Slide 1 Chapter 4 Investment choices PowerPoint presentation by Lindsay Cowling Holmesglen Institute ©2011 John Wiley & Sons Australia, Ltd Introduction Investment choices include exposure to the...

Outline the primary differences between ordinary and preference shares?Q2: what characteristics are typically associated with ethical investments?


Slide 1 Chapter 4 Investment choices PowerPoint presentation by Lindsay Cowling Holmesglen Institute ©2011 John Wiley & Sons Australia, Ltd Introduction Investment choices include exposure to the major and alternative asset classes and direct or indirect exposure through a managed fund In order to build a portfolio the investor must have appreciation of risk and return attributes Risk and return trade-offs are inherent in all investment analysis General Attributes of Investors It is commonly assumed in finance that investors are risk averse, rational and have an unlimited demand for wealth Risk averse investors dislike volatility in returns Rationality – the investor is assumed to be able to rank alternative investments consistently and Unlimited demand – the investor prefers more to less… General Attributes of Investors continued Thus an investor will seek to maximise their ‘utility’ or preference functions by building a portfolio that suits their disposition or needs Exercise: Refer to Table 4.1 – rank yourself according to investor classification, features and approximate asset mix Broad Investment Classes Cash Fixed Interest Property Shares Cash Safe haven Usually has a shorter term outlook Provide interest income - variable Provide liquidity Stable returns Risk free… although banks do fail from time to time – the Federal Government 90 day Treasury Note interest rate is regarded as the risk free rate in Australia …but adversely affected by tax and inflation Fixed Interest Fixed term e.g. term deposit, debenture or government or corporate bond Fixed interest rate with interest paid on a regular basis (a bond) or factored into the final payment and offered as a discount security (a bank bill) Issued by institutions and government / semi government Longer horizon than cash Low risk – corporate bonds are higher risk than Govt bonds though Fixed Interest continued Generally secured apart from Unsecured Notes which are more risky Hybrid instruments – instruments that have some characteristics of debt and equity e.g. a convertible note is debt but may be converted to a share at a future date Can have a stabilising affect upon a portfolio Credit risk can be an issue – more so with corporate bonds Property Property is a longer term investment vehicle that usually provides regular rental income with higher risk than bonds but lower risk than shares… Direct property – apart from the family home – can consist of rental properties; residential, commercial, industrial or rural Indirect: Listed property trusts (REITS) Unlisted property trusts Property continued Drawbacks: Not liquid It takes time to buy and sell Transaction costs are high Diversification can be limited for the smaller investor Ongoing care and maintenance Listed property trusts can have similar risk to shares During the GFC many listed trusts suffered severe falls in value when they were unable to refinance debt and were forced to sell property when the market was at its worst Shares Definition: …fractional ownership of a company Shares are generally high risk and return and therefore suitable for longer term investors In the long term Australian shares have provided long term growth well above inflation – but in the short term market returns can be quite volatile Shares continued Share market returns tend to move in cycles reflecting: Economic growth, the value of the AUD Industry trends Company profitability / dividends Inflation, interest rate expectations and General market sentiment Shares continued Returns can be both capital growth and dividends Mature companies can provide good dividend yields, younger, more growth orientated companies may not pay a dividend Dividends reflect company profitability and can vary from year to year Australian companies can provide tax effective dividends Shares continued An investor can buy shares on international shares and get exposure to markets at different stages of the business cycle International shares can provide good diversification but beware of foreign currency risk A rising AUD can wipe out gains made on international markets - when shares are sold and the foreign currency is exchanged for AUD the investor will receive fewer AUD… The reverse will also be true The Risk and Return Relationship The higher the return the greater the risk Definitions of risk: The chance of loss of capital – a negative real return The chance of loss of purchasing power – will returns be greater or less than the inflation rate? The variability of returns – in finance we use standard deviation as the measure of risk ie the variability of returns around an expected mean How can diversification reduce risk? For a portfolio, we must consider the risk and returns of the whole portfolio rather than just the individual components The expected return for a portfolio is the weighted average returns of the individual shares Example Share A Share B Expected return 10% 14% Standard deviation 3% 5% % of total portfolio 55% 45% Expected return E(R): = 0.55 (10%) + 0.45 (14%) = 11.8% How can diversification reduce risk? continued How can diversification reduce risk? continued Portfolio risk is not simply a weighted average of the standard deviations of individual shares in portfolio. Weights used are not simply the fraction of the total portfolio invested in each share. It is necessary to understand the concept of