Investment Planning Slides designed by Rosilyn H. Overton, MS ...
Upcoming SlideShare
Loading in...5
×
 

Like this? Share it with your network

Share

Investment Planning Slides designed by Rosilyn H. Overton, MS ...

on

  • 563 views

 

Statistics

Views

Total Views
563
Views on SlideShare
562
Embed Views
1

Actions

Likes
0
Downloads
7
Comments
0

1 Embed 1

http://www.slideshare.net 1

Accessibility

Categories

Upload Details

Uploaded via as Microsoft PowerPoint

Usage Rights

© All Rights Reserved

Report content

Flagged as inappropriate Flag as inappropriate
Flag as inappropriate

Select your reason for flagging this presentation as inappropriate.

Cancel
  • Full Name Full Name Comment goes here.
    Are you sure you want to
    Your message goes here
    Processing…
Post Comment
Edit your comment

Investment Planning Slides designed by Rosilyn H. Overton, MS ... Presentation Transcript

  • 1. Investment Planning Slides designed by Rosilyn H. Overton, MS, CFP®, CRPS, LTCP Text pages 381-389
  • 2. What is Investment Planning
    • From a client’s perspective, investment planning is typically the main reason for consulting with a financial planner.
    • Unfortunately, from a planning perspective, investments are normally the last step of the implementation process – after all of the other planning is complete.
    • If investment planning leads the other decisions in the financial planning process, the entire plan is set up for failure.
    • Obviously, the goal of investment planning is to achieve an expected rate of return over a specified time period while minimizing the potential for loss.
  • 3. Six Steps in Investment Planning
    • There are six steps in the investment planning process:
    • 1. Ascertain the current and projected amount to invest
    • 2. Determine the investment time horizon
    • 3. Coordinate investments with risk tolerance
    • 4. Select the investments
    • 5. Evaluate the portfolio’s performance
    • 6. Rebalance when necessary
  • 4. Ascertain the current and projected amount to invest
    • Some clients will already have a portfolio: In this case, an asset allocation appropriate to their needs and risk preference must be designed.
    • If the investor does not have enough saved to meet their needs, the potential investor must first make a conscious decision to save and invest rather than to spend.
  • 5. Determine the Investment Time Horizon
    • Does the investor need to use some portion of the investable assets in the near future?
      • Is the investor buying a house, retiring, sending a child to college?
    • This will help identify the need for shorter-term investments in the portfolio or the ability to invest in longer-term investments that typically will yield a higher expected return.
  • 6. Coordinate Investments with Risk Tolerance
    • In order to achieve a higher rate of return, the investor may need to be willing to accept a higher risk.
    • Losses, even in one year, severely impact overall return. For example, a 100% gain in one year, followed by a 50% loss in the second year results in no gain at all.
  • 7. Selecting the investments
    • Based on the information obtained in steps one through three, the planner can now begin the investment selection process.
    • Care should be taken to ensure that the investments truly reflect the investor’s needs and risk tolerance.
  • 8. Rebalance when necessary
    • Rebalancing the portfolio is a process whereby investors are forced to sell high and buy low.
    • A rebalancing program might call for the sale of equities (which have done well) and the purchase of bonds (which have not done as well).
    • Because the economy is cyclical, an asset class that has done well in one year quite likely will not do nearly as well in the following year, rebalancing forces movement to account for the overweighting in the appreciated asset.
  • 9. Life Cycle Periods
    • Each person typically moves through five financial stages throughout his or her life, which are characterized by various issues and objectives that are distinct to each stage. As the financial planner reviews the following descriptions of these various life cycle stages, try to determine which stage best describes the planner’s or the client’s own situation.
  • 10. Investment Allocation Guidelines
    • A range of acceptable investment percentages are presented for each life cycle stage and are allocated to the following three broad investment categories:
    • low risk, secure, and income-oriented investments
    • medium risk, growth-type investments
    • high risk, speculative investments
    • In addition, mutual funds are available that fit within each of these general classes of investments.
  • 11. Low Risk Investments
    • This category includes:
    • Savings accounts
    • T-bills
    • Money market funds
    • Government bonds
    • High-grade corporate bonds
    • Participation certificates
    • Similar types of investments
  • 12. Medium Risk Investments
    • This category includes:
    • Municipal bonds
    • Convertible bonds
    • Lower-grade corporate bonds
    • Preferred stocks
    • High-quality growth stocks
    • Similar investments
  • 13. High Risk Investments
    • This category includes:
    • More speculative growth stocks
    • Most real estate investments, REITs
    • Options
    • Commodities and futures contracts
    • Similar types of investments
  • 14. Investment Allocations Percentages Which investment percentage is chosen within each class should now depend on an assessment of risk tolerance and the investment horizon.
  • 15. THE EFFICIENT MARKET HYPOTHESIS The concept of random prices Degrees of market efficiency Weakly efficient Semi-Strong efficiency Strong efficiency Investment strategies All strategies can be classified into: Active or Passive
