A TRADITIONAL LONG ONLY PORTFOLIO FOR AN INVESTOR
When a person invests money in a stock market or any other type of market, he/she expects to make money. However, in the worst event, a person may lose part or whole of that money if investment decisions are made inappropriately. To minimize the risks of losing huge sums of money in the worst scenario, an investor must determine his/her appetite risk right at the start of investment. In addition, the right combinations of equities and assets should be made by the person investing the money on behalf of the investor (Hansen 2009). As an illustration of the manner in which a person can invest money in stock market and other types of markets for a long-term goal, this essay creates a traditional long-only portfolio for a client wishing to generate a stable income for retirement.
The first part starts by identifying the client’s short, medium and long-term goals including the growth and defensive objectives that will be utilised to ensure that the client achieves the long-term objective. The second part goes ahead to providing the strategy that would be utilised to ensure that the client achieves his objectives whereas the third part lays out the strategies that would be utilised to allocate assets effectively in line with client’s appetite for risk and market correlations. The fourth part provides the method that would be utilised to backtest the effectiveness of the portfolio whereas the fifth part concludes the essay by providing a general overview of the investment process.
Three classes of assets namely: bonds, property and equities were included in the portfolio. The rationale behind including them was that they would facilitate diversification. On one hand, it was presumed that because properties tend to do well during inflation, then they would protect the portfolio from adverse effects of inflation. On the other hand, it was presumed that equities would enable the portfolio to grow through high returns whereas bonds would act as defensive assets. Throughout, the portfolio was managed in a manner aimed at attaining the highest possible returns relative to the investor’s appetite for risk. Accordingly, active risk positions were taken in a balanced manner to avoid exposing the portfolio to high portions of total risk (Fraser-Sampson 2011). In addition, they were managed in a manner that could allow the portfolio manager to convert them into cash at any given time to provide money for unexpected changes in the composition of the portfolio without necessarily incurring strangely high operation costs. More importantly, the rebalancing mechanisms were carried out in line with applicable rebalancing guidelines that had been determined right at the start of the investment exercise as per the instructions of the investor.
To enhance the sustainability of the investment, the relevant laws and regulations were observed while investing in various markets. The high yield bonds were utilised as the defensive assets even though it was understood that their potential rate of return in the long-term would be relatively low compared to other types of assets. In line with understanding thereby, only a considerable amount of the money was allocated to them. Both local and international bonds were included in the portfolio to take advantage of the varying interest rates in different parts of the world. However, to minimise the negative effects of variations in foreign exchange rate on the profit made, investment in international bonds was made cautiously and was preferred for long-term goals as opposed to short-term goals (Salo, Keisler & Morton 2011). As a result, during the first part of the investment period, the focus on defensive assets was largely on local bonds, but it changed slowly as time went by.
On the other hand, the local and international shares formed the growth asset class of the portfolio. These comprised of the high performing shares in the market that were relatively less volatile to dynamics in the market. Priority was given to financial shares that were relatively on an upward trend in contrast to agricultural shares that were on a downward trend most of the time. In addition, priority was given to companies that pay higher dividends as part of their growth strategies. The intention of doing this was to take advantage of the high dividends within the short and medium term before relatively stable shares could be identified in the long-run.
While investing in international shares, the market correlation between various international markets and local market was considered to inform the decisions. The international markets with high correlation to the local market were ignored when investment had been made in local shares (Marston 2011). In contrast, those with relatively low correlation with local market were preferred over their counterparts with high correlation with the local market while making further investment. Finally, part of the money acquired from the stock market during the medium term period was invested in property whereas part of it was invested in Real Estate Investment Trusts (REITs) listed on the stock market (Hansen 2009). Nonetheless, because of the high transactional costs related to these assets including their low liquidity tendency only small amount of money was invested in these assets despite their possible growth rate. The intention of doing this was to develop a diversified portfolio that would withstand market dynamics.
