1. 1 (of 35) FIN 200: Personal Finance Topic 21–Diversification and Portfolio Theory Lawrence Schrenk, Instructor

2. 2 (of 35`) Learning Objectives 1. Describe mutual fund styles. ▪ 2. Define index fund and compare it with actively managed funds. 3. Define diversification and explain its impact on the risk of a portfolio. ▪

3. 3 (of 35) Mutual Fund Style Analysis

4. 4 (of 35`) Mutual Fund Style Analysis Style Analysis: Style analysis identifies the process of investing by fund managers that leads them to pick certain kinds of securities. Three factors of style analysis:  Growth  Value  Company Size

5. 5 (of 35`) Mutual Fund Style Factors Growth Managers buy stocks in companies whose earnings are growing rapidly. Value Managers are bargain hunters seeking stocks with low prices compared to intrinsic value. Company Size Managers specialize in small or large companies.

6. 6 (of 35`) Mutual Fund Style Analysis Style determines 85-90% of a fund portfolio’s return. Compares a fund against different indexes. The mix of indexes that are most highly correlated determines the style of the mutual fund manager.

7. 7 (of 35`) Mutual Fund Style Types The mutual fund universe can be divided into six basic styles:  Small cap growth funds  Large cap growth funds  Small cap value  Large cap value  International funds  Fixed income funds

8. 8 (of 35`) Mutual Fund Style Investment style should remain constant  Investment fund managers have no authority to change the asset class  If you purchase a small cap fund, you don't want the manager to purchase international shares. Prospectus should clearly define the market, size company, and style tilt for the portfolio.

9. 9 (of 35`) Manager Style Drift Managers Style Box The style box should not change over time

10. 10 (of 35) Fund Information

11. 11 (of 35`) Internet Sources of Fund Information Use web sites to research a fund.  http://finance.yahoo.com http://finance.yahoo.com  www.businessweek.com www.businessweek.com  www.morningstar.com (also other advisory services, such as Value Line). www.morningstar.com  www.smartmoney.com www.smartmoney.com Check mutual fund companies Internet sites.  www.trendstarfunds.com www.trendstarfunds.com  www.vanguard.com www.vanguard.com

12. 12 (of 35`) Other Sources of Fund Information Mutual Fund Annual Report  Performance, investments, assets and liabilities Financial Publications  Business Week, Forbes, Kiplinger's Personal Finance and Money are sources of information.  Business Week’s mutual fund survey includes information such as the... Fund’s overall rating compared to all other funds, and to funds in the same category. Fund size, sales charge and expense ratio. Performance for best and worst quarters.

13. 13 (of 35) Index Funds

14. 14 (of 35`) 14 Index Funds  Mutual Funds or Exchange Traded Funds which hold specific shares in proportion to those held by an index  Their goal is to match the benchmark performance Why have they come about?  Most actively managed funds have not been able to beat their benchmarks after all fees, taxes and costs.  In an index fund investors accept the index return and risk.  Interestingly, in the process, index funds have tended to outperform most actively managed funds

15. 15 (of 35`) Index Funds Advantages No correlation between last year’s and this year’s winners for actively managed funds Actively managed funds tend to hurt performance through excessive trading, which also generates taxes Actively managed funds generally have higher management fees  0.18% for an index fund  0.80-2.50% for an actively managed fund It is very difficult to beat index funds on a consistent basis after fees and taxes

16. 16 (of 35`) Exchange-Traded Funds Exchange-traded funds (ETFs) invest in the stocks contained in a specific stock market index, like the Standard and Poor’s 500 stock index. Low management fees since there is less need for decisions made by a portfolio manager. Baskets of stocks similar to mutual funds which trade on organized exchanges (661 as of March 2008 - Morningstar) Trade more like stocks

17. 17 (of 35) Diversification

18. 18 (of 35`) Diversification As I start adding more stocks to my portfolio, the volatility begins to go down.  The changes in one stock are cancelling the changes in another stock. But volatility can never reach zero.  All stocks respond to some common factors: inflation, taxes, government policy, etc. Diversifiable Risk versus Market Risk

19. 19 (of 35`) What Happens in Diversification? Number of Stocks Volatility of Portfolio Market Risk Diversifiable Risk

20. 20 (of 35`) Diversification Example Five Companies  Ford (F)  Walt Disney (DIS)  IBM  Marriott International (MAR)  Wal-Mart (WMT)

21. 21 (of 35`) Diversification Example (cont’d) Five Equally Weighted Portfolios PortfolioEqual Value in Each of… FFord F,DFord, Disney F,D,I, Ford, Disney, IBM F,D,I,MFord, Disney, IBM, Marriott F,D,I,M,WFord, Disney, IBM, Marriott, Wal-Mart

22. 22 (of 35`) Individual Returns

23. 23 (of 35`) F Portfolio

24. 24 (of 35`) F,D Portfolio

25. 25 (of 35`) F,D,I Portfolio

26. 26 (of 35`) F,D,I,M Portfolio

27. 27 (of 35`) F,D,I,M,W Portfolio

28. 28 (of 35`) F,D,I,M,W versus F Portfolio

29. 29 (of 35`) LCP versus F Portfolio

30. 30 (of 35`) Decreasing Risk

31. 31 (of 35`) 31 Diversification Diversification is your key defense against market risk  Stay diversified at all times. Pick a fund with many companies in their portfolios within your asset class  Remember where you are in the hourglass. Avoid sector (industry) funds, individual stocks or concentrated portfolios of any kind until you have sufficient education, experience, and assets And even then, keep that percentage of these assets small in relation to your overall assets.

32. 32 (of 35`) Diversification Dimensions Numbers  Total: Number of Stock and Bond Holdings Type  Type of holdings (stocks, bonds, cash) Industry/Sector  Types of firms held Location  Location of companies (geographic area)

33. Project Note 33 (of 35`)

34. 34 (of 35`) Ethical Dilemma