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Investment Decisions

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'Junk bonds' high yield bonds issued by low credit quality companies (below investment grade) ... 'Real Estate Investment Trusts' ... – PowerPoint PPT presentation

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Title: Investment Decisions


1
Investment Decisions
  • Fin 434
  • September 25, 2006

2
By the end of this lecture, you should be able to
  • Be able to explain basic portfolio theory
  • The value of diversification
  • How to evaluate risk/return trade-off
  • What do consumers actually do?
  • Explain different classes of investments
  • The special case of company stock
  • Why do firms offer it?
  • How does it affect retiree well-being?

3
A Quick Review of Investment Theory
  • Investor attitudes toward risk
  • Risk vs. return
  • What risk matters?
  • Historical returns

4
Your Risk Attitude - 1
  • Suppose you have 10,000 to invest.
  • Option A Invest 10,000 in risk-free
    securities, have 10,500 for sure next year
  • Option B Invest 10,000 in asset B. There is
    50 chance that you will have 12,000 next year,
    and 50 chance of 9,000.
  • Option C Invest 10,000 in asset C. There is
    50 chance you will have 21,000 next year, and
    50 chance that you will have 0.
  • Which would you choose?

5
Expected Values
  • Let Xi outcome i (i 1 N)
  • If all out comes equally likely and independent,
  • then expected value Xev (1/N)?Xi
  • More generally, if Pi is the probability of
    outcome Xi, then the expected value is

6
Variance
  • Variance of a sample
  • Standard deviation ? square root of variance
  • Variance and standard deviation provide a measure
    of how disperse a distribution of outcomes is

7
Uncertain Outcomes
Same mean Different variance
Xev
8
Choice Between the Three Portfolios
  • Option A 10,500 for sure next year
  • Option B 50/50 chance of 12k or 9k
  • Option C 50/50 chance of 21k or 0

9
Risk Aversion
  • Most investors are risk averse. What does this
    mean?
  • For a given level of risk, individuals prefer the
    investment option with the highest expected
    return
  • For a given level of expected return, individuals
    prefer the investment option with the least risk

10
Your Risk Attitude - 2
  • Suppose you have 10,000 to invest.
  • Option D Invest 10,000 in risk-free
    securities, have 10,500 for sure next year
  • Option E Invest 10,000 in asset E. There is
    50 chance that you will have 12,000 next year,
    and 50 chance of 9,500.
  • Option F Invest 10,000 in asset F. There is
    50 chance you will have 30,000 next year, and
    50 chance that you will have 0.
  • Which would you choose?

11
Choice Between the Three Portfolios
  • Option D 10,500 for sure next year
  • Option E 50/50 chance of 12k or 9.5k
  • Option F 50/50 chance of 30k or 0

12
Financial Market Equilibrium
  • Investors require higher return in order to be
    willing to hold riskier assets
  • In other words, there is a trade-off between risk
    and reward
  • Riskier assets have higher expected returns
  • Higher expected returns are associated with
    higher level of risk
  • But, does all risk matter?

13
Does Market Reward All Risk?
  • A financial asset has two types of risk
  • Systematic / Market / Non-diversifiable
  • Risk that is correlated with market so that
    diversifying does not get rid of it
  • Idiosyncratic / Unique / Diversifiable
  • Unique to the firm, uncorrelated with market, and
    thus can diversify it away

14
Diversification
Unique risk
Market risk
15
Portfolio Theory
  • Adding more securities to a portfolio will
    generally make the portfolio less risky
  • Of all the possible portfolios, some of them are
    efficient and some are not. An efficient
    portfolio is one that maximizes the level of
    return for a given level of risk

16
Minimum Variance Portfolios
Expected Return
Min. Variance portfolios
A
B
Risk
17
Choosing An Optimal Portfolio
Expected Return
Market portfolio
Min. Variance portfolios
rf
Risk
18
Portfolio Choice
  • Portfolio theory suggests that everyone should
    hold some combination of the market portfolio and
    the risk-free asset
  • We really only need one mutual fund a market
    index fund
  • The relative shares in risky vs. risk-free
    portfolio depends on attitudes toward risk

19
Types of Investments
  • Stocks
  • Debt / Bonds
  • Money market
  • REITS
  • Mutual Funds

20
What Do 401(k) Participants Believe?
21
Historical Returns(Real returns from 1926-2000)
  • This probably understates true variance due to
    survivor bias
  • Corp bonds considered riskier than govt due to
    default risk

