1. The Investment Process
Finance 352
Fundamentals of Security Analysis
Dr. Stephen Morrell
Fall Semester, 2015
COURSE NOTES I

2. Preliminary Issue
Investment in equities as well as investment in any other types of either “real” or “financial” assets is a form of saving.
Definition of Saving: Current income not spent on current consumption.
Without saving there can be no investment and, except for safe guarding purposes, no financial sector, no financial institutions, no financial markets and no financial securities.

3. Steps in the Investment Process FIN 352 covers steps 1-4 and the first part of step 7; FIN 470 covers steps 5-10 and the second part of step 7.
1. Investor Objectives.
2. Permissible Asset Classes.
3. ‘Do It Yourself’ or Hire a Professional?
4. Investment Strategy and Tactics.
5. Investment Policy.
6. Portfolio Construction/Asset Allocation.
7. Security Selection/Build the Portfolio.
8. Risk Management.
9. Performance Evaluation.
10. Repeat Steps 1- 7as Conditions Warrant.

5. Step 1 Investor Objectives: The Most Important Step. Five Parts
Purpose(s) of the Investment Fund.
Investor Fund Horizon.
Terminal Wealth and Return Objectives.
Digression -Types of Investors.
Digression - Dodd-Frank Act
Investor Risk Tolerance.
Investor Constraints.

6. P1. Purpose(s) of the Fund
Why is the institution/individual establishing an investment fund in the first place?
Provide financial support to the organization’s operating and/or capital budgets.
Precautionary – “rainy day” savings to help ensure sustainability of the institution.
Opportunistic investments and purchases.
Retirement purposes.
Finance new home, children’s education, bequests to charities, intergenerational transfers.

7. P2. Investor Fund Horizon
How long does the investor plan to operate the fund, contribute monies on balance to it, and have the contributed monies invested before they intend to start on balance withdrawing the monies?
Some institutional investors, such as defined benefit pension plans and endowment funds, have investment horizons that, in concept, stretch into perpetuity. Others, such as VC, Private Equity and Hedge Funds, may have investment horizons that extend only a few years.
Does the length of the horizon affect the design and composition of the portfolio? That is, are some types of securities better investments over longer/shorter horizons? If so, WHY? What is the evidence on investment returns and time horizons?

8. P2: Investor Fund Horizon, cont’d
“The results are not reassuring. We find no evidence of long-term mean reversion in the expanded data sample. Downside risk declines very little as the time horizon lengthens.”
“There is some good news. Diversification across assets pays off. Over a century a global stock market index displayed less downside risk than any single market. Cross country diversification is more effective than time diversification.”
“Phillipe Jorion. “The Long Term Risks of Global Stock Markets.”

9. P3. Return Objectives: Start at the end and work back to the present
1. How much does the investor want in the fund when they start, on balance, to withdraw monies from it? In other words what dollar/currency Terminal Wealth/Net Worth does the investor seek (W)?
2. Determining W
Purpose of the Fund, such as finance a capex, pay liabilities, retirement income.
Macro and market conditions expected over investment horizon, including inflation and taxes over investment horizon.
Years to Terminal Wealth Date (T).
4. Initial Investment (A), annual contribution – if any - growth Rate (g) of Initial Investment.

10. Return Objectives, Continued
Given W, T, A, and g we can solve for R, the Annual Target Return.
Solving for R is the solution to the future value of an ordinary annuity and, in the case where g> 0, the future value of a growing annuity.
Note: Ranges for returns may be preferable to point targets.
W = A[(1+R)T -1] Rapx = W/A = {(1+R)T -1} use excel Rate function
R R
W = A[(1+R)T – (1+g)T] for R≠g
R-g
W = A[T(1+R) T-1] for R≈g.

11. Types of Investors: Two Broad Categories
Type 1: Retail/Individual Investors. Includes IRA, 401(k), ‘Day Traders,’ and Social/Investment Clubs.
Type 2: Institutional Investors. Private Sector Firms, Non-Profit Organizations, and Public Sector Organizations Who Invest Primarily on Behalf of Retail Investors and Other Institutions as well as for their ‘Own - Proprietary Accounts.’
ent/
The above link from the Federal Reserve provides, among other things, aggregate data on stock and bond holdings of retail households and institutional investors as of December 11, 2014.

