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Advanced Economics of System Portfolio Exercise

Projektarbeit 2017 24 Seiten

BWL - Investition und Finanzierung


Table of Contents List of Figures

List of Tables

1. Executive Summary

2. Introduction

3. Self-Risk Tolerance Assessment

4. Portfolio Design Strategy

5. Investment Breakdown and Analysis

6. Analysis of Potential Market Risks

7. Conclusions

8. References

9. Appendix

Lessons Learned

List of Figures

Figure 1 : Process of constructing a Portfolio

Figure 2: Portfolio Growth Focus

Figure 3: Portfolio toward Growth

Figure 4: Portfolio Balanced Growth and Income

Figure 5: Edward Jones Questionnaire

Figure 6: Points for the answers & Risk tolerance Scale

Figure 7: Portfolio Objective Guidance Table and Retirement Goal

List of Tables

Table 1: Cash flow of the cost reduction years

Table 2: Investment volume at the beginning of each Investment phase

Table 3: Split of the Investment phases

Table 4: Portfolio Investment phase

Table 5: Portfolio Investment phase II

Table 6: Portfolio Investment phase III

Table 7: Portfolio Investment phase IV

Table 8: statement of costs

Table 9: Cash flow over entire period

Table 10: Investment volume Phase I

Table 11 : Investment period II

Table 12: Investment phase III

Table 13: Investment phase IV

1. Executive Summary

Nowadays even young people should start thinking about building assets for their future. The task for this portfolio was to analyze the individual risk profile, the design of a portfolio and the active management of it. Before the building of a portfolio, there are some thoughts that must be taken into consideration. After a self-risk tolerance assessment follows the portfolio design strategy that describes the process of the portfolio construction. Then there will follow different analysis‘. An investment breakdown and an analysis of potential market risks are essential for designing a portfolio. The analysis of potential risks includes a description of the market risks, equity and Fixed-Income Investments, too. This report ends up with a conclusion and the central result that it is important to start early with building financial assets and to reduce the individual costs.

2. Introduction

In Germany the statutory pension is considerably lower than the annual salary people get when they are working. Every German is paying for a pension insurance monthly, but the pension payed out is not sufficient for most of them. Some of the pensioners still have to pay a credit for an own flat or house, they got a car and other things and the most important is their lifestyle while getting a good salary every month. (Parchmann, 2013, p. 7) People got used to their lifestyles and as soon as they get into their pension they must live a life with a very low pension. So today most of the young people starting to work should start think about different methods to invest their money for the future.

3. Self-Risk Tolerance Assessment

The understanding of the own risk tolerance helps to reach the long-term financial goals. Based on the risk tolerance Questionnaire from Edward Jones I will explain my comfort level with risk for the right mix of investments for me. The basic objectives of the questionnaire are:

- “How much risk you can take, based on your investments time horizon and other factors.”
- “How much risk may be appropriate for you to take to reach your long-term financial goals.”

To determine the individual risk tolerance the score of each answer will be summed up and interpreted. The points of the answers are awarded from most aggressive (highest points) to conservative (zero points). The total score of the answers will be interpreted in a risk Tolerance Scale which ranges from most conservative to most aggressive. My score is 65 which means my risk tolerance is medium to high. The questions are shown in figure 5 in the appendix (Edward Jones, 2017b). Based on the individual risk tolerance and the time horizon until the retirement Edward Jones build a Portfolio

Objective Guidance Table to identify the retirement goal. Rooted in the assumption that my risk tolerance level is constant during my entire life, my individual Portfolio objective until the retirement is Growth Focus and would change in the retirement period to Balanced toward Growth. Many studies show that there is a relationship between age and the risk tolerance level. The risk tolerance decreases as people age (Wilson, 2008, p.18; Sahm, 2012, p.5). According to this statement my risk tolerance would change with age to medium and this means that my portfolio objective will change in the time horizon 15 years or less until retirement to balance toward Growth. And in the retirement years my portfolio objective would be Balanced Growth and Income. The definition of the portfolio objectives will be explained in the chapter Portfolio Design Strategy.

4. Portfolio Design Strategy

After selecting the portfolio objective based on the result of the risk tolerance questionnaire it is possible to construct a diversified portfolio for the investments. The picture below shows the process of the portfolio construction from the selection of Equity and Fixed-income investments until the Investment Selection.

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Figure 1: Process of constructing a Portfolio (Edward Jones, 2017a, p.l)

To understand all financial technical terms, they will be defined next:

- Equity Investments: The term equity has various definitions. Basically, each definition applies to ownership in an asset. This equation expresses equity: Equity = Assets - Liabilities.

