PORTFOLIO PROJECT PART 3

SAMPLE 2-FINC340

Portfolio-Findings Paper- Step 3

The process of forming a retirement investment portfolio has been challenging and instructive. I chose a passive management approach, realizing that I do not have the interest in becoming well enough versed in the stock and bond markets to actively manage my portfolio. There are many things to consider when forming a portfolio; the first of which must be how much risk one is willing to take. Once that is established, then one can choose an actively or passively managed portfolio and a top down or bottom up portfolio. The availability of index funds is perfect for someone like me who does not know a great deal about the stock market, and is not willing to spend time acquiring the knowledge that would be required to build a portfolio made up of individual stocks and bonds. Like everything else in America, there are so many choices one can make! I settled on a passively managed portfolio made up of index stock and bond funds of varying risk levels, and a small allocation of the portfolio in a money market account. How this performs will depend in large part on the macro and micro economy in the years to come.

After the financial crisis that began in late 2007, the stock market fell and people who were invested in the stock market saw their portfolios decline. The micro environment was affected by the rising number of mortgage defaults, particularly in the sub-prime mortgage industry, coupled with risky investments and lax regulation which led to the demise of some and the financial decline of other companies and industries on Wall Street. This led to the downturn in the real estate and home building industries and the loss of millions of jobs. Anyone who invested in these industries suffered losses in their portfolios. The macro environment suffered as well. The failures of many companies due to the downturn led to high unemployment, which meant more government spending on unemployment benefits, and less tax receipts. Credit markets froze. A diversified portfolio that contained stocks that were and were not sensitive to the business cycle would not have declined as much as stocks invested only in business cycle sensitive industries (for example jewelry). The macro environment is also where you will see demand and supply shocks. These can be positive or negative, and can be events like tax reduction, an increase in the money supply, an increase in exports, (positive) or OPEC raising oil prices, increased inflation caused by an increase in the money supply, (negative) etc. (Zvi Bodie, 2010)

Another determinant of stock performance is due to the competitive situation that a company faces. Michael Porter said there are five areas of competition which are the “threat of entry from new competitors, rivalry between existing competitors, price pressure from substitute products, the bargaining power of buyers, and the bargaining power of suppliers”. (Zvi Bodie, 2010) An actively managed portfolio must contain an analysis of the companies included with regard to these five areas. An additional area that a person with an actively managed portfolio needs to watch is the leading indicators that show how parts of the economy are trending. Examples are new orders for manufactured goods or the number of permits issued for new housing units. (Zvi Bodie, 2010) These will give an indication how stocks may perform. More specifically, a fundamental analysis should be done on each company in the portfolio. This includes an examination of earnings and dividends and a risk evaluation, which will determine what the proper stock price should be. (Zvi Bodie, 2010)

Interest rates play a key role in the performance of your portfolio, and should be one of the things taken into consideration when deciding on the assets the portfolio will contain. According to the text, investors can look at several factors that will affect interest rates: the savings rate from US households, funds businesses require for capital projects, actions of the Federal Reserve, and inflation. (Zvi Bodie, 2010) My portfolio contains 20% index bond funds, so if I was an active manager, I would be focusing on these areas. If interest rates were to go up, I would not want to maintain a lot of assets in fixed income funds.

The Sharpe Ratio and the Treynor Measure can both be used to measure the performance of a portfolio. The difference between the two is that the Treynor Measure only measures systematic risk, as it assumes your portfolio is diversified. The Sharpe Ratio measures the total risk of your portfolio. If a portfolio is adequately diversified, one should get the same result using either of these performance measures. (Hall)

Investors who buy individual stocks may use one or more Stock Analysis Models. The Dividend Discount Model shows how to estimate what the dividend will be at the end of the year, using dividend, price, and required rate of return values. The Price Earnings Multiple shows the ratio of the stock price to the EPS. Forecasting the P/E Multiple can be difficult as there are many macro and micro situations that can affect this estimate. But you can use this ratio to compare different firms expected rates of growth; a very helpful process if you are actively managing your portfolio. If a firm does not pay dividends, an investor can use the free cash flow model, which shows what cash is available after capital investments are deducted.

Since I did not plan to actively manage my portfolio I have not used many of the performance measures and analysis models discussed above. I chose a passively managed portfolio with the majority of investments in index funds, both stock and bond. The diversity of the portfolio minimizes the risk, as evidenced by the small overall portfolio standard deviation. Exploring the options while analyzing what path I would take was eye opening. There are so many things to consider and so many choices available. I understand now why people choose to have an investment manager. There may be a cost to the investor in terms of the amount of money given for investment and the amount actually invested, but the investor leaves the work to someone whose job it is to know the market and that also knows how to react to macro, micro, and international events. That said, I expect a normal return from my portfolio, barring any serious dips in the economy. I believe that the returns and minimal fees associated with this portfolio are well worth the risk. I look forward to enjoying the results of this investment many years from now!

Works Cited Hall. (n.d.). Evaluation of Portfolio Performance. Retrieved 03 04, 2012, from www.cbe.wwwu.edu: http://www.cbe.wwu.edu/Hall/MBA542/evaluation_of_portfolio_performa.htm Zvi Bodie, A. K. (2010). Essentials of Investments. New York: McGraw-Hill/Irwin.