Archive for the 'FInancial Planning' Category

Factors Affecting the Business Cycle

The business cycle refers to the swings in gross domestic product from recovery to recession. There are several factors influencing the business cycle.

Consumers tend to be the most important, reflecting 60-70% of GDP in developed countries. Trends in consumer spending can be monitored through retail sales and personal income data.

Business spending on inventories and investment is a smaller but more volatile component of GDP. It can be tracked using surveys such as PMI or ISM.

Monetary policy is used by governments to dampen the overall business cycle. The ability to use monetary policy as a business cycle lever is dampened by inflation, the pace of growth, unemployment levels and capacity utilization.

Posted on 18th February 2009
Under: Economic Analysis, FInancial Planning, Industry Analysis, Investment Returns, Portfolio Management | No Comments »

Inflation’s Effect on Asset Classes

Inflation has different effects on different types of assets. As a result, it is important both to diversify assets in terms of their response to inflation and to form expectations of inflation in order to overweight the assets that will respond best to future conditions.

Cash – inflation causes rising interest rates, and therefore cash tends to earn a higher return when inflation is higher.

Bonds – inflation erodes the fixed payments and terminal values of bonds. Therefore, bonds perform worse when inflation is higher.

Stocks – inflation can increase asset values but erode real cash flows. Rising interest rates can reduce the present value of future cash flows. Stocks tend to do best when inflation is low and predictable, and to fall in either high inflation or deflation.

Real estate – higher cash flows and asset values tend to result in a positive relationship between real estate and inflation.

Posted on 18th January 2009
Under: Asset Allocation, FInancial Planning, Portfolio Management | No Comments »

Choosing a Fixed Income Manager

When choosing a fixed income manager, some important points to consider include:

  1. Outperformance net of fees is especially difficult for fixed income managers
  2. Style analysis can indicate the ways the portfolio construction differs from that of the benchmark. Is the investor happy with these deviations?
  3. Selection bets can be determined through return decomposition to identify whether the manager is skilled in credit analysis
  4. The investment process should be understood to know the methods used and the drivers of alpha
  5. If multiple managers are used, the alpha generated should not be highly correlated with that of other managers

Posted on 24th November 2008
Under: FInancial Planning, Fixed income investments, Investing in bonds, Portfolio Management | No Comments »

Portfolio Rebalancing Strategies

Buy and Hold

Investors who use a buy and hold strategy set their initial allocation weights and then do nothing. Such allocations are directly related to the market performance of risky assets, and using them implies that risk tolerance is directly related to wealth and market returns.

Consider a 60/40 split between stocks and the risk-free asset. As the stock market rises (falls), stocks represent a larger (smaller) weight in the portfolio and The risk-free asset provides a floor value. Returns are directly related to market performance in a linear relationship.

When markets are trending, buy and hold methods can perform well because the better performing assets get increasingly larger weights and poor-performing assets have less impact.


Constant mix rebalancing is a dynamic process that requires rebalancing to the intial target allocation by trading whenever market conditions alter the ideal balance. The strategy ensures that the portfolio’s risk characteristics remain stable over time, consistent with a risk tolerance that varies proportionately to wealth.

Constant-mix strategies can be characterized as contrarian, as they sell the best-performing assets to buy the worst-performing. However, when markets are mean-reverting this will perform better than a buy and hold strategy. The shape of returns is concave – return increases at a decreasing rate in positive markets and decreases at an increasing rate in negative markets.

Constant Proportion

In a constant proportion strategy, the target allocation is a function of cushion, where cushion is the difference between the portfolio value and the floor value, and the allocation to risky assets is the product of the cushion and the proportion (m).  A buy and hold strategy represents a special case in which m = 1. This strategy is consistent with having no risk tolerance if there is no cushion.

If m > 1, the strategy is known as constant proportion portfolio insurance, or CPPI. CPPI strategies buy more stocks when markets are rising and sell stocks as markets fall. The dynamic allocations also affect the floor value, as changing the weight of the risky asset necessitates an opposite-direction change in the floor value.

In strong bull markets, CPPI performs well by continually allocating more to stocks. In strong bear markets, CPPI avoids large losses by rapidly reducing the allocation to stocks. Such returns can be described as having a convex shape as the return increases at an increasing rate when market returns are positive and decreases at a decreasing weight when market returns are negative.

When markets are characterized by frequent reversals, the constant changes in allocation result in high transaction costs that erode performance.

Posted on 4th November 2008
Under: Active Management, Asset Allocation, FInancial Planning, Investment Returns, Portfolio Management | No Comments »

Investing in Emerging Market Debt


  • Low correlation to developed markets is good for diversification
  • Have proven resilient to financial crises and are earning investment grade ratings in many cases
  • Sovereign emerging market debt in particular can:
    • respond to negative events by raising taxes and reducing spending
    • have access to lenders such as IMF and the World Bank
    • have large foreign currency reserves as a cushion


  • High volatility
  • Negative skewness of returns
  • Lack of transparency
  • Lack of legal and regulatory structure
  • Sovereign borrowers tend to over-borrow and there can be little recourse for foreign lenders in the event of default

Posted on 24th October 2008
Under: FInancial Planning, Fixed income investments, International Investing, Investing in bonds, Portfolio Management | No Comments »

Tools for Setting Capital Market Expectations

When estimating the risk and return characteristics of various asset classes, there are a number of tools available to analysts.