correlation between the shares. How can diversification reduce risk? continued The correlation coefficient shows the extent of correlation among shares. It has a numerical value of –1 to +1 which indicates the risk reduction between shares: Negative correlation (–1)  Large risk reduction Positive correlation (+1)  No risk reduction On average, the correlation coefficient for returns on two randomly selected shares would be in the range of +0.5 to +0.7. Share Share Correlation C D Coefficient Standard deviation 4% 4% –0.1 0.2 0.6 1.0 Portfolio risk 0% 3.1% 3.6% 4% (Standard deviation of the portfolio) Providing the correlation coefficient between shares C and D is less than 1.0, investor will be able to make a higher return at reduced risk How can diversification reduce risk? continued Diversification Across Asset Classes Application of the Diversification Decision The efficient portfolio – investors have return and risk data for a collection of securities This data can be graphed as an upward sloping concave cure called the ‘efficient frontier’ There is no one best portfolio that lies on the frontier – just different combinations of risk and return A portfolio on the frontier is efficient – a portfolio inside the curve is inefficient in terms of risk or return… The risk – return ratio can be minimised or optimised by combing securities with a minimised covariance – a negative covariance would be better still! The efficient frontier shows where the most efficient portfolio’s are located but the Sharpe ratio identifies the best possible proportions of these securities to use in a portfolio Application of the Diversification Decision continued Modern portfolio theory assumes there are only two asset types risky assets risk-free assets Financial planners need to help clients make decisions about investments in growth assets fixed-interest assets Application of the Diversification Decision continued Recommendations for the selection of client investments will depend on a client’s risk tolerance which can be assessed by risk profiling. Application of the Diversification Decision continued Recent Performance of Asset Classes Modern portfolio theory states the risk-return relationship by the formula: where: E(Rp) = expected return on entire portfolio E(Rpi) = expected return on the risky fund p = standard deviation of entire portfolio pi = standard deviation of risky fund Rf = risk-free interest rate Application of the Diversification Decision continued General Investment Strategies Diversification – ‘don’t put all your eggs in one basket’ Diversification raises the question as to how an investment portfolio should be allocated Investors must have allocation decisions based on their risk, return profile General Investment Strategies continued Risk tolerance will be: In some part innate and… Governed by: A person’s age Income Wealth Years to retirement Past financial experiences General Investment Strategies continued Gibson (2000) argued that the risk of portfolios was reduced and the average return increased if four asset classes were held in a portfolio  The reasoning is based on the fact that the four asset classes are not strongly related to each other As one asset class performs well the others are less likely to perform as well and as the better performing asset class reverses its performance the other asset classes tend to perform better… The performances tend to counteract each other which provides for a better long term average and lower level of risk of such a portfolio Investor Behaviour The traditional view is that the market is efficient – Efficient Market Theory Loss aversion – prospect theory Overconfidence – many investors mistakenly believe they can beat the market Biased judgements – ‘house prices never go down’ Investor Behaviour continued Investment scams If it seems to good to be true it probably is! Ponzi schemes Recent ASIC research shows internet scamming is on the rise… Is there really a pot of gold at the end of the rainbow? Information Sources for Investment Choices Economic fundamentals Industry characteristics and reports Company background, prospects, annual reports Current market prices Government reports, ASIC website Analyst reports Using the internet as a search engine Summary A financial planner needs to understand the basic features of an asset class To consider investment choice you need to have an understanding of risk and return Risk and return also needs to be understood in terms of recent performance history and timeframes Behavioural finance research shows that some investors do not behave rationally – scams take advantage of this… Summary continued An assessment of risk and return attributes including measurement principles allows the financial planner to tailor investment alternatives to a client’s specific requirements p pi f pi f p R R E R ) E(R σ σ ú ú û ù ê ê ë é - + = ) ( Slide 1 Chapter 5 Direct Investment Power Point presentation by Lindsay Cowling Holmesglen Institute ©2008 John Wiley & Sons Australia, Ltd Introduction Direct investment occurs when investors make their own decisions where funds are ultimately placed Indirect investment involves investors placing their funds with fund managers It is important to appreciate the nature and structure of the relevant investment markets Cash and Fixed-Interest Securities Deregulation of the Australian financial system in the early 1980s produced a highly competitive finance industry Process of deregulation was to free financial markets by removing many of the legal controls and regulations that restricted competition and stifled technological development Cash and Fixed-Interest Securities Deregulation included: - floating of Australian