3. Investment Planning. 10. Formula Investing & Invest. Strategies Flashcards
Assume the market has been steadily growing for a while and there are rumors that it may be overheating. Would this be a bad time to have a client make an investment? Assume the market has been steadily going south for a few years, and another downturn follows every sign of a rebound. Would now be a good time for your clients to invest their money? The most important part of investment planning is identifying the client’s financial goals, risk tolerance and time horizon. Beyond that, there are various formulas and investing strategies available for investors to make intelligent decisions. These formulas and strategies may help your client attain better returns on their investments.
The Formula Investing and Investment Strategies module, which should take approximately three and a half hours to complete, will explain the different formulas and investment strategies associated with stock, bond and portfolio investing.
To ensure that you have a solid understanding of formula investing and investment strategies, the following lessons will be covered in this module:
* Formula Investing
* Investment Strategies
Upon completion of this module you should be able to:
* Outline a few examples of formula-investing methods, and
* List the various investment strategies.
Section 1 – Formula Investing
This lesson introduces you to the concepts, tools, and applications of personal finance and investments. It also introduces you to various strategies of investing in stocks, bonds and mutual funds.
To ensure that you have a solid understanding of formula investing, the following topics will be covered in this lesson:
* Dollar Cost Averaging
* Dividend Reinvesting
* Bond Ladders, bullets and barbells
After completing this lesson, you should be able to:
* Describe the different strategies for purchasing common stock,
* Apply the strategies to get maximum returns on investments, and
* Compare and contrast ladder, bullet and barbell strategies for bond portfolios.
Practitioner Advice:
Practitioner Advice: The only instance where dollar cost averaging will not work is if the stock or stock fund’s price continues to rise and never drops. If that was the case and your client had a lump sum to invest, it would have been cheaper to buy it in the beginning. While in the short-term this may occur, it is very unlikely for a security to never fluctuate downwards as well as upwards over the long-term. Therefore, dollar cost averaging will still have its merit. However, it should be noted the greatest benefit to the strategy is to teach your clients to be disciplined investors.
Use the table above to calculate the return for the dollar-cost averaging investment.
* 8.18%
* 4.05%
* 7.65%
* 5.98%
8.18%
* The return for the dollar-cost averaging investment was
($4,327 - $4,000) ÷ $4,000 =
8.175%, or 8.18% (rounded).
Practitioner Advice:
Practitioner Advice: Open-ended mutual funds will also accommodate reinvestment of dividends. As long as your fund pays dividends, it can be reinvested back into your account to buy additional shares. Again, unless the mutual fund is held in a tax-deferred retirement account such as an IRA, the amount of dividends will be taxable as income.
Dividend Reinvesting
If you want to use common stock to accumulate wealth, you must reinvest rather than spend your dividends.
Under a dividend reinvestment plan (DRIP), you are allowed to reinvest the dividend in the company’s stock automatically without paying any brokerage fees. Most large companies offer such plans, and many stockholders take advantage of them.
However, DRIPs have several drawbacks, including:
* When you sell your stock, you’ll have to figure your cost basis for your dividends that are reinvested (most brokerage firms do this automatically for clients). In addition, you will pay income tax on the reinvested amounts as if you actually received these dividends.
* You can’t choose what to do with your own dividend. For example, if the company you’ve invested in is performing moderately well, and you just heard about another company whose stock price is rising faster. You are stuck reinvesting instead of trying something new.
Example (Dividend Reinvestment Plans)
An investor bought 150 shares of a local savings bank. He was receiving cash dividends, but then decided to take advantage of the dividend reinvestment program. The 150 shares split at one point, so he had 300 shares from his original purchase. However, due to dividend reinvestment, he has over 750 shares altogether. His father bought 100 shares at the same time that he did, but never took advantage of the dividend reinvestment and has only 200 shares now.
What determines choosing between Bond Ladders, Bullets and Barbells?
They choose between these options based on their expectations of the direction of the yield curve.
* Those investors who anticipate the yield curve to become steeper will use a bullet strategy.
* Those who expect the yield cure to flatten will pick the barbell.
* Those who are neutral or uncertain will buy a ladder.
Describe the barbell strategy
- A barbell is a strategy of holding more bonds at the short and long end of the yield curve with intermediate bonds being underweighted.
- This allows a portfolio’s price to match the volatility of an intermediate-term liability.
- When there is a likelihood that the Federal Reserve will loosen monetary policy in the near term, a barbelled portfolio may increase a bond portfolio’s return.
- High-yield municipal and corporate bonds have two advantages that can be utilized in a barbelled portfolio.
- First, high-yield bonds help diversify a portfolio. Their performance is largely isolated from what’s happening with government interest rates because their yields depend almost entirely on default risk.
