Introduction
Investments have two aspects; returns and risks that determine their desirability to an investor. In that respect, analyzing the two is crucial, and several models have been advanced for the purpose of identifying most suitable portfolios. In addition, investor's preferences and risk profile determine their investments choices. Thus, a portfolio construction is based on the involved assets return and risk as well as the client’s risk profile. To demonstrate the process of portfolio construction in view of the clients’ profile, this report uses a case of a client with identified investments goals. The report uses a questionnaire to evaluate the clients risk profile and the justification, as well as the methodology for the questions, are provided. In addition, equity and fixed assets are used as the investment options available. Thus, the assets historical performance is used to construct a suitable portfolio with the use of the variance-covariance matrix.
- Questionnaire for the determination of the risk profile of the client.
The following questionnaire was used as a means of evaluating the client’s risk profile upon which the portfolio creation is based.
- Which is the best description of your investment experiences well as understanding of the financial markets
- A new investor started investing last year
- I understand investment basics
- Have been investing on my own for several years thus confident with financial market knowledge
Justification: To identify whether the client has experience in investment hence understand their market understanding.
- Given fixed and equity assets, which asset class would you invest in
- I would invest in both asset classes
- I would only invest in fixed assets
- I would only invest in equity assets
Justification: The question seeks to establish the client’s investment preferences and their understanding of the risks involved with the two asset categories.
- Would you accept higher risk for a higher return
- I can accept high risk for higher returns
- I can accept moderate risk for more returns
- I cannot accept more risk even for a higher return
- I only prefer low-risk investments
Justification: The question seeks to identify the client’s risk appetite given assets that have different risks and expected returns.
- How would you allocate your money
- I would invest all my money in high-risk investments that have a high return
- I would diversify between low-risk and high-risk investments
- I would only invest in low-risk investments
Justification: The question is used to measure the portion of money that the client would be willing to invest in a particular asset given its risk and expected return.
- Which statements best describes you?
- I would avoid any short-term losses
- I would like receiving regular income from my investments
- I would like to protect my investments against inflation
- Would like long-term growth in investment value
Justification: To identify the client’s risk appetite.
- Questionnaire affects the portfolio composition
- Which is the best description of your investment experiences well as understanding of the financial markets
- A new investor started investing last year
- I understand investment basics
- Have been investing on my own for several years thus confident with financial market knowledge.
Methodology: The implications of the client’s responses on experience for the listed possible answers can be interpreted as follows.
Answer a) No experience and market understanding.
Answer b) little market understanding
Answer c) Better market understanding of the return and risk involved.
- Given fixed and equity assets, which asset class would you invest in
- I would invest in both asset classes
- I would only invest in fixed assets
- I would only invest in equity assets
Methodology: The implications of the client’s responses on asset class choice for the listed possible answers can be interpreted as one who would be willing to incest in both fixed assets as well as equity assets.
- Would you accept higher risk for a higher return
- I can accept high risk for higher returns
- I can accept moderate risk for more returns
- I cannot accept more risk even for a higher return
- I only prefer low-risk investments
Methodology: The implications of the client’s responses on risk for the listed possible answers can be interpreted to mean that the client can accepts a highest risk for higher return.
- How would you allocate you money
- I would invest all my money in high-risk investments that have a high return
- I would diversify between low-risk and high-risk investments
- I would only invest in low-risk investments
Methodology: The implications of the client’s responses on diversification for the listed possible answers can be interpreted to mean they are ready to invest an equal portion even for high risk assets.
- Which statements best describes you?
- I would avoid any short-term losses
- I would like receiving regular income from my investments
- I would like to protect my investments against inflation
- Would like long-term growth in investment value
Methodology: The implications of the client’s responses on risk and timeframe for the listed possible answers can be interpreted that they would ne willing to accept short-term fluctuations for long-term high returns.
