An investment is the current commitment of dollars for a period of time in order to derive future payments. This Investment Prologue lays out a background for our advanced topic discussion of the field.
- Time of the funds are laid out
- Expected rate of inflation
- Risk of future payments
This page offers an Investment Prologue for a deeper study in the advanced topics of investing. We open with a discussion of the factors in risk and return. Then, we describe how the management of the portfolio starts with studying your goals and needs.Finally, we delve into tot he other side of the decision, asset markets.
We start this section by digging into measuring risk and return. Then, we describe the required return and sources of risk.Finally, we talk about how risk and return are linked.
Measures of Risk and Return
Historical return is the rate of return on an asset over the time period the asset is held. Thus, we are concerned with the change in wealth which can come from cash inflows or a change in the price of the asset. It is found by dividing the ending value of the asset by the beginning value of the asset and subtracting one.
The return for a group of assets is measured by the weighted mean of each of the assets or the overall change in total market value. They are weighted by the beginning value. In any event, either method will yield the same results.
Risk is the uncertainty an asset will earn its expected return. In order to predict an expected rate of return, we need to include this risk into the equation.You would compare this expected return with the return of a risk-free asset to decide whether to buy or not.
Risk can be measured by variance around a mean expected return. Thus, the riskier the asset, the greater the return. The standard deviation is used to make this risk comparable among assets and groups of assets,.
Required Rates of Return Factors
The real risk-free rate is the basic interest rate, assuming no inflation and no uncertainty about future flows. It is called the pure time value of money. In other words, this rate involves what you would be otherwise doing with your money and what competing choices are worth.
The risk free rate is quite stable over time though the most common rate, the US Treasury bill, is not stable overtime. Changes in public policy or expected inflation causes the rate to change. Thus, these factors affect all assets equally.
When investing in other assets than the risk free asset, a risk factor is involved called the risk premium.
- Exchange rate
A distinction arises between two types of risk: systemic which applies to all assets and unsystematic which is unique to a single asset. Modern Portfolio Theory (MPT) says you can get rid of unsystematic risk but not systemic. Thus, you would want a risk premium for unsystematic risk to make the choice to buy.
Relationship between Risk and Return
You tend to increase your required rates of return as perceived risk increases. Thus, this combo of risk and return available in markets is referred to as the security market line. Thus, where you fall in on this line depends on the amount of risk you want to take.
This set of combos or the market portfolio is not constant because the risk can either steepen or flatten.
- Expected real growth of the economy
- Capital market conditions
- Expected rate of inflation
In practical terms, handling this combo of risk and return involves managing the risk portion. Asset allocation is the process of deciding how to distribute your wealth among different countries and asset classes. An asset class is a group of assets with similar traits, attributes and risk/return relationships.
In this section, we talk about your goals and needs. Then, we describe the portfolio management process. After that, we introduce policy statements.. Finally, we talk about the importance of asset allocation.
Needs are different for everyone and change over your life cycle. Most importantly, no plan should be started without adequate income to cover living expenses and a safety net should the unexpected occur. Your life goes through phases depending on net worth and risk tolerance.
Life Cycle Phases
During these life cycles, you will have a variety of life goals.
- Near-term, high-priority
- Long-term, high-priority
In sum, a well-developed investment policy statement considers these diverse goal groupings over your life cycles.
Portfolio Management Process
The process of managing never stops. Then, once the funds are invested according to the plan, the real work begins in watching and updating the status of the holdings and your needs.
- Policy statement
- Examine current and projected financial, economic, political and social conditions
- Implement the plan by building the portfolio
- Feedback loop
Stating the purpose helps you understand your needs, objectives and constraints. Therefore, you specify real goals and become more informed about the risks and returns of investing.
The statement can also assist in judging the performance of Simpson Capital. Thus, it should include a benchmark such as an index and agree with your risk and return needs. Additionally, shortfalls are not a major concern as long as policy is followed, .
The type of return is stated such as capital growth, capital conservation or current income production. Also, your risk profile is stated relative to an average person at your station in life.
Constraints are included such as how fast an asset can be converted to cash.at a price close to fair market value. Additionally, your time horizon factors into most decisions. Tax concerns limit the asset classes used.
Also, legal and regulatory issues are stated. Additionally, any unique circumstances can be laid out. Thus, both these constraints further limit the asset classes available.
Importance of Asset Allocation
Asset allocation is by far the largest factor in long-term returns. Therefore, get this one right and you have a good chance of reaching your goals
Asset Allocation Factors
- Asset classes
- Policy weights assigned to each class
- Allowable ranges
- Specific assets for purchase
Most importantly, the asset mix, not the picking of specific stocks and bonds, yields most of the portfolio’s return over time. Although they seem risky, if you seek capital growth, income and even capital preservation over a long time horizon, you should include a sizable chunk to stocks.
We start off this section by talking about why we should invest. Then describe the scope of investment markets. Finally we talk about the asset classes found in the markets.
Reasons for Investing
Most investments used to be only stocks and bonds sold in US. Now, you can go anywhere in the world. It is largely fueled through the growth of foreign markets, aided by tech innovation.
Global Investing Advantages
- Size of non-US markets is almost one and half times the size of US markets
- Rates of return exceed the US
- One of the main tenets of investing is holding low correlated assets
The main assets traded on these markets are common stock fixed-income assets and cash. Each asset class has unique traits which are helpful in building a balanced portfolio.
Common stock represents owning a firm. Thus, It entails all the ups and downs of ownership is a risky investment compared to fixed-income assets. In addition, they are bought in IPOs or at exchanges.
Fixed-income assets have a fixed payment schedule. Thus, you are really lending money to the issuers and they promise to make interest payments and pay the principal back at the end.
Primary Fixed Income Types
- US Treasury and agency bonds
- Muni bonds
- Corporate bonds
- Preferred stocks
Investment companies offer mutual funds or exchange trades funds (ETF). As such, they feature the same traits as single issues but add pro expertise and admin benes. Mutual funds are bought directly and have extra changes. Lastly, ETFs are traded on exchanges and have lower costs.
This page offered Investment Background for a deeper study in the advanced topics of investing. We opened with a discussion of the factors in risk and return. Then, we described how the management of the portfolio starts with studying your goals and needs.Finally, we delved into tot he other side of the decision, asset markets.