  • 16. Active Versus Passive Management
    • The Simple Logic of Active vs. Passive Investing.
    • Studies* have shown that over the long term, the average actively-managed fund has underperformed its appropriate passive benchmark by about 1.8% per annum on a pre-tax basis (taking taxes into account would increase this figure to approximately 3%).
    • Despite this evidence, the vast majority of individual investors invest in actively-managed funds.
    • Only about 10% of all individual monies are currently invested in passive funds.
    Note: There is some evidence that indicates that these studies were flawed because they did not take into account taxes due upon distribution and increases in return due to rebalancing. For a discussion of “closing the gap” on return, see a discussion by Alliance Bernstein Vice Chairman Roger Hertog and Alliance Bernstein Director of Quantitative Research Mark Gordon at https://www.bernstein.com/Public/story.aspx?cid=1222&nid=185. Be aware of possible bias since Alliance Bernstein is an active management investment advisor.
  • 17. Active Versus Passive Management
    • If “active” and “passive” management styles are defined in sensible ways, the following must be the case:
      • 1.  Before costs – The return on the average actively-managed dollar will equal the return on the average passively-managed dollar.
      • 2.  After costs – The return on the average actively-managed dollar will be less than the return on the average passively-managed dollar.
  • 18. Active Versus Passive Management
    • These assertions must hold for any and all time periods. Furthermore, their veracity does not depend on any sophisticated statistical or mathematical analyses or theorems, per se, but only on the laws of simple arithmetic.
    A scholarly article that tends to refute this simplistic view is Active versus Passive Management: Framing the Decision. By: Arnott, Robert; Darnell, Max. Journal of Investing , Spring 2003, Vol. 12 Issue 1, p31, 6p; ( AN 9845319 ) Once again, rebalancing is part of the picture. It is an interesting debate that still rages.
  • 19. Passive Investors
    • Passive investors always buy every security from the market for their portfolios in the same proportion as the securities represent to the total value of the market.
      • In other words, they essentially own an index of the market.
      • Therefore, if security A represents 2% of the value of the securities in the market, a passive investor’s portfolio will have 2% of its value invested in A.
      • Equivalently, a passive investment manager will hold the same percentage of the total outstanding amount of each security in the market.
  • 20. Active Investors
    • Active investors are other investors who are not passive.
    • Their portfolios will differ from those of the passive investors or managers at some or all times.
      • Active investors or managers usually act on their perceptions of mispricing in the market; because such misperceptions usually change relatively frequently, such investors and managers tend to trade relatively frequently.
      • That is why they are called “active” investors or managers.
  • 21. The Simple Logic of Active vs. Passive Investing
    • Over all periods of time, the market’s return will be a weighted average of the returns on the securities within the market.
      • Each passive investor or manager will earn exactly the market return (before transactions costs) since they own all the securities in the same proportions as the market.
        • From this, it follows by simple arithmetic that the return on the average actively-managed dollar must equal the market return.
        • Why? The returns earned by the passive investors plus the returns earned by the active investors must equal the total returns on the market.
        • If the returns earned by the passive investors on the portion of the market they hold equals the returns on the market, the average returns earned by the active investors on their portion of the market must also equal the market return.
        • The market’s return must equal a weighted average of the returns on the passive and active segments of the market. If the first two returns are the same, the third must be also. This proves the first assertion by using just simple arithmetic.
  • 22. The Simple Logic of Active vs. Passive Investing
    • To prove the second assertion, simply consider the fact that the costs of actively managing a given number of dollars will exceed those of passive management.
      • Active managers must pay for more research than passive managers, and must pay more for trading, too.
        • Security analysts, brokers, traders, specialists, and other market makers all take a “cut of the action.”
      • Because active and passive returns are equal before cost, and because active managers bear greater costs, it must be the case that the average after-cost returns from active management is lower than that from passive management.
  • 23. The Simple Logic of Active vs. Passive Investing
    • Managers who appear to be passive may not be truly passive.
      • Some index fund managers “sample” the market of choice, rather than hold all the securities in market proportions.
      • Some may even charge high enough fees to raise their total costs to equal or exceed those of active managers.
  • 24. The Simple Logic of Active vs. Passive Investing
    • Third, and possibly most important in practice, the summary statistics for active managers may not truly represent the performance of the average actively-managed dollar.
    • To compute the latter, each manager’s return should be weighted by the dollars he or she has under management at the beginning of the period.
  • 25. Active vs. Passive Investing
