Transcript Slide 1

FIN 200:
Personal Finance
Topic 21–Diversification and Portfolio
Theory
Lawrence Schrenk, Instructor
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Learning Objectives
1.
2.
3.
Describe mutual fund styles. ▪
Define index fund and compare
it with actively managed funds.
Define diversification and
explain its impact on the risk of
a portfolio. ▪
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Mutual Fund Style
Analysis
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Mutual Fund Style Analysis
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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:
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Growth
Value
Company Size
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Mutual Fund Style Factors
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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.
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Mutual Fund Style Analysis
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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.
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Mutual Fund Style Types
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The mutual fund universe can be divided into
six basic styles:
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Small cap growth funds
Large cap growth funds
Small cap value
Large cap value
International funds
Fixed income funds
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Mutual Fund Style
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Investment style should remain constant
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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.
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Manager Style Drift
Managers Style Box
The style box should not change over time
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Fund Information
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Internet Sources of Fund Information
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Use web sites to research a fund.
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http://finance.yahoo.com
www.businessweek.com
www.morningstar.com (also other advisory services, such
as Value Line).
www.smartmoney.com
Check mutual fund companies Internet sites.
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www.trendstarfunds.com
www.vanguard.com
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Other Sources of Fund Information
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Mutual Fund Annual Report
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Performance, investments, assets and liabilities
Financial Publications
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Business Week, Forbes, Kiplinger's Personal
Finance and Money are sources of information.
Business Week’s mutual fund survey includes
information such as the...
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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.
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Index Funds
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Index Funds
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Index Funds
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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?
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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
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Index Funds Advantages
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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
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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
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Exchange-Traded Funds
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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
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Diversification
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Diversification
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As I start adding more stocks to my portfolio,
the volatility begins to go down.
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But volatility can never reach zero.
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The changes in one stock are cancelling the
changes in another stock.
All stocks respond to some common factors:
inflation, taxes, government policy, etc.
Diversifiable Risk versus Market Risk
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What Happens in Diversification?
Volatility of Portfolio
Diversifiable Risk
Market Risk
Number of Stocks
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Diversification Example
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Five Companies
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Ford (F)
Walt Disney (DIS)
IBM
Marriott International (MAR)
Wal-Mart (WMT)
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Diversification Example (cont’d)
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Five Equally Weighted Portfolios
Portfolio
F
F,D
F,D,I,
F,D,I,M
F,D,I,M,W
Equal Value in Each of…
Ford
Ford, Disney
Ford, Disney, IBM
Ford, Disney, IBM, Marriott
Ford, Disney, IBM, Marriott, Wal-Mart
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Jul-07
Jan-07
Jul-06
Jan-06
Jul-05
Jan-05
Jul-04
Jan-04
Jul-03
Jan-03
Jul-02
Jan-02
Jul-01
Jan-01
Jul-00
Jan-00
Jul-99
Jan-99
Individual Returns
Individual Monthly Returns
40%
30%
20%
F
10%
DIS
IBM
MAR
0%
WMT
-10%
-20%
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F Portfolio
F Portfolio Monthly Return
40%
30%
20%
10%
F
0%
-10%
-20%
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F,D Portfolio
F,D Portfolio Monthly Return
40%
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20%
10%
F,D
0%
-10%
-20%
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F,D,I Portfolio
F,D,I Portfolio Monthly Return
40%
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20%
10%
F,D,I
0%
-10%
-20%
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F,D,I,M Portfolio
F,D,I,M Portfolio Monthly Return
40%
30%
20%
10%
F,D,I,M
0%
-10%
-20%
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F,D,I,M,W Portfolio
F,D,I,M,W Portfolio Monthly Return
40%
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20%
10%
F,D,I,M,W
0%
-10%
-20%
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F,D,I,M,W versus F Portfolio
F,D,I,M,W versus F Portfolio Monthly Return
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10%
F
F,D,I,M,W
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-20%
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LCP versus F Portfolio
LCP versus F Portfolio Monthly Return
40%
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20%
10%
F
LCP
0%
-10%
-20%
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Decreasing Risk
Portfolio Standard Deviation
12%
10%
8%
6%
4%
2%
0%
F
Average
Standard Deviation
F,D
F
-0.90%
10.92%
F,D,I
F,D
-0.26%
7.83%
F,D,I,M
F,D,I
0.00%
6.82%
F,D,I,M,W
F,D,I,M F,D,I,M,W
0.27%
0.29%
6.45%
5.64%
LCP
LCP
0.51%
5.01%
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Diversification
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Diversification is your key defense
against market risk
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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.
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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.
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Diversification Dimensions
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Numbers
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Type
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Type of holdings (stocks, bonds, cash)
Industry/Sector
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Total: Number of Stock and Bond Holdings
Types of firms held
Location
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Location of companies (geographic area)
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Project Note
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Ethical Dilemma
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