Investment Decisions

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Investment Decisions Fin 434 September 25, 2006 By the end of this lecture, you should be able to: Be able to explain basic portfolio theory The value of diversification How to evaluate risk/return trade-off What do consumers actually do? Explain different classes of investments

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## Investment Decisions

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### Investment Decisions

Fin 434

September 25, 2006

By the end of this lecture, you should be able to:
• Be able to explain basic portfolio theory
• The value of diversification
• How to evaluate risk/return trade-off
• What do consumers actually do?
• Explain different classes of investments
• The special case of company stock
• Why do firms offer it?
• How does it affect retiree well-being?
A Quick Review of Investment Theory
• Investor attitudes toward risk
• Risk vs. return
• What risk matters?
• Historical returns
• Suppose you have \$10,000 to invest.
• Option A: Invest \$10,000 in risk-free securities, have \$10,500 for sure next year
• Option B: Invest \$10,000 in asset B. There is 50% chance that you will have \$12,000 next year, and 50% chance of \$9,000.
• Option C: Invest \$10,000 in asset C. There is 50% chance you will have \$21,000 next year, and 50% chance that you will have 0.
• Which would you choose?
Expected Values
• Let Xi = outcome i (i = 1 … N)
• If all out comes equally likely and independent,

then expected value = Xev = (1/N)*Xi

• More generally, if Pi is the probability of outcome Xi, then the expected value is
Variance
• Variance of a sample
• Standard deviation =  = square root of variance
• Variance and standard deviation provide a measure of how disperse a distribution of outcomes is
Uncertain Outcomes

Same mean

Different variance

Xev

Choice Between the Three Portfolios
• Option A: \$10,500 for sure next year
• Option B: 50/50 chance of \$12k or \$9k
• Option C: 50/50 chance of \$21k or \$0
Risk Aversion
• Most investors are risk averse. What does this mean?
• For a given level of risk, individuals prefer the investment option with the highest expected return
• For a given level of expected return, individuals prefer the investment option with the least risk
• Suppose you have \$10,000 to invest.
• Option D: Invest \$10,000 in risk-free securities, have \$10,500 for sure next year
• Option E: Invest \$10,000 in asset E. There is 50% chance that you will have \$12,000 next year, and 50% chance of \$9,500.
• Option F: Invest \$10,000 in asset F. There is 50% chance you will have \$30,000 next year, and 50% chance that you will have 0.
• Which would you choose?
Choice Between the Three Portfolios
• Option D: \$10,500 for sure next year
• Option E: 50/50 chance of \$12k or \$9.5k
• Option F: 50/50 chance of \$30k or \$0
Financial Market Equilibrium
• Investors require higher return in order to be willing to hold riskier assets
• In other words, there is a trade-off between risk and reward
• Riskier assets have higher expected returns
• Higher expected returns are associated with higher level of risk
• But, does all risk matter?
Does Market Reward All Risk?
• A financial asset has two types of risk
• Systematic / Market / Non-diversifiable
• Risk that is correlated with market so that diversifying does not get rid of it
• Idiosyncratic / Unique / Diversifiable
• Unique to the firm, uncorrelated with market, and thus can diversify it away
Diversification

Unique risk

Market risk

Portfolio Theory
• Adding more securities to a portfolio will generally make the portfolio less risky
• Of all the possible portfolios, some of them are efficient and some are not. An efficient portfolio is one that maximizes the level of return for a given level of risk
Minimum Variance Portfolios

Expected

Return

Min. Variance portfolios

A

B

Risk

Choosing An Optimal Portfolio

Expected

Return

Market portfolio

Min. Variance portfolios

rf

Risk

Portfolio Choice
• Portfolio theory suggests that everyone should hold some combination of the market portfolio and the risk-free asset
• We really only need one mutual fund – a market index fund
• The relative shares in risky vs. risk-free portfolio depends on attitudes toward risk
Types of Investments
• Stocks
• Debt / Bonds
• Money market
• REITS
• Mutual Funds
Historical Returns(Real returns from 1926-2000)
• This probably understates true variance due to survivor bias
• Corp bonds considered riskier than gov’t due to default risk
Relative Risk