22
Relative Risk
  • Our classs
  • Risk rating
  • Individual company stock 4.34
  • Diversified stock fund 2.81
  • Corporate bond fund 2.68
  • Government bond fund 0.90
  • Money market fund 2.10
  • (Scale 0 if no risk, 5 if most risk)

Most risky
Least risky
23
Asset Allocation in 401(k)s ()(EBRI / ICI 2001)
24
Stocks
  • Common Stocks
  • Ownership of a share of a company
  • Preferred Stocks
  • A hybrid stock/bond instrument
  • More regular dividend payments
  • Rights are senior to common stock holders in case
    of bankruptcy

25
Debt
  • Issued when corporations, federal, state and
    local governments need to borrow money
  • Bond buyer is loaning money to bond issuer,
    usually at set interest rate and duration
  • Known as fixed income securities because the
    amount of income (interest) is set when bond is
    sold

26
Four Common Bond Issuers
  • Federal government issues government bonds or
    Treasuries
  • Varying maturities
  • Also offer inflation indexed bonds
  • Other government agencies
  • Ex Federal Natl Mortgage Assn (Fannie Mae)
  • Corporate Bonds
  • Higher interest than govt due to default risk
  • Junk bonds high yield bonds issued by low
    credit quality companies (below investment grade)
  • State Local ? Munis
  • Free from federal income tax

27
Federal Govt Debt
  • Treasury bills or T-bills Short term
    government bonds with maturities of 13, 26 or 52
    weeks.
  • Treasury notes Intermediate term securities with
    maturities of 2, 5 and 10 years
  • Treasury bonds Long-term securities with longer
    maturities (longest used to be 30 years, but US
    govt stopped issuing 30 years recently)
  • Treasury Inflation Protected Securities (TIPS)
    pay fixed plus inflation

28
Money Market
  • Money Market invests in very short term and
    extremely low risk assets
  • Example Holdings of Vanguard Prime Money Market
    Fund as of 5/31/2005
  • 43.3 in Certificates of Deposit (CDs)
  • 32.2 in Commercial Paper (very short term debt
    from corporations high credit quality)
  • 19.5 in short term debt from U.S. government
  • 4.9 in other

29
REITs
  • Real Estate Investment Trusts
  • Special form of equity that allows investors to
    own small pieces of a large group of real estate
    properties
  • Required to pay out 95 of earnings in the form
    of dividends to shareholders

30
Mutual Funds
  • Can buy a diversified portfolio with a single
    purchase
  • Actively managed funds fund managers try to
    pick stocks with a goal of outperforming the
    market
  • Higher expense fees
  • Passively managed funds hold portfolio that
    tries to mirror the market index
  • Ex SP 500 portfolio
  • Tend to have substantially lower expenses

31
Evidence on Fund Mgmt
  • Very little evidence to support the notion that
    actively managed mutual funds are able to
    outperform passively managed funds
  • Also little evidence to support the notion that
    there is much persistence in fund manager
    performance

32
How Do Investors Behave?
  • Fair amount of evidence that investors sort of
    understand diversification, but are not very
    sophisticated
  • Tend to follow naïve diversification strategies
  • 1/N allocation, where N of choices
  • This means you may be able to affect equity mix
    by choice of funds!

33
This Class Investment Choices
  • 2 stock choices 3 safer choices
  • MM fund
  • Treasury bonds
  • Corp Bonds
  • US Stock
  • Intl stock
  • Allocated ____ to stocks
  • 3 stock choices 2 safer choices
  • MM fund
  • Treasury bonds
  • US Stock (large)
  • US Stock (small)
  • Intl stock
  • Allocated ___ to stocks

Replacing bond fund with equity fund
34
How Do Investors Behave?
  • Evidence also suggests that people rarely
    rebalance their portfolios
  • Example
  • Initially put 50 in bonds, 50 in stocks.
  • After 10 years, stocks have gone up faster, now
    have 35 bonds, 65 stocks.
  • If 50/50 was optimal portfolio, then should
    rebalance
  • Yet most investors do not rebalance.

