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Personal Financial Management

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 5 McRae: Chapter 2. Risk and Return. Consider two work colleagues who share a £200,000 lottery win early in 1994

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Personal Financial Management

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  1. Personal Financial Management Semester 2 2008 – 2009 Gareth Myles g.d.myles@ex.ac.uk Paul Collier p.a.collier@ex.ac.uk

  2. Reading • Callaghan: Chapter 5 • McRae: Chapter 2

  3. Risk and Return Consider two work colleagues who share a £200,000 lottery win early in 1994 • Each receives a total of £100,000 • Each invests this sum • What is their financial position ten years later?

  4. Investment Choices • Investor 1 • Studies the financial press • Takes note of the share tips • Chooses Marconi as a “hot tip” • Investor 2 • No time for studying investment • Puts all money in a 90-day deposit account

  5. Investment Value up to 2000

  6. Entire Period For the story of the Marconi collapse, see: End of the Line for Marconi Shares

  7. Lessons? • Different investments, different outcomes • Some are safe (deposit account), some are not (shares) • Trends cannot be forecast • Should diversify (hold a range of assets) • This is portfolio construction How do we quantify these properties?

  8. Return The return on an investment is defined as the proportional (or percentage) increase in value Return is defined over a fixed time period, usually 1 year but can be 1 month etc. It can be applied to any asset

  9. Return Example 1. £1000 is paid into a savings account. At the end of 1 year, this has risen in value to £1050. The return is: So the return can also be viewed as an interest rate

  10. Return • Example 2. A share is bought for £4. One year later it is sold for £5 • Example 3. A share is bought for £4 One year later it pays a dividend of £1 and is then sold for £5

  11. Return • Example 4. A share is bought for £12. One year later it is sold for £10. • The return can be negative • The definition of return can be applied to any asset or collection of assets • Classic Cars • Art

  12. Expected Return • The previous calculations have been applied to past outcomes • Can call this “realized return” • When choosing an investment expected return is important • Expected return is what is promised • Realized return is what was delivered

  13. Expected Return • Expected return is calculated by • Evaluating the possible returns • Assigning a probability to each • Calculating the expected value • Example 1 • Toss a coin • Receive £1 on heads, £2 on tails • Expected value is (1/2) 1 + (1/2) 2 = 1 1/2

  14. Expected Return • Example 2 • Buy a share • Return 20% if oil price rises to $70 (prob. = 0.25) • Return 5% if oil price remains below $70 (prob. = 0.75) • Expected return (0.25) 20 + (0.75) 5 = 8.75%

  15. Expected Return • Potential investments are compared on the basis of expected return • The use of expected reminds us that nothing is certain • Actual return may be far from the expected value • The mean return (see later) is an estimate of the expected return

  16. Risk • Risk measures the variation in return • Not much risk Return Mean Return Period

  17. Risk Return • Considerable risk Mean Return Period

  18. General Motors 25 years

  19. General Motors 6 months

  20. General Motors 5 days

  21. General Motors 1 day

  22. General Motors Return on General Motors’ Shares 1993 – 2003

  23. Measurement of Risk • Need a number that is always positive (the least risk is zero) • Must treat “ups” and “downs” equally • Should be measured relative to average value:

  24. Measurement of Risk • Example. A share is observed for 5 years. In these years it earns returns of 2%, 6%, 3%, 8% and 1%.

  25. Variance and Standard Deviation • The risk is defined as the variance of return • Or, in brief

  26. Variance and Standard Deviation • Example 1. The returns on a share over the past five years are 5, 8, 4, -2, 1. The mean return is: • And the variance is:

  27. Variance and Standard Deviation • Example 2. The returns on a share over the past five years are 7, 10, 6, -6, -2. The mean return is: • And the variance is:

  28. Standard Deviation • The risk can also be measured by the standard deviation • This is the square root of the variance • The two are equivalent

  29. Return and Risk Table taken from: Risk and Return

  30. Market Implications • The market (meaning the average of all investors’ attitudes) • Likes returns • Dislikes risks • To accept risk, investors must be rewarded with higher return • Assets with low risk give low returns • Assets with high risk have the possibility of high return

  31. Market Implications • This relationship will not be violated • if it were, trades could be made that gave a profit for no investment • Risk-free assets (meaning government-backed) have the lowest return • Risky assets (such as shares) must promise higher returns

  32. Put Another Way • “There is no such thing as a free lunch” • if an asset offers a high return, there must be a risk involved • Marconi shares offered a higher return than the deposit account but the collapse was the “risk” • This should always be remembered • an investment is judged on its combination of return and risk

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