- Expected returns for equity asset class using the Dividend Discount Model
- Dividend Discount Model
Identifying the fair value of an investment requires use of its discounted cash-flows. The term discounted is used to represent the time value of money since future payments are worth less that the same payment at the current time. On the other hand, dividends represent the cash-flows from the assets hence the need to discount them to reflect the investments value. Thus, the model is a critical valuation tool for dividend-paying assets, and most straightforward form is represented by the Gordon Growth Model. Some of the advantages of using the model are that it is applicable to all markets and simple to use. In addition, dividend growth can be calculated using macro data while its can also be used for assets that can be repurchased like the equity assets in this case. Thus, the return for each asset are calculated by considering the sum of the dividend returns and the price gain as shown on the excel file. (James, & Farrell, 2010)
- Converting monthly returns to annual returns
Return statistics for equity assets are often calculated in monthly terms thus a need to convert them to the annual returns. The process of converting the monthly returns to annual returns as computed in the excel file has been done as follows. The monthly returns are changed from a percentage to decimal numbers. The numbers are added the value 1 and then the computed values for all twelve months are multiplied to provide a factor for a given year. Finally, the value 1 is subtracted from the calculated annual factor, and the computed value becomes the annual return for that year. (Strong, 2009)
- Increasing the accuracy of the forecasting methodology
The following analysis demonstrates different time horizon’s expected return as well as variance with reference to Australian Equity. That is meant to identify the model’s efficiency in forecasting for long term returns over different timeframes of ten years long-term horizon, medium-term returns of 5 years and short-term returns for 3 years
Given the above calculations of the AUS Equity returns and risk, there is an indication that increases in the period under consideration is increasing the expected return value as well as the risk involved. That means that the longer the period, the better the forecasting as the returns and risk involved are not underestimated. In that view, the analysis has used a period of 34 years historical data beginning the year 1980 to 2013 for all assets to construct a portfolio. (Strong, 2009)
- Expected return for all the assets
Expected returns for investments are the weighted average of its likely returns. The following table shows the calculated expected returns and risk for individual assets given their historical performance.
The asset with the highest return is the long-term bond with 0.71% while AUS Equity has the lowest return. On the other hand, Cash has the highest risk with a S.D of 0.41% while USA Equity has the lowest risk with an S.D of 0.19%. (Bodie, Kane, & Marcus, 2008)
- Portfolio construction: Variance covariance matrix based on the historical returns
- Variance
Variance measures the variability of a variable in a given data. Thus, variance can be summarized as the average squared deviation from the elements mean score. (Bengtsson & Holst, 2002)
- Covariance
Covariance measures the degree of change for variables and the extent of their variation. A positive covariance of two variables is an indication that they vary in the same direction relative to the expected values. On the other hand, a negative covariance is an indication that variables vary in the opposite direction. Finally, a zero variance shows that there is no linear dependence between the variables. (Bengtsson & Holst, 2002)
- Variance-covariance matrix
Variance - covariance is a square matrix that has the variances and covariance that for various variables. The matrix’s diagonal elements represent the variances while the off-diagonal represents the covariance of all possible variables’ pairs. The following is the matrix for the four asset classes.
The variance-covariance matrix shows that the asset combination with the highest covariance bond and cash while that with the lowest covariance is the combination between AUS Equity and US Equity. Thus, the two portfolios fall in the category of optimizing portfolios. (Bengtsson & Holst, 2002)
- Portfolio report: An optimal portfolio composition based on the answers to the questionnaire and considering the four possible asset classes of AUS Equity, US Equity, Cash and Long-term Bond.
- Overview
The client’s suitable portfolio is based on their objectives and investment plan. That includes a planned investment of $10m for ten years after which they intend to purchase a large vineyard and its attached winery in Southern Australia whose expected value is $15m. Further, there is a small probability that he will have to pay back a business loan of whose maturity value is $9,500,000 after three years. However, they plan to renew the loan but if the bank refuses he will have to invest his personal wealth. In addition, if, at the maturity of the loan, the bank requires full payment and the client is unable to comply, the bank will extend an emergency loan and charge a costly extra fee. Thus, the clients plan has the following implications.
- They have funds equivalent of $10 million that is available for investment over the next ten years.
- The investment portfolio chosen should be able to provide a maturity value of $15 million after the ten years.
- The funds available have a cost that will be at the end of the set three years when the clients could be needed to renew the loan. That means that the investment should be able to cover the high cost of finance.