  1. Statistical methods can be descriptive (classify past results) or inferential (used for predicting results.)
    • Sample estimators estimate the future mean and variance based on the sample’s past mean and variance.
    • Shrinkage estimators rely on judgment to weight historical estimates with other parameters in order to reduce the impact of extreme values
    • Time series estimators forecast a variable based on the lagged values of either the variable itself or other variables
    • Multi-factor models explain returns for an asset in terms of the values of a set of return drivers or risk factors
  2. Discounted cash flow models express current value in terms of the future cash flows an asset will generate
  3. The risk premium approach expresses expected return as the risk free rate plus a risk premium that reflects the uncertainty surrounding future results
  4. Financial market equilibrium models describe relationships between expected return and risk in which supply and demand are in balance

Posted on 18th October 2008
Under: Asset Allocation, FInancial Planning, Investment Returns, Portfolio Management | No Comments »

Portfolio Rebalancing: Setting Optimal Asset Class Target Corridors

One way to balance the costs and risks associated with portfolio rebalancing is to set target corridors for asset class weights rather than specific weights. At least five factors should be considered when setting the tolerance ranges:

  1. Transaction costs – higher transaction costs should result in a wider corridor so that rebalancing occurs less frequently
  2. Risk tolerance – higher risk tolerance also justifies wider corridors
  3. Correlation with the rest of the portfolio – when assets move in the same direction as the rest of the portfolio they are unlikely to drift further from target weight. This, in turn, allows for a wider target corridor.
  4. Asset class volatility – the more volatile the asset class, the more likely a wider divergence from the optimal weight. This requires a tighter corridor.
  5. Volatility of the rest of the portfolio can also lead to large divergences from optimal weights and the need for tighter corridors.

Once a target corridor is breached, the portfolio may be rebalanced to the target weight or to some level within the target corridor. The latter methods allow for more control, particularly with regard to illiquid assets. The alignment to strategic asset allocations would be less, but transaction costs would be lower.

Posted on 4th October 2008
Under: Active Management, Asset Allocation, FInancial Planning, Investment Returns, Portfolio Management, Risk Management | No Comments »

Portfolio Rebalancing: Cost/Benefit Analysis

Portfolio rebalancing requires a trade-off between the cost of rebalancing and the cost of not rebalancing. Costs of rebalancing include trading costs and taxes, which must be weighed against:

  • the reduction in expected portfolio value resulting from suboptimal asset allocation
  • exposure to greater risk as the riskier assets typically earn more and become a larger percentage of the portfolio
  • shifting risk factors as asset weights change
  • using rebalancing to reduce exposure to the assets that have risen most and may be overvalued

To reflect this trade-off, rebalancing is typically performed in a disciplined fashion, based either on the calendar or on tolerance corridors.

Calendar rebalancing takes place at specific times, and as such does not require constant monitoring. However, it is insensitive to market conditions and may allow weights to drift substantially between rebalancings.

Tolerance corridors call for rebalancing whenever an asset class drifts out of proportion to a pre-specified range around the target weight. It allows tighter control as it is directly related to market performance, but also requires continuous monitoring.

Posted on 4th September 2008
Under: Active Management, Asset Allocation, FInancial Planning, Investment Returns, Passive Management, Portfolio Management, Risk Management | No Comments »

Psychological Traps in Investment Analysis

Investment analysts can fall into several psychological traps (and should strive to avoid doing so.)

Anchoring refers to giving disproportionate weight to the first information received about a topic.

Status quo bias is the tendency to perpetuate recent observations in forecasts.

Confirming evidence is the tendency to give more weight to information that supports existing or preferred points of view than to information that contradicts the preferred view.

Overconfidence is having too much faith in the accuracy of one’s forecasts.

Recallability is when forecasts are overly influenced by events that left a strong impression on the forecaster’s memory.

Posted on 18th August 2008
Under: Asset Allocation, Behavioral Finance, FInancial Planning, Institutional Investing, Portfolio Management | No Comments »

Portfolio Monitoring: Security Characteristics

Portfolio monitoring includes monitoring changes in the characteristics of individual securities or asset classes. Over time, underlying average returns, volatility and correlations with other asset classes can change. Such changes alter the appropriate mix of assets for meeting an investor’s objectives and constraints. If the changes are perceived as temporary, they may also present opportunities to make tactical changes.

The market and economic environment also require monitoring. Of particular importance can be the yield curve, market risk premia, central bank policy, and unusual deviations from normal relationships between securities or asset classes.

Posted on 4th August 2008
Under: Active Management, Asset Allocation, Economic Analysis, FInancial Planning, Portfolio Management | No Comments »