Covariance: absolute measure of comovement between two rate of return series

  • Correlation: relative measure of comovement

    • can be positive or negative

    • can be strong or weak

  • Example


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Importance of the Global Perspective: Summary

  • Many opportunities to invest outside the US

  • May be able to enhance expected return

  • Opportunity to exploit weaker correlations among country returns to diversify risk


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Asset Allocation and Investment Objectives

  • Investment Objectives – the articulation of risk and return issues;

    • Risk Tolerance

      • depends on many factors (insurance, cash reserves, dependents, age, time horizon, net worth, income)

    • Return Objective

      • can be absolute (“8% per year”) or relative (“1% above the S&P”); Can also state return objective as a general goal


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Asset Allocation and Investment Objectives

  • Investment Constraints – 5 classes of constraint

    • Liquidity Needs

      • need for income now? at some specific point in the future?

    • Time Horizon

      • typically, longer time horizon means lower liquidity needs and higher risk tolerance

    • Tax Concerns

      • taxes must be paid by most investors on current income and on realized capital gains. Unrealized capital gains allow an investor to defer a tax liability to a later date.

    • Legal and Regulatory Factors

    • Unique Needs and Preferences


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Asset Allocation and Investment Objectives

  • Given objectives and constraints, portfolio formation involves:

    • Asset Allocation - proportions invested by asset class

      • Equity, Fixed Income, Cash, RE, …

      • Foreign vs domestic

    • Security Selection - individual assets chosen to meet target asset allocation


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