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Personal Financial Management

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  1. Personal Financial Management Semester 2 2008 – 2009 Gareth Myles Paul Collier

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

  3. Investing in Financial Assets • There are many financial assets available • Some are accessible to private investors • Some are primarily for institutions • We will focus on the former but mention some of the latter • Investment funds allow access to all assets

  4. Portfolio Choice • The basic investment issue is to construct a portfolio of investments • This should have return and risk characteristics that match the investor’s needs • Example 1. An investor aged 25 in full-time employment may feel safe to “take a chance” and aim for a high risk/high return portfolio • Example 2. An investor aged 65 who is retired may want primarily to protect their capital in a low return/low risk portfolio

  5. Portfolio Choice • Example 3. (Annuitisation) • A private pension is invested in a range of assets during working life • Upon retirement the majority of the fund is used to buy an annuity • An annuity pays a fixed income for remainder of life • This represents transfer from risky to safe assets

  6. Portfolio Choice • The basic issue in portfolio design is to choose the assets to match risk preference • We need to know • The risk and return characteristics of individual assets • How they interact with other assets • But first we need to know the available assets

  7. Assets • Non-Marketable • Assets which cannot be sold to someone else (e.g. bank accounts) • Marketable • Assets which can be traded • Included here are bonds and stocks • Derivatives • A specialised group of assets for institutions or very sophisticated private investors • Indirect Investments • Simplify portfolio construction and reduce costs

  8. Non-Marketable Assets • The most important assets within this category are • Bank and building society accounts • Royal Bank of Scotland • Government savings bonds • National Savings and Investments • To purchase these private information must be revealed • Name, age, address, employment status, even source of income

  9. Marketable Assets • Shares (common stock, equity) • Issued by companies to fund investment • Holder receives a dividend (share of profit), • Holder has ownership rights (voting) • To trade must open an account at a broker • On-line Broker • Information is readily available • Yahoo Finance

  10. Marketable Assets • Bonds (government or corporate) • Promise a flow of payments (coupon payments – equivalent to interest) • Pay face value on maturity • Maturity (at issue) from 3 months to many years • Return depends on market assessment of risk (default) • Example

  11. Marketable Assets • Derivatives • Assets based on the price of other “underlying assets” • Call option: the right to buy • Put option: the right to sell • Futures: contracts in advance of delivery

  12. Marketable Assets • Indirect Investing • Purchase of a share in a portfolio • Choice of portfolio (ethical, trackers) • Allows diversification at low cost • Abbey

  13. Trading • Going long: holding a positive quantity of an asset • This is the typical investment • Selling short: holding a negative quantity of an asset • Takes advantage of expected price falls • Buying on the margin: borrowing money to invest • Increases expected return and risk

  14. Portfolio • A set of assets and the proportion of the portfolio in value terms they constitute • Example ICI shares (20%), BP shares (10%), Deposit account (30%), Bonds (30%), Unit trust (10%) • The return on a portfolio is the weighted average of that on the assets in the portfolio • The risk is more complex to compute

  15. Effect of Covariance • Consider the returns on two assets in the two possible events next year • Consider the return on a portfolio: 1/3 of asset A, 2/3 of asset B

  16. Effect of Covariance • In this example the risk in the individual assets cancels when they are combined • Each asset does well in a different state

  17. Effect of Covariance • This is an example of negative covariance • Because of the strong influence of market factors most assets have returns with positive covariance • But some combinations of assets have lower risk than other combinations with the same return

  18. Portfolio Risk • When assets are combined into a portfolio it is possible to trade risk for return • There are some portfolios which are efficient (maximum return for given risk) • Some portfolios are inefficient • There is always a portfolio will least risk (the minimum variance portfolio)

  19. Return and Risk Asset B only Asset A only

  20. Market Model • Consider the entire set of financial assets: these form the “market” • The riskiness of each individual asset can then be measured relative to the market • This gives an asset’s “beta” • Portfolio risk is then proportional to weighted average beta plus asset-specific risk

  21. Beta Return on Asset Return on Asset A risk-free asset has a b of 0 The slope of this line is b for the asset Return on Market Return on Market Risk-free Asset Introducing b

  22. Beta Return on Asset Return on Asset The b of this asset is less than 1 The b of this asset is more than 1 45o 45o Return on Market Return on Market Defensive Asset Aggressive Asset

  23. Company Betas

  24. Portfolio Return and Risk • Let be the proportion of asset i in the portfolio • Portfolio return is • The b of the portfolio is • The portfolio variance is • So larger b, larger variance

  25. Portfolio Return and Risk Portfolio Return Market Return Choice of efficient portfolios Risk-free Asset Portfolio b b = 1

  26. Idiosyncratic Risk • What has happened to the idiosyncratic risk (risk not due to market) ? • this is eliminated by diversification • as the number of assets held rises, the individual variations cancel • How can we diversify economically? • by buying a tracker fund

  27. Practical Observations • Risk is reduced by diversification • Higher returns bring higher risk • Risk can be assessed by using b • By altering ratio of risk-free and market, can run through all feasible returns • A return higher than the market can be obtained by going short in the risk-free: borrowing to invest (yes, this is risky)