The most important part of any investment portfolio is the type of objectives that a person wishes to achieve at a specified time. Depending on what one wishes to achieve the objectives may be in short, medium or long-term. The short-term objectives define what a person wishes to achieve within the shortest time probably within a year or a period lesser than a year. Given the market dynamics, a person may not target huge profits unless one is focused on taking excessive risks that may be risky. However, during this period, a person may be able to monitor the market and determine the goals that may be achieved during that time.
Besides the short-term goals, a person may define the medium term goals that he/she wishes to achieve probably within a period of between two and five years. During this time, the market dynamics might have stabilised to the extent of determining with some level of accuracy what one can achieve within the stipulated time (Ferri 2010). However, once again, an investor may not be able to predict with accuracy the goals that would be achievable in the future. As a result, there is a need to develop long-term goals that may extend beyond ten years. With the help of these goals, one would be able to tell what is achievable within a stock market and that which cannot be achieved in it.
In line with the above understanding, the portfolio’s objectives were in different levels and categories. The first category focused on short-term objectives that defined the goals the portfolio was supposed to achieve within a period of a year and within a few months. Some of those goals included safeguarding the initial investments to ensure that they were able to generate stable and predictable returns within the specified timeframe. In developing this objective, the investor understood that returns within this period would be moderate meaning that nothing much would be expected from them. Another short-term objective was focused on generating liquidity at any given time meaning that the investor could be able to obtain money from certain investments if there was a need to do that without necessarily waiting for the specified time (Hughes 2005). The purpose of doing this was to facilitate investment to be made in the most profitable assets given that the investor was likely to make minor mistakes in selecting the assets.
The second category focused on medium-term objectives that defined the goals that the investor wished to achieve within a period of between two and five years. The medium goal for the investor was focused on generating a stable income from the stock market through interest rates from high yield bonds and dividends paid on annual basis. Another goal was focused on enhancing objectives attained in the short-term and developing further objectives. The third category focused on the long-term objectives that defined the goals the portfolio was supposed to achieve within a period of between 10 to 15 years and above (Anson, Fabozzi & Jones 2011). In this case, the main goal was to generate a stable income from the stock market with a capacity to enable the investor to retire peacefully and build a residential home within a period of 15 years.
To meet the above three categories of objectives, part of the assets were focused on defending the portfolio whereas another part was focused on growing it. The growth objective resulted in investing in growth asset classes that had the potential of earning higher rates of returns. The rationale of including this type of assets in the portfolio was that even though the assets would be vulnerable to high risks of volatility, they would earn high margins of profit in the long-term if the investor could hold onto them for a longer period (El-Erian 2008). Some of the assets included in the portfolio in line with objective were shares both local and international, property securities both local and international as well and direct properties.
In making the above decision, the investor understood that even though share prices could fluctuate in value throughout the period especially during the medium and short term, they had the capacity to increase in value in the long-term. Accordingly, most of the shares that were bought were never sold as soon as their prices dropped a bit or as soon as they increased in prices slightly. Instead, the investor focused on staying on course to earn dividends and sell them at the end of the investment program once the long-term objective had been achieved. In line with this objective, a wide range of shares was included in the portfolio as part of diversification method to lessen the impact of volatility in a single share or a small number of them (Brentani 2003). In addition, shares from international markets that were considered less correlated to the home market were included in the portfolio to enable the investor benefit from a wide range of industries and markets.
Besides the above, part of the money was invested in property securities, which in contrast to buying investment property or house, entailed investing in Real Estate Investment Trusts (REITs) listed on the stock market. The intention of investing in this type of property was to enable the investor to enjoy income from such investments while at the same time retaining the ability to obtain that money at any given time if need be in line with short and medium-term goals. Furthermore, part of the money that was obtained from short and medium term goals was invested in direct property for renting purposes (Hansen 2009). However, only a small part of that money was invested in this asset class due to the inability to convert the assets into cash at the time of need.
