1. I nvestment A nalysis II Investment Analysis II - © 2012 Houman Younessi MGMT-6330 Investment Analysis II 1 Investment and Spending Goals Having your cake and eating it too is it possible? Yes, but only if your cake is growing at least at the rate you are eating it

2. I nvestment A nalysis II Investment Analysis II - © 2012 Houman Younessi 2 Why maintain a stable/growing portfolio? Maintain independence Maintain agility Maintain stability Maintain excellence

3. I nvestment A nalysis II Investment Analysis II - © 2012 Houman Younessi 3 Failing to plan, is planning to fail You must have a very concrete set of investment goals (It is best/easiest if you only have one) Always a trade off between Injection (outside) and reinvestment (inside) Today and tomorrow

4. I nvestment A nalysis II Investment Analysis II - © 2012 Houman Younessi 4 Investment Policy Three important factors: How to accumulate (in-flow) How to maintain and grow (investment philosophy) How to spend (out-flow) A concrete and measurable set of goals and processes stating the general investment objectives of a client describing the strategies that the manager should employ to meet these objectives. Specific information on matters such as asset allocation, risk tolerance, and liquidity requirements are part of a well-form investment policy An investment policy is usually formally captured in an Investment Policy Statement NOTE: The manager may be the investor her/himself

5. I nvestment A nalysis II In-flow May be in the form of : - Savings - Gifts OR - Reinvestment OR Combination of both May result in some restrictions (e.g. Grandpa’s gift has strings attached, or a donor wants investment in classroom equipment) Limits current spending (payout)

6. I nvestment A nalysis II 6 Investment Analysis II - © 2012 Houman Younessi Investment Philosophy Every fund manager has a way of approaching his or her job. The basis on which a fund manager invests is called their Investment Philosophy

7. I nvestment A nalysis II 7 Investment Analysis II - © 2012 Houman Younessi Investment Philosophy Every investment philosophy is contingent upon three factors: Asset Mix Market Timing and Security Selection

8. I nvestment A nalysis II 8 Investment Analysis II - © 2012 Houman Younessi Security Selection Accept Illiquidity Inefficient markets are where the best opportunities lie. Be where everyone else is not. Chasing strong returns and forgetting the weak performers is a recipe for NOT being able to consistently beating the market (why? Because everyone else is doing the same thing, and everyone else IS the market!!) buy future value

9. I nvestment A nalysis II Investment Analysis II - © 2012 Houman Younessi Asset Mix 9 Diversification is Key In forming a portfolio, a prudent investor combines assets that react fundamentally differently to market forces (everyone knows this) What they don’t tell you is that certain assets have proven to return better than others. This is mainly due to their inefficiency and illiquidity. For instance small cap stock have out performed US Treasury bills by an approximately 2300 times (1800-Present) Aim for a diversified yet equity market oriented portfolio

10. I nvestment A nalysis II 10 Investment Analysis II - © 2012 Houman Younessi Why does an equity orientation make sense? Because we assume that industry adds value In an environment where those firms whose equities we purchase are believed to add value, a $ borrowed (i.e. Treasury bill, bond, etc.) should return more than a $ of value in the same period. If we could find and buy into opportunities that are in the process of adding value at a rapid rate, we are succeeding.

11. I nvestment A nalysis II 11 Investment Analysis II - © 2012 Houman Younessi Market Timing Overzealous attempts at predicting how the market might behave will cause the investors to react at an inappropriate time. Such time difference, in turns causes the portfolio to differ from what our investment policy dictates. (more on this later) Proper risk control requires regular portfolio rebalancing so that the portfolio closely reflects the investment policy (and therefore is aligned with its goals) at all times.

12. I nvestment A nalysis II 12 Investment Analysis II - © 2012 Houman Younessi Regret, Pride and Market Timing The main reason why most investors do not take action when they should (that is they have incorrect market timing) are that they form an emotional attachment to their investments and investment decisions. The two foremost emotions are: Regret: of having done, or not having done something Pride: in having done, or not having done something

13. I nvestment A nalysis II 13 Investment Analysis II - © 2012 Houman Younessi Regret, Pride and Market Timing We avoid regret and seek pride Therefore we sell our winners too soon and Keep our losers too long This is called the disposition effect This hurts investors in many ways: The winner that will continue to win is sold, therefore we will not benefit from the additional growth We sell winners and pay capital gains tax We do not sell losers to realize tax advantage Losers we still hold, will continue to lose money for us We increase trading frequency and as such lose margin to fees

14. I nvestment A nalysis II 14 Investment Analysis II - © 2012 Houman Younessi Regret, Pride and Market Timing Sometimes investors get emotionally entangled in how to calculate profits or losses Example: Al bought a stock at $50 three years ago. Two years ago it hit $186. Last year it hovered around $135 for the better part of the year. Lately the stock has been declining. Today Al sold the stock for $81. How do you think Al is feeling right now? How would you be feeling if you were Al? OR

15. I nvestment A nalysis II 15 Investment Analysis II - © 2012 Houman Younessi Regret, Pride and Market Timing Some reference points: All time high 52 week high Purchase price Price last sold some

16. I nvestment A nalysis II Investment Analysis II - © 2012 Houman Younessi Out-flow 16 Balance between current and future purchasing power Preserving maximum portfolio value Maximizing flow of funds to operating budget Extreme case Pay nothing out Extreme case Cash everything out