- Second, compared to equity alternatives, they are often undervalued. If the yield curve continues to flatten, the return on a barbelled portfolio is optimized.
Describe the bullet-structured portfolio
- A bullet-structured portfolio benefits when the yield curve is expected to steepen.
- A bullet structure usually weighs heavier around intermediate term assets.
- A bulleted maturity tends to outperform a barbell structure when the yield curve steepens because in a rising rate environment, intermediate-term securities usually hold up better than long-term securities.
- Also, in a declining interest-rate environment, intermediate securities produce significantly greater price appreciation than do short-term securities.
Section 1 – Formula Investing Summary
There are some basic formula strategies that can be used to improve the return of a client’s or your personal portfolio. However, each strategy needs to be appropriate for the investor. For example, for a person who is investing for the long-term such as 20 or 30 years, who has a lump sum ready to invest, breaking up the lump sum for dollar cost averaging will probably not mean that much. Dividend reinvestment would not be suitable for a person who needs current income from his or her investment portfolio. If a person is just beginning his wealth accumulation, he may not be able to afford buying a portfolio of bonds on his own.
In this lesson, we have covered the following:
- Dollar cost averaging describes the practice of purchasing a fixed dollar amount of stock at specified intervals. Over the long-term, it could lower the average cost per share, which in turn will generate a higher return.
- Dividend reinvesting describes the strategy of reinvesting dividends in a company’s stock or a mutual fund. The dividends are used to purchase more shares.
- Bond ladders, bullets and barbells: Bond portfolio structures are chosen based on the portfolio manager’s expectations of the direction of the yield curve. A passive portfolio would likely choose a ladder structure, which gives up some potential return, but also lowers risk.
PRACTITIONER ADVICE:
Similar to asset allocation and portfolio diversification, the formulaic strategies presented in this lesson are meant to lower risk. Dollar cost averaging and dividend reinvestments are simple and common strategies that planners will urge clients to apply to their long-term investment strategies. The strategies are easy to explain and to implement. For investors who have conservative goals, there are options to create bond ladders with a broker. A less expensive alternative would be to create a ladder using CDs.
Consider the following case: You invest $250 in stock every month over a period of a year. Which investment strategy are you applying?
* Buy and Hold
* Dollar Cost Averaging
* Dividend Reinvestment Plan
* All of the above
Dollar Cost Averaging
* Dollar cost averaging is the practice of purchasing a fixed dollar amount of stock at specified intervals. The logic behind dollar cost averaging is that by investing the same dollar amount each period instead of buying in one lump sum, you’ll be averaging out price fluctuations by buying more shares of common stock when the price is lowest, and fewer shares when the price is highest.
Your client owns a stock fund in a joint account with his wife. He elected to have the distributed dividends and capital gains reinvested back into the fund. Which of the following statements are true? (Select all that apply)
* The reinvestments will have a dollar cost average effect on the account.
* Since he did not take the dividends and distributed capital gains as cash, he will not need to pay taxes on them.
* The reinvested amounts will not affect the cost basis of the account.
* The reinvested amounts will purchase additional shares.
The reinvestments will have a dollar cost average effect on the account.
The reinvested amounts will purchase additional shares.
* Reinvestment of dividends and distributed capital gains is a method to purchase additional shares rather than taking the amounts as cash.
* Since it is a purchase on a regular basis, it is gives the effect of dollar cost averaging.
* The cost basis of the account will change because the additional shares will be purchased at different share prices.
* Although the client does not take the money out of the account, the dividends and distributed gains are still taxable.
Which of the following statements is true about a normal yield curve? (Select all that apply)
* Short-term yield is lower than long-term yield.
* A portfolio with a bullet strategy is best suited to this environment.
* A portfolio with a ladder strategy is best suited to this environment.
* A portfolio with a barbell strategy is best suited to this environment.
Short-term yield is lower than long-term yield.
A portfolio with a ladder strategy is best suited to this environment.
* A ladder structure will be the most beneficial in a normal upward sloping yield curve indicating higher yield at longer maturities, with a stable interest rate environment.
* Barbells work better in a flat yield curve while
* bullet works better for a steep yield curve.
Dollar cost averaging is a risk reduction method that would lower risk and likely increase return. Which of the following market conditions would be the LEAST favorable for dollar cost averaging?
* Stock price is on the rise
* Stock price is dropping
* Stock price is level
* Stock price is fluctuating
Stock price is on the rise
* Dollar cost averaging can help investors lower their overall average cost per share in most market conditions except for when the stock price is continuously increasing.
* In that case, the investor would have been better off investing everything at the lower price in the beginning.