In relation to defence objective, part of the money was invested in defensive assets that were relatively less volatile, but with lower potential rates of return in the long-term. The intention of doing this was to ensure that while part of the money was invested in risky businesses, it was safeguarded by those invested in less volatile business (El-Erian 2008). In spite of this, because the portfolio was focused on growth a substantial amount of the money (60%) was invested in shares both local and international. In addition, another portion (20%) was invested in high yield bonds both local and international whereas the other portion (20%) of the money was invested in property both REITs and direct properties. This investment decision was informed by the fact that money invested in real estate would be relatively hard to obtain for further investment than that invested in shares and short-term bonds. As a result, a larger portion of the money was invested in shares that were relatively liquid.
The first step in implementing an investment strategy starts by understanding the return ambitions and risk tolerances for a client. This helps to determine the asset classes that would be utilised in an investment strategy. However, this depends on the constraints of each asset class that would be included in an investment portfolio. The proposed strategy will include the local and international shares, the local and international high yield bonds and real estate equities. Once this has been done, the next step goes ahead to determine the characteristics of each asset class in terms of expected returns, their possible variances and standard deviation. Table 1 provides the probable characteristics of the various assets classes that would be included in the proposed strategy.
Upon determining the characteristics, the next step would entail deriving an efficient portfolio comprising of the different asset classes. Such a portfolio would be efficient if, for specified risk levels, it would maximise the expected returns. Standard mean variances would be utilised as a measure of risks in terms of volatility (Brentani 2003). Finally, the next step would be to select the portfolio that would serve as a strategic benchmark. It would involve analysing several return/risk measures for various asset combinations on the basis of the efficient frontier. Its risk measures would be as Table 2 depicts. It provides the various combinations with their respective expected return, standard deviation and variances.
Once the above has been done, the focus would now shift to implementing the preferred exposures. This would involve making several considerations on the basis of the client’s risk appetite and market volatility. The main problem with traditional long-only portfolio is that it tends to allocate a higher degree of risk on the portfolio by allocating more stocks than any other asset class. The problem with this strategy is that stocks are prone to higher volatility risks than other asset classes. Nonetheless, their rates of returns tend to be significantly higher than that for other asset classes. This is in spite of the fact that higher returns in the stock market are directly linked to higher levels of volatility. Accordingly, anybody wishing to maximise returns should risk more money whereas anybody wishing to protect his/her investment should invest in the less volatile assets such as bonds.
The most important thing in investment is investing for long-term goals as opposed for short-term goals because stock changes that occur within short-term are unpredictable and short-lived. Previous studies suggest that the longer an investor invests money in a stock market the more that person is likely to benefit from the market. Analysts argue that since it is not possible to predict what might happen in the future, the majority of the people who invest for short-term goals tend to forego the long-term gains in the stock market. For this reason, it would be advisable to develop a long-term tactical strategy for the client to give him the chance of benefit from long-term gains in the market. Nonetheless, in doing so, it would be important to determine with accuracy the amount of money an investor would be willing to invest in stock market, the amount of time the person would be willing to invest the money and the goals that investor wishes to achieve at the end of the investment period.
Furthermore, it would be important to determine the type of risk that an investor would be prepared to take, whether the investor would be willing to incur high transactional costs and evaluate the most suitable asset class for a client (El-Erian 2008). Doing this would help to create a clear roadmap that would be utilised to invest money in a stock market or any other type of market. The most important thing to remember is that the best investment strategy would be the one that would enable one to achieve desired objectives with the correct balance of trade-off between returns and risks.