17. I nvestment A nalysis II 17 Investment Analysis II - © 2012 Houman Younessi Out-flow In reality the policies range Only pay out the inflation adjusted net after all costs earnings that is Make sure that the principal is protected against inflation and all costs are paid from the pay-out not from the principal Of course, you cannot have this every year Pay out just enough to cover the current needs that is Irrespective of conditions, cover current needs even though the principal is not inflation and cost protected Of course, this will eventually erode the base (humans are greedy) TO:FROM:

18. I nvestment A nalysis II Investment Analysis II - © 2012 Houman Younessi 18 Disbursement (Spending) Policy No successful investment policy may be sustained without a clear disbursement (spending) policy A clear, concise and measurable spending policy makes the job of portfolio management a lot simpler and therefore, potentially more successful Spending policy must be sensitive to the current needs of the investor but it must consider such needs within the context of the overall long-term strategic objectives [That is; the investor’s overall long-term well-being and not just their financial long-term well-being] After all, what is money for?

19. I nvestment A nalysis II 19 Investment Analysis II - © 2012 Houman Younessi Investment Policy Statement An Investment Policy Statement (IPS) is a physical document that can be a few to several dozen pages long which captures the essence of the investment policy for the organization or the individual. There are no legal requirements for establishing an IPS. However, A number of legal standards strongly imply the existence of an IPS as a minimum requirement for satisfaction of other legal requirements. An example of such standard is the Employee Retirement Income Security Act (ERISA) that expects the existence of an IPS as the basis for the correct discharge of the fiduciary responsibilities of the trustees.

20. I nvestment A nalysis II Executive Summary Statement of IPS purpose (purpose of document) Investment philosophy: Inflow Outflow Spending policy, etc. Investment Methodology: Roles and Responsibilities Investment domain and options (e.g. allowables, exclusions, etc.) Selection criteria (of the allowable securities) Procedures and time scales Portfolio monitoring processes (procedures of keeping the portfolio balanced) Plan document (IPS) maintenance (keeping the IPS and investment philosophy in balance. 20 Investment Analysis II - © 2012 Houman Younessi Investment Policy Statement A good IPS must – at a minimum – contain the following sections:

21. I nvestment A nalysis II 21 Investment Analysis II - © 2012 Houman Younessi Investment Policy Statement Let us review a few

22. I nvestment A nalysis II Investment Analysis II - © 2012 Houman Younessi Who decides and how? 22 In an institutional setting, the investment (and therefore spending) policy is set and controlled by the board of trustees/regents/directors/etc. The board has ultimate fiduciary responsibility over the portfolio A board’s purpose is to strategize regarding the future versus current needs of an investor Generally a balance between asset preservation and pay-out is struck. A linear or exponential smoothing model may be used

23. I nvestment A nalysis II Investment Analysis II - © 2012 Houman Younessi 23 What personal characteristics must board members have? They must be: Competent – But know the limits of theory Confident – But not overly so Controlled (in control of their biases) – But not robots Connected (informed of what is going on and able to exert some influence) But not corrupt also helps if they are:

24. I nvestment A nalysis II Investment Analysis II - © 2012 Houman Younessi Over-confidence 24 Most people are over-confident, we are probably wired that way We tend to take credit for our successes and blame our failures on others or on bad luck

25. I nvestment A nalysis II Investment Analysis II - © 2012 Houman Younessi In terms of investing, this means: 25 Most people over-trade (have higher turn-over than necessary) Most people take on more risk than necessary Even if you were right in selling A and buying B (usually not the case with over-confident investors), the trading fees will kill you In the long-run, you lose more than you need to for the same amount of return intended

26. I nvestment A nalysis II Investment Analysis II - © 2012 Houman Younessi 26 Causes of over-confidence: Illusions of : Knowledge Choice Outcome sequence Task familiarity Active involvement Past success Availability of technology

27. I nvestment A nalysis II 27 Investment Analysis II - © 2012 Houman Younessi Financial Assets Financial Asset: Current or future ability to purchase Three forms: Cash: Immediate or near immediate purchasing instrument Contract: A financial right or obligation set not necessarily through a document Security: A document that confers upon its owner a financial claim Note: Cash is arguably a form of security or a form of contract depending on how we look at it.

28. I nvestment A nalysis II 28 Investment Analysis II - © 2012 Houman Younessi Financial Assets Securities Cash Contract Fixed IncomeEquities Fixed income: instruments that pay a fixed amount of money to their owners Equity: A security that confers to its owner the right to a part of and a corresponding portion of profits of an economic concern. An equity is sometimes called a share

29. I nvestment A nalysis II 29 Investment Analysis II - © 2012 Houman Younessi Fixed Income Bonds Money-Market Accounts Savings Accounts … Bond: A security purchased by its owner called the creditor; at an agreed amount called the bond price that gives the owner the right to a fixed, pre-determined payment called the nominal value (or face value, par vale or principal); at a future, predetermined date called the maturity date (or simply maturity).

30. I nvestment A nalysis II 30 Investment Analysis II - © 2012 Houman Younessi Equities Shares Stocks Stock: An equity issued by a company called the issuer and usually sold and traded by a third party (such as an exchange) and purchased and held by an owner called the stockholder.

31. I nvestment A nalysis II 31 Investment Analysis II - © 2012 Houman Younessi Contracts Simple Contracts Derivatives Derivative: A contract whose payoff depends on the value of another financial variable such as the price of a stock, price or maturity of a bond, an exchange rate, or the price or another feature of another derivative)