- The client’s risk profiling summary
Investors’ attitudes towards risks differ given the differences in experience, expectations and ability to take the risk. Thus, it is crucial to considering a client's risk tolerance and profile before recommending an investment portfolio. That involves considering their comfort with possible loss of their, money or with the possibility that the expected return could vary from one period to another.
Some of the key aspects of a client's profile can be summarized as follows
Classification of risk profiles and investment styles and the client’s category
- Conservative: The client’s investment goal would be capital protection as they would require a stable growth and access to their investments in a period of about three years.
- Cautious: The client’s investment goal is also capital protection with the need for a moderate level of income and an investment time frame of three year and above.
- Moderate: The client has a capital growth goal and can tolerate some fluctuation in the short term in anticipation of higher returns in a period of about five years.
- Moderately aggressive: The investor has a primary goal of capital growth. In addition, they can tolerate fair fluctuations in investments value in short-term with expectation of high returns in long-term of up-to ten years.
- Aggressive: The client investment goal is long-term capital gain and can tolerate high fluctuations in their investments’ value in short-term as they anticipate higher returns in the long-term period of ten years and above. (Bodie et al., 2008)
Thus, the client in this case can thus be classified as moderately aggressive based on the following evaluations.
- Risk Tolerance
Establishing an investment strategy that suits the client requires understanding their risk tolerance. That involves considering the possibility that the investment’s value may decrease but may be temporary. That sought to identify whether the client is prepared to accept negative return possibility at any time in exchange for possible higher returns in the long-term. That will helped identify that the client would be willing to invest equal portion of the available funds between individual assets regardless of the risk involved as they would be comfortable investing in higher risk assets. (Strong, 2009)
- Investment Goals and Objectives
They identify the reasons for the client’s investments in short terms of long-term periods. Thus, short terms investments would mean a person with the need for the money in a short-term hence a need to consider low-risk investments. On the other hand, clients with long-term investment goals can invest in high-risk assets. In that view, the client was identified to have long-term investment goals. (Strong, 2009)
- Investment Timeframe
It considers when the client would need their money. That would define immediate, short-term, mid-term or long-term investments timeframes. In that respect, the clients’ time frame is provided by the investment goals set at ten years and beyond hence defining them as long-term investors who would accept higher risk in short-run for possible higher returns in long-run. (Bodie et al., 2008)
- Income and cash needs
The client’s source of investment funds in crucial in determining their investment strategy. In that respect, the consideration of the client’s loan that is repayable in three years defines the cost of funds and the possibility of a repayment. Further, the client already has $10 million that is not needed for spending in the short-term, but the property buying after the ten years period. (Strong, 2009)
- Optimal portfolios
The modern portfolio theory states that investors construct portfolios with the aim of maximizing the expected returns given the level of investment risk. It also makes an emphasis that risk is an inherent part of higher returns. In that respect, the optimizing portfolios in this case are Bond & Cash, which maximizes the expected return and the US Equity & AUS Equity that minimizes the risk involved. In that respect, an investor with a high-risk appetite would choose the first portfolio while a risk averse investor would choose the risk maximizing portfolio. (Bodie et al., 2008)
- Portfolio choice
Given the above summary of the possible portfolios and the client’s risk profile, the most suitable portfolio is the one that maximizes the return regardless of its risk. That is because the client is moderately aggressive thus can accept high risk for a higher return in the long-term. In that view, the most suitable portfolio is the one of Bond and Cash as it has the highest expected return of 0.66%. In addition, the portfolio has the highest risk of 6.12%, but which the client would be willing to accept. (Ledoit & Wolf, 2003)
References
Bengtsson, C. & Holst, H. (2002). “On portfolio selection: Improved covariance
matrix estimation for Swedish asset returns”, Working paper, Lund University and Lund Institute of Technology, 2002.
Bodie, Z., Kane, A. & Marcus, A. (2008). Investments. 8th ed. New York: McGraw-
Hill/Irwin.
James, L. & Farrell, J. (2010). The Dividend Discount Model: A Primer. Financial Analysts
Ledoit, O. & Wolf, M. (2003). Improved estimation of the covariance matrix of stock
Returns with an application to portfolio selection. Journal of Empirical Finance, 10: 603-621
Strong, R. (2009). Portfolio Construction, Management and Protection. 5th ed. London:
Richard D. Irwin Inc.