Portfolio: Asset Allocation
In the light of the above, both strategic and tactical asset allocation methods were utilised to apportion the three classes of assets. Strategic method entailed setting and sustaining long-term portfolio structures in line with investor’s appetite for risk and long-term objectives. The intention of utilising this method was to help the investor increase the possibilities of benefiting from the three classes of assets that were included in the portfolio while smoothing out the volatility effect of the various markets (Anson, Fabozzi & Jones 2011). On the other hand, the tactical method entailed changing the portfolio on a short-term basis to take advantages of the changes that were occurring in the market on a short-term basis. This entailed reviewing assets allocated to each combination on a periodical basis and adjusting them accordingly. It started by allocating a hundred percent of the money available for investment to shares/stocks to determine the possible rate of return (Kaplan 2012). Then a small portion was allocated to bonds thereby reducing the shares’ portion by a small proportion. The process went on to determine the best combination by varying allocation until the right combination was attained in line with diversification practices.
To determine the exact amount of money that could be invested in each asset class, the Excel program was utilised to allocate funds effectively. The first step in allocating assets effectively entailed determining the expected return from each asset class based on the overall long-term objective (El-Erian 2008). In this case, the long-term objective was focused on generating high income from stock market capable of providing a retirement package and part of the money that could be utilised to build a residential home. In line with this objective, it was determined that the annual rate of return from stocks/shares would be 11% whereas that from bonds would be 2 percent and that from properties would be 4 percent (Table 1).
The second step entailed determining the variance of return from each asset class, which was determined to be 180% for stocks, 40% for bonds and 70% for properties (Table 1). As the figures indicate, returns from stocks/shares were expected to vary significant at 180 percent. In contrast, returns from high yield bonds were expected to vary minimally at 40 percent whereas returns from properties were expected to vary at 70 percent. Their respective standard deviations were 134 percent for shares, 63 percent for bonds and 122 percent for properties.
The third step entailed determining the correlation between various asset classes that were included in the portfolio. As Table 1 depicts the correlation between bonds and shares was 0.3 whereas that between properties and shares was 0.6 and that between properties and bonds was 0.1 (Anson, Fabozzi & Jones 2011). This suggests that there was higher correlation between properties and shares and least correlation between properties and bonds. The fourth step, on the other hand, entailed determining the right mix of the assets that could maximise returns in line with investor’s appetite for risks. This involved computing the expected return for each combination by multiplying the assets’ expected return by the possible allocation and adding them to obtain the possible return as the Excel output depicts. Afterwards, the annualised standard deviation was plotted against annualised possible return to determine the best combination as Figure 1 depicts.
In line with investor’s appetite for risk and market volatility, it was determined that the best combination would be 60 percent on shares, 20 percent on bonds and another 20 percent on properties (Kaplan 2012). This would give an expected rate of return of about 7.8 percent of the money that would be invested as Figure 1 depicts. In spite of this, Figure 1 depicts that if the investor would invest all the money in stocks, he would earn the highest returns even though the returns’ variability would be high. In contrast, if the investor would invest 50 percent of the money in property and another 50 percent in bonds, then the rate of return would be the least even though return variability would be least. For this reason, to maximise returns, the investor has to invest part of the money in shares, another part in property and another part in bonds as Figure 1 depicts.
Upon determining the right amount of money that could be allocated to each asset class, the process of selecting the right mix of bonds, properties and shares from the stock market involved selecting assets in each class on the basis of their performance. For the shares, the high performing shares with high dividends were evaluated first to determine their viability in the portfolio. Similarly, the high yield bonds were considered first before other bonds were evaluated to determine their viability based on authorities providing them (El-Erian 2008). Furthermore, the REITs were also evaluated to determine the most rewarding ones with minimal variability.
