How to Build an Investment
PortfolioInvestors have many assets to choose from, ranging from basic checking and savings
accounts in banks to stocks and bonds to complex financial securities.What principles should investors follow as they build an investment portfolio? We begin by examining the objectives of investors. You might expect that investors will attempt to earn the highest possible rate of return on their investments. But suppose you have the opportunity to choose an investment on which you expect a rate of return of 10% but on which you believe there is a significant chance of a return of -5%.Would you choose that investment over an investment where you expect a return of 5% and do not believe there is a chance of a negative return? Would your answer be different if you had $1,000 in investments than if you had $1,000,000? Would your answer be different if you were 20 years old than if you were 60 years old?
The Determinants of Portfolio Choice
Different investors will give different answers to the questions just raised. There are many ways to build an investment portfolio. Even investors with the same income, wealth, and age will often have very different portfolios. There are five basic criteria that investors use to evaluate different investment options. These determinants of portfolio choice, sometimes referred to as determinants of asset demand, are:
accounts in banks to stocks and bonds to complex financial securities.What principles should investors follow as they build an investment portfolio? We begin by examining the objectives of investors. You might expect that investors will attempt to earn the highest possible rate of return on their investments. But suppose you have the opportunity to choose an investment on which you expect a rate of return of 10% but on which you believe there is a significant chance of a return of -5%.Would you choose that investment over an investment where you expect a return of 5% and do not believe there is a chance of a negative return? Would your answer be different if you had $1,000 in investments than if you had $1,000,000? Would your answer be different if you were 20 years old than if you were 60 years old?
The Determinants of Portfolio Choice
Different investors will give different answers to the questions just raised. There are many ways to build an investment portfolio. Even investors with the same income, wealth, and age will often have very different portfolios. There are five basic criteria that investors use to evaluate different investment options. These determinants of portfolio choice, sometimes referred to as determinants of asset demand, are:
- . The saver’s wealth or total amount of savings to be allocated among investment
- . The expected rate of return from an investment compared with the expected rates of return on other investment
- . The degree of risk in the investment compared with the degree of risk in other investments
- . The liquidity of the investment compared with the liquidity of other investment
- . The cost of acquiring information about the investment compared with the cost of acquiring information about other investments We’ll now consider each of these determinants.
Wealth Recall that income and wealth are different. Income is a person’s earnings during a particular period, such as a year. On the other hand, wealth is the total value of assets—such as stocks and bonds—a person owns, minus the total value of any liabilities—such as loans or other debts—that a person owes. As a person’s wealth increases, we would expect the size of the person’s financial portfolio to increase but not by proportionally increasing each asset. For instance, when you first graduate from college, you may not have much wealth, and the only financial asset you have may be $500 in a checking account. Once you have a job and your wealth begins to increase, the amount in your checking account may not increase very much, but you may purchase a bank certificate of deposit and some shares in a money market mutual fund. As your wealth continues to increase, you may begin to purchase individual stocks and bonds. In general, however, when we view financial markets as a whole, we can assume that an increase in wealth will increase the quantity demanded for most financial assets
Expected Rate of Return Given your wealth, how do you decide which assets to add to your portfolio? You probably want to invest in assets with high rates of return.As we saw in Chapter 3, though, the rate of return for a particular holding period includes the rate of capital gain, which an investor can calculate only at the end of the period. Suppose that you are considering investing in an IBM 8% coupon bond that has a current price of $950. You know that you will receive a coupon payment of $80 during the year, but you do not know what the price of the IBM bond will be at the end of the year, so you cannot calculate your rate of return ahead of time. You can, though, make informed estimates of the price of the bond one year from now, so you can calculate an expected rate of return (which we simplify to expected return).