The value of an asset substracted by the value of all liabilities is the equity. It is divided in the following three Investment categories:

- Aggressive: Aggressive Investments have the property of potentially high margins though they are riskier and price volatility. The asset classes are Commodities and Emerging Markets (Edward Jones, 2017a, p. 1).
- Growth: Growth Investments naturally offer low constantly dividend earnings and depend upon earnings growth for their long-term returns. In Addition, their prices can be volatile. The asset classes are u.s. or International small- and mid-cap stocks (Edward Jones, 2017, p. 1).
- Growth and Income: Growth and Income Investments combined have a better price stability than entirely Growth Investments. And the prices vary more than the prices of purely income investments. The potential growth is due to increasing revenue and contribute income due to dividends earnings. The asset classes are u. s. or International large-cap stocks and Real estates (Edward Jones, 2017a, p. 1).

- Fixed-Income Investments: Real return rates or periodic income is received regularly and predictable. As fixed-income investments are less risky than other investments it diversifies portfolios. Pensioners often invest in these investments because they are highly reliable (Investopedia LLC, 2017).

- Income: Income Investments have higher rates than cash investments. The interest is mostly fixed but could also be variable. Usually if interest rates fall the bond prices rise. The longer the period before the due date, the higher the value of an investment will fluctuate because of the fluctuations in the interest rate. The value of an investment fluctuates because of variations in the interest rates, as the period time prior maturity gets longer. The asset classes are CDs, u.s. Investment-grade, International and High- yield Bonds (Edward Jones, 2017a, p. 1).
- Cash: The basis for investments is cash including funds held in savings and money market accounts for investment. The value of excess cash is decreasing due to inflation and additionally represents missed opportunities for other higher-return investments. The asset classes are Cash and Money Market (Edward Jones, 2017a, p. 1).

Based on my risk level my portfolio strategy management is divided in to the four phases, which are shown in Table 3: Split of the Investment phasesand will be explained in the following.

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5. Investment Breakdown and Analysis

The calculations in this paper are made on the circumstances of a German employee which starts working with 23 years and works for 40 years until retirement. Two children are considered in the calculation which will financially be supported for 24 years. The German government provides a retirement plan by law which is included in the retirement years. Based on the exchange rate from December 2nd $100,000 are equivalent to 84,000 €. Based on a 2% increasing salary the taxation changes during the regarded time horizon (hofmann & partner Steuerberater, 2017).

Following Cost reductions are taken in the Cash flow and shown in the table 1 :

1) After the children educated the costs of children will reduced in the cash flow.

2) After 30 years all repayments of credits are done (e.g. house and car).

3) As a pensioner some cost are no longer required, they are basically 33% lower (Tapia & Yermo, 2008, p. 14).

Table 1: Cash flow of the cost reduction years

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The annual consumer expenses are average values calculated by the German Federal Statistics Office for a typical German family with 2 children (Statistisches Bundesamt, 2017, p. 14). They calculated the shares of each costs from historical data. These percentage values stay constant for the calculated time horizon. The statement of costs is listed in the table 8 in the appendix. This indicates that the purchasing power parity (PPP) is decreasing over the time, because the inflation rate is higher than the growth of the income. This trend is reflected in the history of Germany (Statistisches Bundesamt, 2017, p. 5). The 5% inflation rate has been taken in the calculation of the Investment Volume for each year. The investment volume is raising from 0 to $ 2.116.902,97 (table 2) at the beginning of the retirement, due to the compounded interest. During the retirement the investment cash is increasing because of the deficiencies of the cash flow. The only income is the statutory pension which is in the first year about $38.400 (Vermögenszentrum GmbH, 2016). The assets should suffice at least to the life expectancy of a German male (78.13 years) (Luy, 2017,p. 2). As it is shown in table 9 I will have

great assets to compensate the financing gap during retirement. Even if life expectancy should rise the capital built up would be sufficient for many years. But with the addition that risks like unemployment, health problems and depressions were disregarded. Any of the named risk could have a considerable influence on the calculated investment volume. The detailed calculations are listed in the appendix.

Table 2: Investment votume at the beginning of each Investment phase

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6. Analysis of Potential Market Risks

With every investment, there are risks and potentials. It’s a risk to lose all the invested money but as well it is a chance to get a return of the money that was spent for the investment. Every investment has got a different balance between risks and chances. It varies with the type of investment, the economic situation and other aspects. People who want to get higher returns have to take the greater risk. If the risk is very low, there will also be the lowest return (The Securities Industry and Financial Markets Association, 2013). There are many market risks that can cause losses for the investor. For example, recessions, political turmoil, natural disasters, terrorist attacks and changes in Interest rates. Those risks influence the whole financial market. They are called 'systematic risk', too. Risks cannot be eliminated but reduced. A common way is diversification (Investopedia LLC, 2017). With diversification McKinsey follows the objectives to reduce capital absorption and increase returns on capital absorbed (Costa, Khan, Levy, Natale, & Tanrikulu, 2014, p. 12).