Most

risky

Our class’s

Risk rating

Individual company stock 4.34

Diversified stock fund 2.81

Corporate bond fund 2.68

Government bond fund 0.90

Money market fund 2.10

(Scale = 0 if no risk, 5 if most risk)

Least

risky

Stocks
• Common Stocks
• Ownership of a share of a company
• Preferred Stocks
• A hybrid stock/bond instrument
• More regular dividend payments
• Rights are senior to common stock holders in case of bankruptcy
Debt
• Issued when corporations, federal, state and local governments need to borrow money
• Bond buyer is loaning money to bond issuer, usually at set interest rate and duration
• Known as “fixed income” securities because the amount of income (interest) is set when bond is sold
Four Common Bond Issuers
• Federal government – issues government bonds or “Treasuries”
• Varying maturities
• Also offer inflation indexed bonds
• Other government agencies
• Ex: Federal Nat’l Mortgage Assn (Fannie Mae)
• Corporate Bonds
• Higher interest than gov’t due to default risk
• “Junk bonds” – high yield bonds issued by low credit quality companies (below investment grade)
• State & Local  “Munis”
• Free from federal income tax
Federal Gov’t Debt
• Treasury bills or “T-bills”: Short term government bonds with maturities of 13, 26 or 52 weeks.
• Treasury notes: Intermediate term securities with maturities of 2, 5 and 10 years
• Treasury bonds: Long-term securities with longer maturities (longest used to be 30 years, but US gov’t stopped issuing 30 years recently)
• Treasury Inflation Protected Securities (TIPS): pay fixed % plus inflation
Money Market
• Money Market: invests in very short term and extremely low risk assets
• Example: Holdings of Vanguard Prime Money Market Fund as of 5/31/2005
• 43.3% in Certificates of Deposit (CDs)
• 32.2% in Commercial Paper (very short term debt from corporations – high credit quality)
• 19.5% in short term debt from U.S. government
• 4.9% in “other”
REITs
• “Real Estate Investment Trusts”
• Special form of equity that allows investors to own small pieces of a large group of real estate properties
• Required to pay out 95% of earnings in the form of dividends to shareholders
Mutual Funds
• Can buy a diversified portfolio with a single purchase
• Actively managed funds: fund managers try to pick stocks with a goal of outperforming the market
• Higher expense fees
• Passively managed funds: hold portfolio that tries to mirror the market index
• Ex: S&P 500 portfolio
• Tend to have substantially lower expenses
Evidence on Fund Mgmt
• Very little evidence to support the notion that actively managed mutual funds are able to outperform passively managed funds
• Also little evidence to support the notion that there is much persistence in fund manager performance
How Do Investors Behave?
• Fair amount of evidence that investors “sort of” understand diversification, but are not very sophisticated
• Tend to follow “naïve diversification strategies”
• 1/N allocation, where N = # of choices
• This means you may be able to affect equity mix by choice of funds!
2 stock choices + 3 “safer” choices

MM fund

Treasury bonds

Corp Bonds

US Stock

Int’l stock

Allocated ____% to stocks

3 stock choices + 2 “safer” choices

MM fund

Treasury bonds

US Stock (large)

US Stock (small)

Int’l stock

Allocated ___% to stocks

This Class’ Investment Choices

Replacing bond fund with equity fund …

How Do Investors Behave?
• Evidence also suggests that people rarely rebalance their portfolios
• Example:
• Initially put 50% in bonds, 50% in stocks.
• After 10 years, stocks have gone up faster, now have 35% bonds, 65% stocks.
• If 50/50 was optimal portfolio, then should rebalance
• Yet most investors do not rebalance.
Special Case of Company Stock
• Many large 401(k) plans offer company stock as an investment option
• 42% of participants
• 59% of account balances
P&G 95%