12. Types of Institutional Investors
Pension Plans.
Private Sector Pension Plans.
Public Sector Plans.
ERISA Laws.
Defined Benefit & Defined Contribution Plans.
Investment Companies/Mutual Funds.
Open – End Mutual Funds.
Closed – End Mutual Funds.
Exchange – Traded Funds (ETF).
Unit Investment Trusts.
Real Estate Investment Trust (REITS)
Investment Company and Investment Advisor Acts of
Insurance Companies.
Health and Life.
Property and Casualty.
Regulations.

13. Institutional Investor’s Continued
4. Trusts.
Usually Division/Department of a Commercial Bank.
Personal Trusts and Corporate Trusts.
OCC, FDIC, Federal Reserve.
5. Asset Management/RIA Companies.
May be an Independent Firm, or Part of a Larger Financial Services Organization (FSO).
Invest for Individuals and Institutions.
SEC, FINRA, Investment Advisor Act of 1940
6. Security Brokers and Dealers.
Invest for Their Own Firm’s Account.
May be Part of a Larger FSO.
SEC/NASD Regulations.

14. Institutional Investors, Continued
7. Private Equity Funds.
Raise Money from “Accredited Investors.”
SEC Rule 502,Section D.
Less Public Scrutiny & Regulation.
Invest Generally for Minimum 3 years in Higher Risk/Higher Return (often) LBOs/MBOs.
UCC Fraud, Misrepresentation, etc. Laws. Now some regulations under Dodd – Frank Law of 2013.
8. Hedge Funds.
Name a Misnomer.
Generally Pursue Very High Return/High Risk Strategies.
UCC Fraud, Misrepresentation, etc. Laws. Now, some regulations under Dodd – Frank Law of 2010.

15. Institutional Investors, Continued
9. Venture Capital Firms.
Raise Money from “Accredited Investors.”
Equity Investments in Early Stages of Companies.
Seek Return When Company ‘Goes Public.’
High Return and High Risk.

16. Institutional Investors, Completed
10. Endowment Funds.
Monies Donated to Non-Profit Organizations, e.g. Universities, Hospitals, Charities, etc. that are part of their ‘Permanent Capital.’
11. Sovereign Wealth Funds.
Investment Funds Operated by National Governments.
12. Algorithmic/High Frequency/Dark Pools.
May be an Independent Firm, or Part of a Larger Financial Services Organization (FSO).
Program trading, nanosecond trading, unidentified traders.
There are Significant Legal, Tax, and Regulatory Difference Between the 12 Types of Institutional Investors.

17. The Dodd – Frank Act
In late 2013 the U.S. Congress finalized a seismic, wide-ranging overhaul of the U.S. financial sector. The new law is called the Dodd- Frank Act. A link to a summary of it is can be found below: ank_Wall_Street_Reform_comprehensive_summary_Final.pdf

18. RISK TOLERANCE P4.INVESTOR OBJECTIVES-
The next step in specifying investor objectives is to determine the investor’s tolerance for risk.
Risk is defined as the probability that
the actual return on the portfolio
will be different from the expected one.
That is, the likelihood that the
actual dollar amount of “terminal wealth’ will be different from the desired one.
The above definition of risk, however, gives equal importance to actual returns both greater than and less than the desired one(s).

19. Risk Tolerance: The Subjective/Personal Side
Investors may be only one of the following at any point in time: Risk Averse: Risk is, in and of itself, undesirable. Risk Neutral: Risk is neither good nor bad. Risk Peferrers: Risk is, in and of itself, desirable. In Investments we assume that investors are Risk Averse because of the entirely reasonable assumption of Diminishing Marginal Utility of Wealth. Why are investors risk averse? ct