To keep the example simple, suppose you believe that at the end of the year, there are only two possibilities: (1) The bond will have a price of $1,016.50, in which case you will have earned a capital gain of 7% and a rate of return of 8% + 7% = 15%; or (2) the bond will have a price of $921.50, in which case you will have suffered a capital loss of -3% and will have a return of 8% -3% = 5%. The probability of an event occurring is the chance that the event will occur, expressed as a percentage. In this case, let’s assume that you believe that the probability of either of the prices occurring is 50%. In general, we calculate the expected return on an investment using this formula:
One way to think of expected returns is as long-run averages. That is, if you invested in this bond over a period of years, and your probabilities of the two possible returns occurring are correct, then in half of the years you would receive a return of 15% and in the other half you would receive a return of 5%. So, on average, your return would be 10%. Of course, this is a simplified example because we assumed that there are only two possible returns, when in reality there are likely to be many possible returns.We also assumed that it is possible to assign exact probabilities for each return, when in practice that would often be difficult to do. Nevertheless, this example captures the basic idea that in making choices among financial assets, investors need to consider possible returns and the probability of those returns occurring.
a probability of 50% or a return of 8% with a probability of 50%. The expected return on the GE bond is
or the same as for the IBM bond. Although the expected returns are the same, most investors would prefer the GE bond because the IBM bond has greater risk. So far, we have mentioned default risk and interest rate risk, but economists have a general definition of risk that includes these and other types of risk: Risk is the degree of uncertainty in the return on an asset. In particular, the greater the chance of receiving a return that is farther away from the asset’s expected return, the greater the asset’s risk. In the case of the two bonds, the IBM bond has greater risk because an investor could expect to receive returns that are either 5 percentage points higher or lower than the expected return, while an investor in the GE bond could expect to receive returns that are only 2 percentage points higher or lower than the expected return. To provide an exact measure of risk, economists measure the volatility of an asset’s returns by calculating the standard deviation of an asset’s actual returns over the years. If you have taken a course in statistics, recall that standard deviation is a measure of how dispersed a particular group of numbers is.
Most investors are risk averse, which means that in choosing between two assets with the same expected returns, they would choose the asset with the lower risk. Riskaverse investors will invest in an asset that has greater risk only if they are compensated by receiving a higher return. Because most investors are risk averse, in financial markets we observe a trade-off between risk and return. So, for example, assets such as bank CDs have low rates of return but also low risk, while assets such as shares of stock have high rates of return but also high risk. It makes sense that investors are usually risk averse because many individuals purchase financial assets as part of a savings plan to meet future expenses, such as buying a house, paying college tuition for their children, or having sufficient funds for retirement. They want to avoid having assets fall in value just when they need the funds.
Some investors are actually risk loving, which means they prefer to gamble by holding a risky asset with the possibility of maximizing returns. In our example, a risk-loving investor would be attracted to the IBM bond with its 50% probability of a 15% return, even though the bond also has a 50% probability of a 5% return. Finally, some investors are risk neutral, which means they would make their investment decisions on the basis of expected returns, ignoring risk.
Most investors are risk averse, which means that in choosing between two assets with the same expected returns, they would choose the asset with the lower risk. Riskaverse investors will invest in an asset that has greater risk only if they are compensated by receiving a higher return. Because most investors are risk averse, in financial markets we observe a trade-off between risk and return. So, for example, assets such as bank CDs have low rates of return but also low risk, while assets such as shares of stock have high rates of return but also high risk. It makes sense that investors are usually risk averse because many individuals purchase financial assets as part of a savings plan to meet future expenses, such as buying a house, paying college tuition for their children, or having sufficient funds for retirement. They want to avoid having assets fall in value just when they need the funds.
Some investors are actually risk loving, which means they prefer to gamble by holding a risky asset with the possibility of maximizing returns. In our example, a risk-loving investor would be attracted to the IBM bond with its 50% probability of a 15% return, even though the bond also has a 50% probability of a 5% return. Finally, some investors are risk neutral, which means they would make their investment decisions on the basis of expected returns, ignoring risk.
No comments:
Post a Comment