35
Special Case of Company Stock
  • Many large 401(k) plans offer company stock as an
    investment option
  • 42 of participants
  • 59 of account balances

36
Nov 2001 Co. Stock Holdings
  • PG 95
  • Sherwin-Will. 92
  • Abbott Labs 90
  • Pfizer 86
  • BBT 82
  • Anheuser-Busch 82
  • Coca-Cola 82
  • GE 77
  • Texas Instr. 76
  • Wm. Wrigley 76
  • Williams 75
  • McDonalds 74
  • At its peak, Enron was at 60 of assets

37
Restrictions on Co. Stock
  • ERISA prohibits defined benefit plans from
    holding more than 10 percent of plan assets in
    company stock
  • There are no such restrictions on 401(k) plans
    firm is permitted to match in company stock, and
    there are no caps on total investment in company
    stock

38
Enron and Other Failures
  • Fall 2001 shortly after 9/11
  • Enrons stock implodes
  • From March 2000 to December 2001, Enrons stock
    price fell 99.6 !!!
  • At its peak, 60 of pension assets were in Enron
    stock (closer to 40 around time things went
    really bad)

39
Enron was not unique
Plus several others!
40
More Enron Details
  • Diversification restrictions
  • Match in company stock
  • Employees made own contributions in company stock
  • Blackout period
  • during vendor change
  • THE IMPLICATIONS OF ENRON

41
Response to Enron
  • Lawmakers began to call for new regulation
  • Boxer / Corzine cap at 20
  • What would this do to match policy?
  • PBGC coverage of DC plans
  • Could be disastrous! Why?
  • Some more measured approaches
  • Allowing diversification out of employer stock
  • Restrictions on blackout periods
  • Facilitating more investment advice

42
Company Match Policy
  • Many companies not only offer company stock as an
    investment option, but they make their match in
    company stock as well
  • Prior to post-Enron legislation, participants
    often were restricted in their ability to
    diversify their match out of company stock

43
Effects of Match Policy
  • Employees that work for plans that match in
    company stock tend to put more of their own
    contributions in company stock
  • Why?

44
Why Use Co. Stock?

45
Why NOT Use Co. Stock?

46
BP Amoco Case

47
The Setting
  • August 11, 1998 Amoco and BP announce merger
  • Now it is January 1999
  • Combined plan would have 40,000 employees and 7
    billion in assets
  • How to integrate defined contribution pension
    assets for US employees?
  • What investment options to choose?

48
Comparing BP Amoco Pensions
49
Active vs. Passive
  • Active Beat the market
  • Passive replicate market index
  • Active involves
  • Stock picking, research, more trading, possibly
    higher risks than index
  • Costs may reach 100 b.p.
  • Note Expense ratios generally net of trading
    costs, which may be another 100 b.p.!

50
How Pick Investment Choices?
  • Seeking high returns
  • Seeking low risk
  • Can we achieve both?

51
CAPM
  • In CAPM terms, beta tells us how much an
    individual security varies with the portfolio,
    i.e., the market risk
  • (Ri Rf) ? (Rm Rf) ?i
  • Ri return on asset i
  • Rm return on market
  • Rf return on risk free asset
  • ?i idiosyncratic risk (mean 0)
  • Only market risk is priced or rewarded by the
    market
  • Higher ? ? higher expected return

52
CAPM
ERi
Rm
Rf
?i
1.0
53
CAPM in Practice
  • Run regression of excess returns on a constant
    and the markets excess return
  • (Ri Rf) ?i ?i (Rm Rf) ?i
  • According to CAPM
  • Average ?i will be equal to zero
  • ?i will measure market risk if market goes up
    by 1, security i goes up by ?i
  • Var(?i) measures idiosyncratic risk

54
Meaning of Alpha
  • (Ri Rf) ?i ?i (Rm Rf) ?i
  • What if ?i gt 0?
  • What if ?i lt 0?
  • What is ?i supposed to measure?
  • Remember GMs alpha strategy?

55
CAPM
ERi
?igt0
?ilt0
Rm
Rf
?i
1.0
56
Pre-Merger Investment Options
  • What are the alphas on the BP funds like?
  • What were the BP fund expense ratios like?
  • What role did company stock play?

57
Performance Persistence
  • The Peter Lynch experiment
  • Our penny flipping exercise
  • Why is it so hard to beat the market?

58
How Many Funds?
  • Is one fund enough?
  • Safe Harbor provisions
  • Ruey increase number of core investment options
    to cover wide region of risk-return spectrum
  • What would you do?

59
What did they do?
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