Portfolio Construction
A portfolio is an accumulation of assets owned by the investor and designed to transfer purchasing power to the future. Factors include the goals of the investor, risks involved, the taxes imposed on income and gains and knowledge of the available opportunities. Security analysis considers the merits of the individual asset while portfolio management determines the impact that a specific asset has on the portfolio.
Preliminary Definitions
- Investment- The purchase of a physical asset such as plant, equipment or inventory. Or acquisition of an asset such as a stock or a bond.
- Secondary Markets- A market for buying and selling previously issued securities.
- Primary Markets– The initial sale of securities.
- Value- What something is worth; the present value of future benefits.
- Valuation- The process of determining the current worth of an asset.
- Return- The sum of income plus capital gains earned on an investment in an asset.
- Income- The flow of money or its equivalent produced by an asset; dividends and interest.
- Capital Gain- An increase in the value of a capital asset, such as a stock.
- Rate of Return- The annual percentage return realized on an investment.
- Risk- The possibility of loss; the uncertainty of future returns.
- Speculation- An investment which offers potentially large returns but is also very risky; a reasonable probability the investment will produce a loss.
- Marketability- The ease with which an asset may be bought and sold.
- Liquidity- Moneyness; the ease with which assets can be converted into cash with little risk of loss of principal.
Sources of Risk
- Systematic risk- Associated with fluctuation in security prices; e.g.market risk.
- Unsystematic risk- The risk associated with individual events which affect a particular security.
- Business risk- The risk associated with the nature of a business.
- Financial risk- The risk associated with a firm’s sources of financing.
- Market risk- Systemic risk; the risk associated with the tendency of a stock’s price to fluctuate with the market.
- Interest Rate risk- The uncertainty associated with changes in interest rates; the possibility of loss resulting from increases in interest rates.
- Reinvestment Rate risk- The risk associated with reinvesting earnings or principal at a lower rate than initially earned.
- Purchasing Power risk- The uncertainty future inflation will erode the purchasing power of assets and income.
- Exchange Rate risk- The uncertainty associated with changes in the value of foreign currencies.
Efficient and Competitive Markets
Markets with many participants who may enter and exit freely will be competitive. An efficient financial market implies the security’s price embodies all the known information concerning the potential return and risk associated with the particular asset. Although security prices and returns are ultimately determined by the interactions of buyers and sellers, there is little an individual can do to affect a security’s price.
Investments and Business Finance
Finance can be studied from the perspective of the investor who puts up the funds or the corporate manager who is responsible for using the funds to earn a profit. While it is assumed the manager will take action in the best interests of the shareholder, they might pursue their own best interests. Higher management salaries reduce earnings and the investor’s return.
Visit these topics for further detail or return to the Investment Basics page:
- Basics Introduction
- Security Markets
- Information Sources
- Risk and Portfolio Theory
- Investment Companies
- Stock Valuation
- Macroeconomic Environment
- Statement Analysis
- Bond Market
- Foreign Securities
The material presented on this page and Investment Basics pages were adapted from Dave’s lecture notes for the Investments for Professionals course taught at UCLA 1998-2005 and three decades of practical experience. See our Site Credits page for reference sources.
