Page 250 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 9: Portfolio Management

9.1 Turning your Goals into a Strategy Notes

Every strategy has certain performance implications. The word strategy implies a conscious
effort to achieve stated goals. Their concern is to at least meet their minimum acceptable return
levels without taking excessive risk. They want a comfortable and stress-free retirement.
The asset-allocation design will determine results in both short- and long-term periods. What's
more, both risk and returns will be driven far more by asset allocation than stock selection or
market timing.

We could have looked at the 20-year, asset-class returns and seen that foreign, small-company
stocks produced the highest return. But putting all the Joneses' money in foreign, small-company
stocks will not produce a comfortable and stress-free retirement. Any asset class can and will
have extended periods of serious under-performance from its long-term trend. And foreign,
small-company stocks can and do have wild swings in short-term performance.
Specification of Investment Objectives

The commonly stated investment goals are income, growth and stability. Since income and
growth represent two ways by which return is generated and stability implies containment of
risk, investment objectives may be expressed more succinctly in terms of return and risk.

Constraints

You might be familiar with the risk-reward concept, which states that the higher the risk of a
particular investment, the higher the possible return. But, many investors do not understand
how to determine the level of risk their individual portfolios should bear. This unit provides a
general framework that any investor can use to assess his or her personal level of risk and how
this level relates to different investments.

9.2 Risk-reward Concept

This is a general concept underlying anything by which a return can be expected. Anytime you
invest money into something there is a risk, whether large or small, that you might not get your
money back. In turn, you expect a return, which compensates you for bearing this risk. In theory
the higher the risk, the more you should receive for holding the investment, and the lower the
risk, the less you should receive.

Determining your Risk Preference
With so many different types of investments to choose from, how does an investor determine
how much risk he or she can handle? Every individual is different, and it's hard to create a
steadfast model applicable to everyone, but here are two important things you should consider
when deciding how much risk to take:

Time Horizon

Before you make any investment, you should always determine the amount of time you have to
keep your money invested. If you have 20,000 to invest today but need it in one year for a
down payment on a new house, investing the money in higher-risk stocks is not the best
strategy. The riskier an investment is, the greater its volatility or price fluctuations, so if your
time horizon is relatively short, you may be forced to sell your securities at a significant loss.

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