Section 2 – Investment Strategies
Investment professionals adopt a variety of strategies in order to either simulate their target benchmark index’s return or to beat it. There is some merit to each of the strategies, and some strategies work better in specific market environments. Overall, it is important to determine whether or not the strategy suits your client’s risk tolerance, time horizon and of course, investment objectives. This lesson helps you identify the purpose of each investment strategy and the type of investor who can take advantage of it.
To ensure that you have a solid understanding of investment strategies, the following topics will be covered in this lesson:
* Market Timing
* Passive Investing (Indexing)
* Technical Analysis
* Fundamental Analysis
* Buy and Hold
* Portfolio Immunization
* Swaps And Collars
* Efficient Market Anomalies
After completing this lesson, you should be able to:
* Analyze investment style and measure an investment manager’s ability to time the market,
* Differentiate between passive and active management,
* Differentiate between technical and fundamental analysis and their respective strategies,
* Describe portfolio immunization and the different strategies of portfolio managers, and
* Test market efficiency and list examples of market anomalies.
PRACTICE STANDARD 400-1
Identifying and Evaluating Financial Planning Alternative(s)
The financial planning practitioner shall consider sufficient and relevant alternatives to the client’s current course of action in an effort to reasonably meet the client’s goals, needs and priorities.
Describe a market-timer structured portfolio
A market-timer structures a portfolio to have a relatively high beta when he expects the market to rise and a relatively low beta when a market drop is anticipated. In other words, a market timer will:
* Hold a high-beta portfolio when Expected Market Return > Risk-free Return, and
* Hold a low-beta portfolio when Expected Market Return < Risk-free Return.
If the timer is accurate in his forecast of the expected return on the market, then his portfolio will outperform a benchmark portfolio that has a constant beta equal to the average beta of the timer’s portfolio. However, forecasting the market return is the hard part. The actual result will be determined by the accuracy of his or her forecast regarding the relationship between the market’s return versus a risk-free return.
To “time the market,” one must change either the average beta of the risky securities held in the portfolio or the relative amounts invested in the risk free assets and risky securities.
For example, selling bonds or low-beta stocks and using the proceeds to purchase high-beta stocks could increase the beta of a portfolio. Alternatively, Treasury bills in the portfolio could be sold, with proceeds being invested in stocks or stock index futures. Because of the relative ease of buying and selling derivative instruments such as stock index futures, most investment organizations specializing in market timing prefer the latter approach.
CASE-IN-POINT:
* Remember, having a high beta does not necessarily mean that the portfolio will behave like the market.
* R-squared (coefficient of determination) should also be checked to determine how closely correlated the portfolio is to the market.
PRACTITIONER ADVICE:
Market timing is very hard to accomplish. People rarely get it perfect. Not only must you decide when to get out of the market before it starts to going down, but you also have to determine the precise moment to get back in to take advantage of an expansion. Often, bottom fishers will buy into the market after a significant adjustment, effectively stopping the downward momentum. However, they will also take profits shortly thereafter, which restarts the market’s downward momentum. For market timers who have been waiting for signs of a switch in the business cycle stage, these short-term fluctuations can be very misleading.
Describe Passive Investing (Indexing)
Within the investment industry, a distinction is often made between passive management - holding securities for relatively long periods with small and infrequent changes - and active management.
- Passive managers generally act as if the security markets are relatively efficient. Put somewhat differently, their decisions are consistent with the acceptance of consensus estimates of risk and return. The portfolios they hold may be surrogates for the market portfolio, known as index funds, or they may be portfolios that are tailored to suit clients with preferences and circumstances that differ from those of the average investor. In either case, passive portfolio managers do not try to outperform their designated benchmarks.
- Active managers believe that from time to time there are mispriced securities or groups of securities. They do not act as if they believe that security markets are efficient. Put somewhat differently, they use deviant predictions; that is, their forecasts of risks and expected returns differ from consensus opinions.
For example, a passive manager might only have to choose the appropriate mixture of Treasury bills and an index fund that is a surrogate for the market portfolio. The optimal mixture is only changed when:
* The client’s preference changes,
* The risk-free rate changes, or
* The consensus forecast about the risk and return of the benchmark portfolio changes.
The manager must continue to monitor the last two variables and keep in touch with the client concerning the first one. No additional activity is required.
Passive Management
Management Style
* S&P Index Fund Passive
* SPIDR (ETF) Passive
* Growth & Income Fund Active
* Small Co. Value Fund Active
Practitioner Advice: Typically, a blended approach is used in portfolio management when a portion of the assets is bought and left alone while another portion is actively managed. Also, a client may apply a passive buy and hold strategy, but then occasionally rebalance the asset allocation to actively manage the portfolio. Moreover, some securities are more suited for passive strategies than others. Large cap stocks have a more efficient market (according to the Efficient Market Hypothesis), so they are more suited for passive investment than smaller companies.
