Introduction to Investment Planning

1
Chapter 12

• Introduction to Investment Planning

2
Establishing Financial Goals

• Typical Financial Goals
• Common Investment Goals
• Capital accumulation
• Preservation of capital
• Maximizing returns
• Minimizing risk
• Budgeting
• Methods of Increasing Savings

3
Investment Risks

• Systematic Risks
• Market risk
• Interest rate risk
• Purchasing power risk
• Foreign currency (exchange rate) risk
• Reinvestment risk
• Unsystematic Risks
• Business risk
• Financial risk
• Default risk
• Country (or regulation) risk

4
Investment Risks (contd)

• Risk and Return
• There is a direct relationship between risk and
  return. As the level of risk increases, the
  expected return increases, and as the level of
  risk decreases, the expected return decreases.
• Liquidity vs. Marketability

5
Investment Choices

• Lending investments
• Default risk
• Interest rate risk
• Ownership investments in business
• Ownership investments in real estate
• Cash flow
• Depreciation deduction
• Low correlation with other assets

6
Investment Choice (cont.)

• Derivatives
• Options
• Puts
• Calls
• Futures
• Direct vs. Indirect Investing

7
Measures of Risk

• Beta a measure of systematic risk derived from
  regression analysis
• Standard Deviation measures total volatility
  (systematic and unsystematic risk)
• Semivariance measures downside volatility

8
Measures of Return

• Holding period return
• Arithmetic mean
• Geometric mean
• Internal rate of return
• Real rate of return

9
Holding Period Return

• HPR EI BI /- Cashflows
• BI
• EI Ending Value of Investment
• BI Beginning Value of Investment

10
Arithmetic Mean
HPR1 HPR2 HPR3 HPRt
AM
n
HPRt Return for period t
n Number of periods
11
Geometric Mean

GM is interest rate when solving PV -100 FV
100 (1R1) (1R2) (1R3) (1Rn) N n
Rn Return for period n
n Number of periods
12
Internal Rate of Return
PV Present Value
CFn Cash flow for period n
n Number of cash flows
k IRR
13
Real Rate of Return
1 R
( )

Real return

n
1


1 I
( )
Rn Nominal rate of return
I Inflation rate
14
Modern Portfolio Theory

• Modern portfolio theory is the concept that
  describes the diversification process among a
  portfolios asset classes

15
The Efficient Frontier
16
Markowitzs Three Rules

1. Same return choose lower risk.
2. Same risk choose higher return.
3. Choose higher return with lower risk.

17
Modern Portfolio Theory (contd)

• The following are the foundation for most of the
  asset allocation (mean-variance optimization)
  software packages used by financial planners
• Standard Deviation of a Multi-Asset Portfolio
• Expected Return of the Portfolio

18
Correlation Coefficient

• R 1.0 perfect positive correlation
• R -1.0 perfect negative correlation
• R 0 no correlation
• R2 Coefficient of determination

19
Investment Strategies and Theories

• Efficient Market Hypothesis
• Active vs. Passive Investing
• Indexing
• Timing the Market