Sherwin-Will. 92%

Abbott Labs 90%

Pfizer 86%

BB&T 82%

Anheuser-Busch 82%

Coca-Cola 82%

GE 77%

Texas Instr. 76%

Wm. Wrigley 76%

Williams 75%

McDonalds 74%

At its peak, Enron was at 60% of assets

Nov 2001 Co. Stock Holdings
Restrictions on Co. Stock
• ERISA prohibits defined benefit plans from holding more than 10 percent of plan assets in company stock
• There are no such restrictions on 401(k) plans – firm is permitted to match in company stock, and there are no caps on total investment in company stock
Enron and Other Failures
• Fall 2001 – shortly after 9/11
• Enron’s stock “implodes”
• From March 2000 to December 2001, Enron’s stock price fell 99.6% !!!
• At its peak, 60% of pension assets were in Enron stock (closer to 40% around time things went really bad)
Enron was not unique

Plus several others!

More Enron Details
• Diversification restrictions
• Match in company stock
• Employees made own contributions in company stock
• “Blackout period”

during vendor change

THE IMPLICATIONS OF ENRON

Response to Enron
• Lawmakers began to call for new regulation
• Boxer / Corzine – cap at 20%
• What would this do to match policy?
• PBGC coverage of DC plans
• Could be disastrous! Why?
• Some more measured approaches
• Allowing diversification out of employer stock
• Restrictions on blackout periods
Company Match Policy
• Many companies not only offer company stock as an investment option, but they make their match in company stock as well
• Prior to post-Enron legislation, participants often were restricted in their ability to diversify their match out of company stock
Effects of Match Policy
• Employees that work for plans that match in company stock tend to put more of their own contributions in company stock
• Why?

### BP Amoco Case

The Setting
• August 11, 1998: Amoco and BP announce merger
• Now it is January 1999
• Combined plan would have 40,000 employees and \$7 billion in assets
• How to integrate defined contribution pension assets for US employees?
• What investment options to choose?
Active vs. Passive
• Active – “Beat the market”
• Passive – replicate market index
• Active involves:
• Stock picking, research, more trading, possibly higher risks than index
• Costs may reach 100 b.p.
• Note: Expense ratios generally net of trading costs, which may be another 100 b.p.!
How Pick Investment Choices?
• Seeking high returns
• Seeking low risk
• Can we achieve both?
CAPM
• In CAPM terms, “beta” tells us how much an individual security varies with the portfolio, i.e., the market risk
• (Ri – Rf) =  (Rm – Rf) + i
• Ri = return on asset i
• Rm = return on market
• Rf = return on risk free asset
• i = idiosyncratic risk (mean = 0)
• Only market risk is “priced” or rewarded by the market
• Higher   higher expected return
CAPM

E[Ri]

Rm

Rf

i

1.0

CAPM in Practice
• Run regression of excess returns on a constant and the market’s excess return

(Ri – Rf) = i + i (Rm – Rf) + i

• According to CAPM
• Average i will be equal to zero
• i will measure market risk – if market goes up by 1%, security i goes up by i%
• Var(i) measures idiosyncratic risk
Meaning of Alpha
• (Ri – Rf) = i + i (Rm – Rf) + i
• What if i > 0?
• What if i < 0?
• What isi supposed to measure?
• Remember GM’s “alpha strategy”?
CAPM

E[Ri]

i>0

i<0

Rm

Rf

i

1.0

Pre-Merger Investment Options
• What are the alphas on the BP funds like?
• What were the BP fund expense ratios like?
• What role did company stock play?
Performance Persistence
• The Peter Lynch experiment:
• Our penny flipping exercise
• Why is it so hard to beat the market?
How Many Funds?
• Is one fund enough?
• Safe Harbor provisions
• Ruey: increase number of core investment options to “cover wide region of risk-return spectrum”
• What would you do?