    • Some comparisons use a simple average of the performance of all managers (large and small); others use the performance of the median active manager.
    • While the results of this kind of comparison are, in principle, unpredictable, certain empirical regularities persist.
      • Perhaps most important, equity fund managers with smaller amounts of money tend to favor stocks with smaller outstanding values.
      • Thus, de facto, an equally weighted average of active manager returns has a bias toward smaller-cap stocks vis-a-vis the market as a whole.
      • As a result, the “average active manager” tends to be beaten badly in periods when small-cap stocks underperform large-cap stocks, but may exceed the market’s performance in periods when small-cap stocks do well.
    • In both cases, of course, the average actively-managed dollar will underperform the market, net of costs.
  • 26. Investing the Winners among Actively – Managed Funds
    • Mutual fund returns are notoriously inconsistent. This makes it difficult to select those funds that will outperform going forward.
      • Investors cannot predict where a fund will rank next period based on its performance this period, except to say that if it ranked in the top 25% it is very unlikely to rank there next period, and if ranked in the bottom 10% it is a flip of the coin whether it will still be there next period or not.
  • 27. More Considerations in Investing in Actively-Managed Funds
    • The worst funds are throttled by high fees and, therefore, cannot gain ground.
    • The high flying funds, on the other hand, are likely to be highly-concentrated and, therefore, annual returns will be volatile.
    • Outperforming funds are also often flooded with new deposits, making those funds more difficult to manage.
  • 28. The Conclusion
    • Investors have no way of determining which funds will perform well next year based upon their performance this year and, therefore, may incur significant underperformance risk by selecting actively-managed funds.
  • 29. Study of Odds
    • The Winter 2001 issue of the Journal of Private Portfolio Management contained a study that looked at the odds of active managers outperforming passive managers or index funds.
      • The study looked at all 307 large-cap funds with at least a 10-year history.
      • This methodology creates what is known as “survivorship bias” in favor of active management.
      • Funds that perform poorly typically close because of redemptions by investors, or they are merged out of existence by their sponsor.
        • Thus their performance data disappears.
  • 30. Study of Odds (cont.)
    • The returns of the funds were then compared to that of the benchmark S&P 500 Index.
    • Over the most recent 20-year period, the passive strategy outperformed over 93% of all surviving funds.
      • For the most recent 15-year period it outperformed over 99% of all surviving funds.
      • For the most recent 10-, 7-, 5-, and 3-year periods, the passive strategy outperformed at least 95% of all surviving active funds.
      • Finally, for the 61 rolling 5-year periods since the end of World War II, the passive strategy outperformed at least half the active funds 58 times (95%). These results were all computed on a pre-tax basis. Based on historical data, it is quite clear that the results would have been even worse if the returns had been measured on an after-tax basis.
  • 31. Choosing the Simple Strategy
    • Investors in actively-managed funds were choosing the wrong strategy. Simply accepting market returns would have improved their collective results dramatically.
  • 32. Past and Future Performance
    • One example of the fallibility of relying on past success is the findings of William Bernstein.
    • He examined the performance of the top 30 funds for successive five years beginning in 1970, and then compared their performance against that of the S&P 500 Index through 1998. Here is what he found:
    • Never did the top performers from one 5-year period continue to outperform in the subsequent 5-year period.
  • 33. Past and Future Performance (cont.)
      • The top 30 funds from 1970 through 1974 went on to underperform the index by 0.99% per year.
      • The top 30 funds from 1975 through 1979 went on to underperform the index by 1.89% per year.
      • The top 30 funds from 1980 through 1984 went on to underperform by 2.75% per year.
      • The top 30 funds from 1985 through 1989 went on to underperform by 1.57% per year.
      • The top 30 funds from 1990 through 1994 went on to underperform by 10.9% per year.
  • 34. Past Performances do not guarantee Future Results
    • Past performance is simply not a good indicator of future performance.
      • However, with so many active funds in play, some are likely to be winners over any given time frame (and must be, if there are any losers).
      • The evidence suggests that despite investors’ generally-held perception that skill is what causes the winning result, it appears to be much more likely that the winners are randomly generated and, thus, not likely to be repeated.
  • 35. Generate Superior Returns
    • The conclusion to draw, once again, is that the prudent strategy – and the one most likely to generate superior returns – is the passive one.
  • 36. Take the Rest to Atlantic City
    • Active management does, however, hold out the hope of outperforming other actively-managed funds and, certainly, passive investing.
      • This hope is what Wall Street and the financial press sell.
      • Unfortunately, the odds of winning the game have proven to be so low that unless one attaches a high value to the entertainment aspect of the effort, then it does not pay to play.