20. Risk Tolerance, Continued
The Concept of DMUW
Definition: As a person’s wealth increases so does their utility. But, beyond some amount of wealth, an additional unit of wealth provides a smaller increase in utility.
Implications:
Suppose that an investor is at the point of DMUW.
Then, the gain in utility from obtaining an additional unit of wealth is less than the loss in utility from losing a unit of wealth. “Losing Hurts Worse Than Winning Feels Good.”
As a result, investors are more averse to a loss than they have a preference for a gain.
k/riskaversion.htm
s.stern.nyu.edu/~adamodar/New_Home_Page/risk/riskaversion.htm

23. Risk Tolerance, Continued
As a result, investors will always prefer lower risk investments to higher risk ones, other things equal (ceteris paribus). That is, there is always a greater demand for lower risk than higher risk investments.
In order to be induced to invest in higher risk investments, risk averse investors must be compensated with higher expected returns.
Is the relationship linear, curve-linear, exponential, etc.? It depends on the investor’s Utility Function. timization/
Risk, Risk Premia, and Returns.

24. New Developments in Assessing Risk
There is still much we do not know about investor attitudes towards risk and the factors which change it.
Several years ago a new perspective called Prospect Theory emerged. One implication of this vein of research is that investors are risk averse when it comes to gains and risk preferers when it comes to losses!
micae/Figures/Prospect.htm

25. Even Newer Developments in Assessing Risk
Neuro Science: The study of how the human nervous system works. This includes the brain.
/pii/S
neuroscience-of-risk/

26. Measuring Your Degree of Risk Aversion
A number of surveys have been developed purporting to measure the magnitude of investor risk aversion. One such survey may be found at: k-tolerance-survey.php A recent important research article in the field may be found at: effects/measuring-investortrader-risk- aversion

27. Return and Risk: Objective Measures
Finally, we will need objective measures of return, that is how well or poorly our investments have performed, and objective measures of risk.
A variety of such measures exist. While none are ‘perfect’ we nonetheless need to know: (a) what they are; (b) how to calculate them; (c) how to interpret, analyze, assess, evaluate and use them in investment decision making.

28. P5. Investor Objectives : Constraints.
An internal constraint is one or more limitations the investor places on the investment process. Constraints will affect the composition of the investor’s portfolio. Prohibited Investments, such as no investments in companies that manufacture nuclear weapons; Cash Withdrawal Needs, such as the investor needs to withdraw $X per year from the portfolio are examples of internal constraints.
An external constraint is a limitation placed on the investment process owing to regulatory, tax, or legal requirements. The ‘prudent expert’ rule applied to Defined Benefit plans; diversification requirements for mutual funds are examples of external constraints.

29. Step 2 Permissible Investment Classes
In Step 1, we defined the investors Goals, Time Horizon, Expected Returns E(r); Risk Tolerance (s2), and any Constraints.
The next issue is to determine the broad investment classes – types of securities that can possibly be used to achieve the objectives.
The number, type and variety of investable securities is expanding at a stunningly rapid pace. It is part of the sweeping innovation taking place in the financial sector.
Each asset class has a different (historic) return and risk.

30. Aset Classes, Continued
Equities/ Stock. Global Market Capitalization $70 Trillion, U.S. = $ 28 Trillion
1. Large Capitalization: Greater than $5 billion market capitalization.
2. Mid-Cap: $1 billion - $5 billion.
3. Small – Cap: Less than $1 billion.
4. International/ Developed.
5. International/Emerging Market.
6. International/Frontier.
Bonds/Fixed Income. Global Market Capitalization,$170Trillion.
U.S. = $44Trillion.
1. U.S. Treasury Bonds.
2. U.S. Government Agency/ GSE Bonds.
3. Corporate Bonds.
4. Municipal Bonds.
5. Asset Backed Securities (ASB)
6. International Government, Corporate & Emerging Market Bonds.
Hybrid Securities – Securities with Features of Stocks and Bonds.
1. Convertible Bonds.
2. Preferred Stock.

31. Asset Classes, Continued
IV. “Risk Free”/ Cash Equivalents. $ 11 Trillion .
1. U.S. Treasury Bills.
2. Bank Certificates of Deposits.
3. High Grade Commercial Paper.
4. Eurodollar Deposits.
V. Derivative Contracts. Global Notional Total = $360Trillion.
1. Options.
2. Futures.
3. Forwards.
4. Swaps.
5. Swaptions.