As written in the Portfolio construction the following asset classes are part of my portfolio: Emerging Markets, Stocks, Real Estate and Bonds. The analysis of each potential market risk will be explained next. Based on my personal purpose I will not invest in Cash and Money market and Commodities.

Market risk of Emerging Markets:

Investments into emerging markets provide an opportunity to obtain high returns, even though there is a potential for losses and growth is not guaranteed. Newly-industrialized countries are progressing, the proportion of industry of the GDP is rising due to renewal of machinery and the growth of labor which lead in to higher efficiency. Their markets are known as Emerging markets and have a higher growth potential than the markets in developed countries. The political systems are often volatile which is the main reason of the elevated risk. However, investments in emerging markets can be used to make high-risk investments in the portfolio (Credit Suisse Group AG, 2017; Henisz & Zelner, 2010).

Market risks Stocks

Systematic risks, such as economic growth, inflation, interest rates, recessions or currency fluctuations, are connected to the stock market. Because they are unpredictable they are creating a volatility and risks for the stock market. Whereas investors search for high rates of return they prefer higher risk stocks. However, these are normally smaller and weaker than the average stocks. Those stocks often lead in rallies, but they are collapsing in down markets. One strategy to manage risk is to establish a maximum tolerated loss for the portfolio. Tactical asset allocations help to take benefits of volatility. This means to purchase more of an asset when prices are cheap and less if the prices are high. Stocks are arranged into the three classes: Large-, Mid- and Small-caps (Faulkenberry, 2015). Large-cap stocks are known as a safe investment, because they are ordinarily established companies which have a strong market presence (Equitymaster Agora Research Private Limited., 2017). Mid-caps represent more risky investment options than Large-caps. These are mid-sized companies and not as risky as Small-cap companies. Mid-caps are lying in between of both extremes. The parameters to rank the three options are for example the size, revenues, employees and the client base. Investing in Mid-caps could be useful for the future because those companies may become successful after that. Consequently, Mid-cap stocks will bring higher returns in 3 to 5 years whereas large-cap stocks bring moderate and safer returns in those years (Equitymaster Agora Research Private Limited., 2017).

Small-cap companies are not hazardous or “quick rich” stocks as viewed from many persons. They just have smaller revenue and client bases. Often those Small-caps are start-up companies and still have to develop a lot. Small-Caps have a large growth potential and still can be discovered. But it is important to do a detailed research about Small-cap companies because many of them are not financial strong enough to survive tough times. In addition, some of them can be mismanaged. Hence, before investing, the research should regard the promoters’ credentials, the management strength and the long- and short-term growth plans of the company (Equitymaster Agora Research Private Limited., 2017).

Market risk real estate

In the past years Real estate market has been growing strong. Nevertheless, there can be no assurance that this trend will sustain (Andreevska, 2016). When using the real estate market offers beside the stock market there are opportunities for Growth and Income in the long-term returns. Small investors can participate in enterprises that they normally would not reach with real estate sector funds. If they understand the risks and the advantages, investors can reach high returns and a competitive dividend income (Cüssen, 2017). The most important risk of real estates is the illiquidity. To sell a real estate asset in a large city takes often a few months. To avoid this risk, it is recommended to invest in real estate funds for short- and long-term plans (Williams, 2014, p. 5).

Market risks of bonds

Bonds can generate income and they are referred as a safe investment. But it is important to know some risks and pitfalls before investing (Curtis, 2017). The interest rate risk is one of the most popular ones. As the interest rate rises the bond prices will fall. Bondholders commit to receive a rate of return for a fixed period. Then the bonds will be listed at a discounted price (Langager, 2017).

It seems that bonds are very risky, but they are less risky than stocks because with bonds it is promised that there will be a return. With stocks, the promise is not as safe as it is with bonds. Most investors of bonds get a fixed rate of income whereas stocks sometimes only pay dividends but those are even not obligatory. In history the stock market was more vulnerable than the bond market for price swings or volatility, but the average returns were higher (The Securities Industry and Financial Markets Association, 2013).

7. Conclusions

The portfolio construction assignment showed the importance to examine the individual cost flow. In addition, the exercise demonstrates significantly the urgent to build financial assets for the retirement and the continuous reduction of costs. Living longer than the expected life expectancy is getting hard without enough money. Through annual investments in assets that have a greater rate of return than the inflation rate large financial reserves can be realized. By the right assessment of the individual risk level and a basic financial knowledge it is possible to show the potential market risks. It is necessary to consider about the risk for the construction and the management of the portfolio to be successful. Other risks have not been complied could completely change the calculated results and the choice of the assets. If the worst comes to the worst, this may lead to poverty especially in old-age.



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Portfolio Management



Titel: Advanced Economics of System Portfolio Exercise