Finance School of Management Chapter 12: Choosing an Investment Portfolio Objective To understand the theory of personal portfolio selection in theory and in practice uesTc
1 Finance School of Management Chapter 12: Choosing an Investment Portfolio Objective • To understand the theory of personal portfolio selection in theory and in practice
Finance School of Management Chapter 12: Contents The process of personal portfolio selection The trade-off between expected return and risk Efficient diversification with many risky assets uesTc
2 Finance School of Management Chapter 12: Contents ❖ The process of personal portfolio selection ❖ The trade-off between expected return and risk ❖ Efficient diversification with many risky assets
Finance School of Management The Concept of portfolio A person's wealth portfolio includes Assets: stocks bonds, shares in unincorporated business, houses or apartments, pensions benefits, insurance policies, etc Liabilities. student loans. auto loans. home mortgages etc uesTc
3 Finance School of Management The Concept of ‘Portfolio’ ❖ A person’s wealth portfolio includes – Assets: stocks, bonds, shares in unincorporated business, houses or apartments, pensions benefits, insurance policies, etc. – Liabilities: student loans, auto loans, home mortgages, etc
Finance School of Management Portfolio selection A study of how people should invest their wealth optimally A process of trading off risk and expected return to find the best portfolio of assets and liabilities Narrow and broad definitions How much to invest in stocks bonds. and other securities whether to buy or rent ones house What types and amounts of insurance to purchase How to manage one's liabilities How much to invest in ones human capital uesTc
4 Finance School of Management Portfolio Selection ❖ A study of how people should invest their wealth optimally ❖ A process of trading off risk and expected return to find the best portfolio of assets and liabilities ❖ Narrow and broad definitions: – How much to invest in stocks, bonds, and other securities – Whether to buy or rent one’s house – What types and amounts of insurance to purchase – How to manage one’s liabilities – How much to invest in one’s human capital
Finance School of Management Portfolio selection Although there are some general rules for portfolio selection that apply to virtually everyone, there is no single portfolio or portfolio strategy that is best for everyone. uesTc
5 Finance School of Management Portfolio Selection ❖ Although there are some general rules for portfolio selection that apply to virtually everyone, there is no single portfolio or portfolio strategy that is best for everyone
Finance School of Management The Life cycle In portfolio selection, the best strategy depends on an individuals personal circumstances (family statuS, occupation, income, wealth). Illustrations Young couple: buy a house and take out a mortagage loan older couple: sell house and invest in assets provding a steady stream of income Investing in stock market: Chang (30, a security analyst)/ Obi(30, an English teacher) Buying insurance policies: Miriam(a parent with dependent children)/ Sanjiv(a single person with no dependents) uesTc
6 Finance School of Management The Life Cycle ❖ In portfolio selection, the best strategy depends on an individual’s personal circumstances (family status, occupation, income, wealth). ❖ Illustrations – Young couple: buy a house and take out a mortagage loan / older couple: sell house and invest in assets provding a steady stream of income. – Investing in stock market: Chang (30, a security analyst) / Obi (30, an English teacher). – Buying insurance policies: Miriam (a parent with dependent children) / Sanjiv (a single person with no dependents)
Finance School of Management Ti 1me Horizon In formulating a plan for portfolio selection, you begin by determining your goals and time horizons. Planning horizon: the total length of time for which one ans Decision horizon: the length of time between decisions to revise the portfolio Trading horizon the minimum time interval over which investors can revise their portfolios /its determination and impacts Investment strategy trading horizon: portfolio insurance or dynamic portfolio strategy uesTc
7 Finance School of Management Time Horizon ❖ In formulating a plan for portfolio selection, you begin by determining your goals and time horizons. – Planning horizon: the total length of time for which one plans – Decision horizon: the length of time between decisions to revise the portfolio – Trading horizon: the minimum time interval over which investors can revise their portfolios / its determination and impacts – Investment strategy & trading horizon: portfolio insurance or dynamic portfolio strategy
Finance School of Management Risk Tolerance a major determinant of portfolio choices It is influenced by such characteristics as age, family status, job status, wealth, and other attributes that affect a person' s ability to maintain his standard of living in the face of adverse movements in the market value of his investment portfolio uesTc
8 Finance School of Management Risk Tolerance ❖ A major determinant of portfolio choices ❖ It is influenced by such characteristics as – age, family status, job status, wealth, and – other attributes that affect a person’s ability to maintain his standard of living in the face of adverse movements in the market value of his investment portfolio
Finance School of Management Professional Asset Managers Investment advisors finished products from a financial intermediary SpecialIzation, information and cost advantages uesTc
9 Finance School of Management Professional Asset Managers ❖ Investment advisors & “finished products” from a financial intermediary ❖ Specialization, information and cost advantages
Finance School of Management The Trade-off between Expected Return and risk The objective is to find the portfolio which offers investors the highest expected rate of return for the degree of risk they are willing to tolerate。 Iwo step process find the optimal combination of risky assets. mix this optimal risk -asset with the riskless asset uesTc 10
10 Finance School of Management The Trade-off between Expected Return and Risk ❖ The objective is to find the portfolio which offers investors the highest expected rate of return for the degree of risk they are willing to tolerate. ❖ Two step process: – find the optimal combination of risky assets. – mix this optimal risk-asset with the riskless asset