SU5- Financial Planning & Portfolio Management
Financial planning
Investment policy statement (IPS)
Individual
Business
Different scenarios
Optimal project evaluation
Methods
Investment portfolio
Risk
Return
Management process
Performance evaluation methods
E.g. mortgage/retirement/savings/investment plan
Financial models- helps to make financial decisions
Assistance- investment managers, financial planners
What?
Strategic guide to plan, implement investment
Customised to unique investor
Based on
Objectives
Tolerances
Restrictions
Preferences
Key components
Purpose, scope
Governance
Procedures
Definition
Investor's factual data e.g. assets to be used
Investment manager's duties
Asset custodian
Who determines and executes policy?
Who monitors results?
To update IPS
To respond to situational changes
Goal
Return
Risk tolerance
Of each asset class
Investment
Client's conditions, constraints, risk tolerance
Customised investment strategy
Performance evaluation benchmark
Absolute (nominal/real term)- does not indicate how good
Relative- performance compared to some benchmark (e.g. an index)
Ability (quantitative)- defined by life circumsances
Willingness (qualitative)
Time horizons
Asset vs liability amt
Saving rate
Income vs expenses
Job security
Explicit/implicit
Risk-aversion questionnaire
Categories (diff attitudes, behaviours)
Averse (avoiding)- satisfaction/utility from gain < dissatisfaction from loss of equal amt
Neutral (indifferent)- satisfaction/utility from gain = dissatisfaction from loss of equal amt
Seeking (loving)- satisfaction/utility from gain > dissatisfaction from loss of equal amt
Liquidity
High- many large near-term expenditure (e.g. living fees)
Related to lifestyle, preferences
Age-related- length of time to reach investment goal
Longer- can tolerate more risk, less liquid
Tax minimisation considerations
Debts- (/non) tax-deductible
Investment accounts
Tax-exempted/deferred
Fully taxable
Consider after-tax returns over time
Profile- ethical/religious/personal preferences
Investor type e.g. corporate account cannot invest in some asset types
Plan
Long-term
Short-term e.g. working capital daily/monthly cash inflow and outflow
Sales forecast
Financing
Amt needed
Way to acquire
Capital investment
Decision factor
Value creation
Mission alignment
E.g. PPE procurement, new product development, mergers
Revenue, cost, capital requirements
Salvage/terminal value at project end
Independent vs. mutually exclusive (opportunity cost considerations) projects :
Project sequencing- some projects can only be executed in a specific order
Unlimited funds (can undertake all profitable projects) vs capital rationing (prioritise projects to maximise shareholder returns, working around budget constraints)
NPV- diff btw PV of initial cash investment and future cash flow
IRR
Payback period (PBP)
Discounted PBP
Profitability index (PI)
Years to recover initial investment cost
Risk indicator- considering liquidity needs
Does not account for time value of money
Years to recover initial investment cost in PV terms
Accounts for TVM
PV of future cash flow/initial cash investment
Scales NPV to each investment dollar
Decision rule
PI > 1- accept
P1 = 1- indifferent
PI < 1- reject
PI > 1 = positive NPV
Depends on weighted returns of individual assets within the portfolio
Weight of individual asset = asset market value / portfolio market value
Volatility (variance/SD)- how returns fluctuate over time
Depends on weighted risk of individual assets within the portfolio
Asset allocation
Rebalancing
Diversification
Steps
Correlation
Within asset class- high
Between asset classes- low for diversification
Asset class selection- based on economic conditions, macroeconomic variable forecasts
Security categories selection e.g. short/long-term bonds
Bottom-up security analysis- to identify undervalued securities
Specify each asset class % allocation
Feedback step
Realign asset weights/mix- per changing investor circumstances
Recommended frequency- min. once yearly
Limits exposure
Portfolio risk- depends on asset class covariances
More asset class- mitigates risk
Conventional
Risk-adjusted
Benchmark comparison- against broader market index
Style comparison- against portfolio with similar investment style
Adjust portfolio returns
Accounts for portfolio and benchmark risk diff
Methods
Sharpe ratio
M-squared measure (Modigliani risk-adjusted performance measure)
Sortino ratio
Risk-free return per total portfolio risk unit
Portfolio return - risk-free return = excess return; investor reward
Large positive ratio- better
Negative ratio- portfolio performing below risk-free rate
Caveat- assumes return follow normal distribution
Sharpe ratio in %
Allows for meaningful interpretation
Focus- downside deviation (instead of total volatility)
Portfolio returns for a given level of bad risk
Larger ratio- higher return; better
Maximum drawdown (MDD)
Risk-indicator- maximum loss (from a peak to bottom) before new peak; volatility downside
Express in %- usually negative
Large absolute $- potential of great loss