      • When one considers the additional costs of active management (the “vigorish” or “house take” as they call it in the gambling community), investors might be better off investing most of their money passively and then playing Black Jack with the rest of it in Las Vegas or Atlantic City.
  • 37. Active Management in Inefficient Markets
    • The controversial “efficient market hypothesis” concludes that there is no point to fundamental or technical security analysis because all stocks are fairly priced.
      • According to this hypothesis, active buying and selling of stocks adds no value – it just incurs additional transactions costs.
      • Hiring a professional manager is even worse because of the fees required.
  • 38. Market Efficiency
    • If markets are efficient, indexing becomes a better alternative. Most investors have come to accept that the big markets are pretty efficient, but what about the smaller markets and/or foreign markets? They cannot be as efficient as the big markets, can they?
  • 39. Investing is a skill-based game
    • As has been demonstrated above, more than half of all active mutual fund managers underperform the market.
      • This is often interpreted as proof of market efficiency. But the fact is that mutual fund managers consistently underperform the market by more than can be accounted for by the extra costs of active management.
      • This in fact is proof that investing is a skill-based game and that active mutual fund managers, as a group, have below-average skills.
  • 40. More difficult to pull off in small-cap and foreign funds
    • In the small-cap arena or in foreign markets, the proportion of active investors outperforming a small-cap index fund or foreign index fund should be even lower, on average, than in the large-cap arena because active investing in small-cap and foreign equities involves higher transaction and research costs.
    • This obvious logic and arithmetic, once again, contradicts conventional wisdom that active managers can do better in the less-efficient small-cap market.
  • 41. Who is more successful?
    • Which investors or investor groups are most likely to be in the “successful” top group in terms of skills, information, or other competitive advantages?
      • Mutual fund managers, as a group are definitely not in the top group.
      • Two other investing groups, insiders and hedge fund managers, both of which have identifiable competitive advantages, are more likely candidates to be in the top group.
        • And yet there is no empirical evidence suggesting that even these groups can consistently outperform.
  • 42. Win more often in investing passively
    • So on what possible grounds could virtually any individual investors feel they actually had a competitive advantage or above average skills in the large-cap market, the small-cap market, foreign markets, or any markets? Why play a game in which one’s competitors have an advantage, if one can win more often than not by staying out of the active game and taking the average result by investing passively?
  • 43. Investors are Not Always Rational
    • More than half of all active investors, whose only financial justification for being active is beating the index, must fail in that objective each year.
    • Although when it comes to the logic and arithmetic of investing, investors’ behavior suggests they may tend to over-represent the bottom half of that distribution.
  • 44. Tactical Asset Allocation and Market Timing
    • This question is constantly debated. However, the overwhelming evidence is that even professional market timers cannot consistently outperform the market.
    • Market timing, like all active management strategies, is a “zero-sum” game whereas investing in the market as a whole is a “positive-sum” game.
  • 45. Timing reduces risk
    • The argument is sometimes made that timing reduces risk, since one is invested in cash or T-bills a portion of the time and in the market the rest of the time. Since T-bills are less risky than stocks, the argument goes, the overall risk is lower.
  • 46. Gains made during short periods
    • The fallacy here is in failing to account for the risk of missing the big gains in the market.
    • Most of the gains in the market are made during relatively short periods surrounded by long periods of relative stagnation.
  • 47. Monthly Stock Returns Figure 28.2 shows monthly stock returns from 1926 through 1987 on S&P 500 and small-cap stocks. All of the return for S&P 500 stocks occurred in just 6.7% of the months; for small-cap stocks, just 4% of the months account for all of the return over this period. Only 3.5% and 2.3%, respectively, of the months accounted for all of the return in excess of T-bills. In other words, if one were invested in the market 96.5% of the time, but one were out for the months of greatest gain, one would have done no better than investing in T-bills.
  • 48. Cost of not being in the market A similar study of the bull market from 1982 to 1987 gave similar results, based on days, rather than months in the market. This study showed that if one missed just the 40 biggest days, or just 3% of the 1,276 trading days of this bull market, one would have missed 83.7% of the market’s 26.3% annual compounded return over the period.
  • 49. Invest for the Long Term and be in the market consistently
    • Clearly, the risk of not being in the market when it makes its run is very significant, and conveniently overlooked when the market timers try to sell their concept.
    • The best advice is to invest for the long term and be in the market consistently.
    • No market timer can claim to be accurate over 80% of the time, so timing will inevitably lead to cases where the big market runs are missed.
  • 50.  
  • 51. Repercussions of the Efficient Market Hypothesis 1. Discount brokerage 2. Index funds 3. Much less market timing 4. Changed approach to financial planning 5. Increased global investing