32. Asset Classes, completed.
VI. Commodities.
VII. Collectibles.
VIII. Real Estate.
IX. Human Capital.

33. Step 3: Do It Yourself, Or Hire a Professional.

34. Step 4 Active versus Passive Management
Active Investment Management: Investment Strategies and Policies Designed to Earn Returns that Consistently “Beat the Market.” AKA “Positive Alpha Strategies.” Question: What is meant by consistently beating the market? Answer: Earning a return, adjusted for risks, taxes, expenses and inflation that consistently exceeds relevant benchmark indices. Question: What percent of ‘public’ investors are successful with active strategies? Answer: (a) 10%. (b) 30%. (c) 20%. (d) none of the above.

35. Active versus Passive Strategies
Question: “How does one consistently beat the markets?”
Answer: “Consistently be among the first to find mis-priced markets and securities.”
Question: “Ok, so how do I consistently be among the first to find these mis-priced markets and securities ?”
Answer: “Be consistently smarter and harder working than most everyone else;” OR find and nurture your passion.
Michael Lewis, The Big Short: Inside the Doomsday Machine. W.W. Norton & Company,

36. Active versus Passive Strategies, completed
Passive Investment Management: Investment Strategies and Policies that are designed to consistently earn returns that are approximately the same as those of relevant, benchmark indices.
Passive strategies involve buying the relevant market indices, e.g. the S&P 500, the Barclays Aggregate, the GSCI, etc.
Passive strategies are generally much less expensive to design, develop and implement than active ones.

37. Step 5: Investment Policy Statement
Roadmap and Blueprint for all important aspects of investing.
Needs to be:
Clear and understandable;
Establish Expectations for the purpose(s) and goal(s) of the investments.
Delineate method(s) by which goals will be achieved.
Develop processes for management, review, evaluation, and changes.

38. Investment Policy Statement
1. Client Description (include brief history, mission) 2. Purpose(s) of the Portfolio (Step1,Part1above) 3. Investment Governance (responsibilities of parties) 4. Investor Objectives (time horizon, return target(s), risk tolerance, internal & external constraints. Step1, Parts 2-5) 5. Investment Strategies (Step 4 active, passive, mixed,) 6. Asset Classes & Styles. 6. Benchmark Indices & Performance Measures. 7. Risk Management Processes. 8. Schedule for Performance Evaluation 9. Re-balancing guidelines. 10. Review and Revisions to the Process.

39. Step 6 The Asset Allocation Process
Asset allocation is the apportionment of the investment funds among the selected, permissible asset classes in order to achieve the investor’s objectives.
Research indicates that the asset allocation decision accounts for 90 plus percent of investment performance compared to security selection and market timing.
The asset allocation process is a technically challenging one.
Distinguish between ‘strategic,’ ‘dynamic’ and ‘tactical’ asset allocations.

40. Step 7 Security Selection
After the decision on how to allocate assets among stocks, bonds, etc. the next step is to select the specific stocks, bonds, etc. to put into the portfolio.
Active managers must research dozens of countries and markets, scores of sectors and industries, thousands of stocks and bonds in this step searching for mis-priced securities. All of this is expensive.
Passive managers, in contrast, must research dozens of countries and markets.

41. Step 8 Risk Management
Investor’s subjective risk tolerance – Part 4 of Step 1.
How is portfolio to be structured to meet this?
Identify and weight sources of risk.
Determine measure(s) of risk.
Establish processes for measuring & monitoring risk.
Establish processes for controlling sources of risk.

42. Step 9 Performance Evaluation
Periodically, the return on the portfolio, adjusted for risk, expenses, taxes, inflation, etc. must be compared to the investor’s objectives and benchmarks.
How well/poorly is the portfolio performing? How is performance measured?
How can the performance of the portfolio be explained?
What changes should be made?

43. Step 10 Restructure the Portfolio as Conditions Warrant.
Changes in investor objectives.
Changes in expected market conditions, e.g. changes in expected returns, risks, correlations of returns.
Changes in the number and types of investable securities.
Regulatory and tax law changes.