PROJECT: PORTFOLIO CONSTRUCTION
I. OBJECTIVE
The objective of this project is to construct a portfolio for Mr. Donothing. He hires you to manage his money.
II. INVESTOR PROFILE
Mr. Donothing is a real person. He is 50 years old and single. He does not work. He survives based on an inheritance of $10 million. He is an amphibious person: he spends his time in cruise lines. He needs $600 per day throughout the year for cabin charges and food. He needs another about $25,000 for secretarial services and incidental expenses. He wants to settle in Pompano Beach, Florida at 55, get married, and father a child. The type of house he wants to buy sells today for $500,000. His cash needs would remain unchanged after he settles on land.
In investing money for a client you will consider factors like necessities of life, precautionary needs, need for lump-sum expenditure in the future, retirement needs, and insurance needs. After investing appropriate sums to meet some or all of these needs, if there is money left over, you can consider active investing: invest to beat the market - do better than the overall market does. Two approaches to beating the market are: asset allocation (market timing) and identifying mispriced securities (security selection).
III. POLICY STATEMENT
After identifying needs and preferences of the investor, the next step is to construct a policy statement. This will specify the type of risk the investor is willing to take, and investment goal(s) and constraints. This statement is periodically updated as investor needs change. The statement helps the investor decide on realistic but challenging investment goals after learning about the prospects of the markets and the risks. It also creates the standard by which the performance of the portfolio is judged. A policy statement should incorporate the investor's objectives (risk and return) and constraints (liquidity, time horizon, tax factors, legal and regulatory constraints, and unique needs and preferences. Chapter 28 goes over the inputs for the policy statement.
IV. CONCEPTUAL NOTES: ASSET ALLOCATION ISSUES
One approach used in outperforming the market is asset allocation: identifying how much to invest in stocks, bonds, cash, real estate, precious metals, international assets, etc. After you have assessed the proportion you should invest in stocks, bonds, cash, etc., you might delve into the issue of security selection: selecting individual securities in each asset category (stocks, bonds, cash, etc.).
A. Economic Analysis
The starting point for asset allocation is economic analysis. Based on short-run and long-run forecasts made by economists, try to assess short-run and long-run direction of the economy.
Economists look at a host of macro-economic variables to help us in assessing the direction of the economy. The more important ones are:
· Money supply and interest rates (which determine easy of credit availability);
· Retail sales, unemployment rate, personal income, personal consumption, new-car sales, consumer credit (these and other variables help to assess consumer spending);
· Budget deficit (which reflects government spending);
· Merchandise trade deficit (which reflects relative strength of exports compared to imports);
· Industrial production, capacity utilization, order for durable goods, business inventories, non-residential construction, capital outlays (these and other variables including some mentioned earlier, help to assess the level of business activity).
If these and other variables suggest a continued growth of the economy then investing major part of your money in stocks might appear an attractive prospect. The possibility of recession might suggest that a larger portion be devoted to bonds. An uncertainty in the state of the economy in the near future might suggest that if you have new money to invest, you should invest in money market instruments as a temporary "parking-place" - which can subsequently be easily divested and invested in stocks and/or bonds when the direction of the economy is known with more certainty.
You do not have to collect raw data and analyze each of the macroeconomic variables listed. Financial services companies analyze various macroeconomic variables and provide outlook about the economy. Also you will find a whole gamut of information in the internet.
Even if strong indications suggest that the economy will continue to grow at a healthy rate, portfolio theory still suggests that our money be diversified among different asset classes: stocks, bonds, cash, etc. -- maybe more in stocks and less in bonds and cash. Through this, even if a stock investment goes sour, the position in bonds and/or cash would offset some of the losses incurred.
B. Industry/Sector Analysis
Once you get an idea (via economic analysis) as to how much to invest in stocks/bonds/cash/etc., you then have to select securities from these asset classes through industry/sector analysis. The objective is to identify promising sectors within the economy in which you might invest. Even in a bull market all sectors of the economy do not grow/benefit to the same degree. During your economic analysis, note the industries/sectors which are considered by experts to be highly prospective.
C. Company/fund Analysis
Analyze the companies to identify the most promising/mispriced stocks and/or funds within the most promising industries/sectors that you identify from industry/sector analysis.
V. REPORT
A. MANAGEMENT SUMMARY
1. Introduction:
State briefly the objective of the report
2. Investor Profile and policy statement:
Provide a brief but clear sketch of the investor in terms of the short-run and specific long-run goal(s) he likes to achieve, level of return sought, level of risk tolerance, tax status, investment horizon, etc. (Please note that the investment vehicles/instruments you select has to match with these factors. For example, if you assume a low level of risk tolerance for the investor, you may choose not to invest in high beta stocks or in junk bonds).
3. Economic analysis/outlook:
Follow guidelines given under "Economic Analysis", and any guideline to be given in class. The analysis should contain adequate data and statistics to support your assessment about the near term (one to four quarters) direction of the economy. Provide detailed analyses as appendix(es) and include synopsis of it in the management summary. Refer to the sources of statements, data and statistics as footnotes. Refer to such appendixes in the relevant part(s) of your management summary. The last paragraph of this section should outline your asset allocation decision (that is, given the economic scenario and the goals and preferences of the investor, how much would you put in stocks, bonds, cash, etc.? You can invest in any other type of asset category).
4. Industry/sector analysis:
Based on criteria you consider to be appropriate, select sectors/industries in which you would invest. Criteria might include potential competition, stability, industry helpers, historical and prospective growth rate, return on investment, return on equity, stability, etc. Selection criteria should match the needs and preferences of the investor. For example, if the level of investors risk tolerance is low, one of the criteria for selecting industries would be their ‘stability'. (But how do you measure stability? Mention that in the section on criteria). Include as appendix detailed analysis and relevant data on industries/sectors you opt to invest in. Justify why you decide to invest in some industries over others. The management summary would contain synopsis of the detailed industry/sector analyses included as appendix(es).
5. Company/fund/money market instrument analysis:
In case of investment in mutual funds, you will include analysis of the promising funds (stock funds, bond funds, money market mutual funds) to rationalize why you would select a particular vehicle. Rationalize as to why you select certain companies/funds over so many others. Selection must be based on some well thought out criteria as you do for industry analysis. Include as appendix(es) relevant historical data on each instrument selected. The outcome of industry/sector analysis and company/fund/money market instrument analysis is the resolution of the security selection decision. (The outcome of economic analysis, as indicated earlier, is the resolution of asset allocation decision). Once again, include detailed company/fund/money market instrument analysis as appendix(es) and summarize your analyses in the management summary.
6. Conclusion:
How does your final portfolio look like in terms of its composition? What overall expected return does it promise? Is the expected return for the long-term portfolio enough to meet the long-term goal(s)? Does the portfolio seem to meet the needs and preferences (including risk tolerance) of the investor?