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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

  • 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 ROR ARITHMETIC ROR STANDARD DEVIATION

  • Large Stocks 11.2% 13.2% 20.3%

  • Small Stocks 12.4 17.4 33.8

  • 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: 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 Coefficients for Equity Markets

CN FR DM JP SW UK US

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 Correlation

  • 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 Correlation

  • 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 Correlation

  • 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 Correlation

  • 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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