Back Testing the Portfolio
After the portfolio was developed, it was then necessary to backtest it to determine its viability in comparison to future possible returns. To do this, a simulation test was carried out using an online backtesting tool. The process entailed inserting a time period by specifying the start and end period in terms of years together with an initial amount that the investor would invest in the stock market. The portfolio assets were then selected for the various assets that would be included in the portfolio on the basis of the preferred asset allocation of 60 percent shares, 20 percent bonds and 20 percent properties. Upon inserting the assets, the online tool calculated the respective portfolio results that depicted the possible amount of return for each possible allocation. The output provided the final balance that the investor would have made at different points including their respective standard deviation and other relevant figures (Kaplan 2012). It was determined that based on historical data the portfolio would generate varying results based on the portfolio assets that were included in the analysis. The back testing’s rationale was that if a similar strategy could have worked in the past, then it could work in the future if things would not change significantly. Similarly, it was presumed that if a similar strategy could not have worked in the past, then it was not necessary to bother developing a comparable strategy.
In spite of the above, it was noted that past performance did not necessarily guarantee that the stock market would behave in the same way because of the possible errors and the fact that the market does not follow a pre-determined path. However, it was noted that it could provide an overview of what might happen in the future based on the repeated of a similar trend in the future. In spite of this, a comparison of the past performance on the basis of back testing is instrumental in any investment because it depicts what might happen or not happen in the future (Anson, Fabozzi & Jones 2011). Normally, it depicts that volatility may vary from one asset class to the other thereby heightens the importance of diversification.
Besides the above, the asset allocation for each asset class was varied at different levels. The first process entailed allocating all the money to bonds and determining the possible rate of return that could be obtained from that combination. It was determined that the bonds would provide 2 percent of the total investment. Although this was a good defensive combination, it was the worst in terms of returns. Then all the money was allocated to properties; the combination provided a 4 percent rate of return that was relative lower than the one for shares (El-Erian 2008). As a result, it was determined that the combination would not be good based on the growth objective that had been set right from the start of the investment program. Other combinations were made, but with a special attention on bonds because they were meant to play a defensive role. As a result, a significantly larger part of the money was allocated to bonds in other alterations to determine their possible effect on the portfolio. The least amount of money was allocated to properties because once invested, it would have been almost impossible to obtain it to re-invest it in other assets.
Upon backtesting the portfolio, it was determined that the expected rate of return would decrease as more money was allocated in bonds and properties. However, it was determined that the portfolio variance and standard deviation would decrease as a lot of money was allocated in property and bonds. Nonetheless, given that one of the portfolio’s objectives was to grow the portfolio while defending it, this was not the best alternative (Kaplan 2012). As a result, it was determined that the 60 percent share allocation, 20 percent bond allocation and 20 percent property allocation would be the best allocation in the midst of all possible allocations. While this process was not mandatory, it was necessary to ensure that the right decision was made in line with the investor’s objectives and risk appetite.
Figure 2 depicts that growth rate objective would be maximised at 100 percent stock/share allocation. It further indicates that it would decrease as stock/share allocation decreases. Nonetheless, it depicts that a slight growth rate would be realised with an increase in bond and property allocation. Since the growth rate would not equal that of 100 percent share allocation, then it would not maximise growth objective if an investor would be willing to risk all the money. However, it would defend the portfolio from high volatility levels suggesting that it would maximise the defensive objective.
The essay has evaluated the diversification process that would be utilised to invest money for an investor who intends to grow his money with a long-term objective of developing a retirement package capable of building him a residential home. Since it would be risky to invest all the money in shares despite the high rate of return, it was determined that it would be necessary to diversify the investment to protect it from possible negative market effects. In addition, since the portfolio was focused on growing the investment, it was determined that it would not be advisable to invest all the money in bonds. Furthermore, it was determined that because investing all the money in the property would deny the investor from benefiting from high returns from shares, then it would not be advisable to invest a significant amount of money in property. Overall, it was determined that even if diversification would reduce the amount of money that would be invested in shares with a high rate of returns; it would protect the investment from possible negative effects of the market. Accordingly, it was determined a substantial amount of the money should be invested in shares and a relatively small amount of money in properties.
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Table 1: The expected return, variance and standard deviation for asset classes
Table 2: The possible asset combinations
Figure 1: The probable stock-bond-property combination
Figure 2: The possible growth rate