MAF101: FUNDAMENTALS OF FINANCE

TABLE ONE: HISTORICAL ASSET CLASS RETURNS

Source: IRESS, Colonial First State, RIMES
YEAR TO 30TH JUNE 1997 1998 1999 2000 2001 2002 AUST. SHARES GLOBA L SHARE S 28.46% 41.58% 8.21% 23.69% -5.82% -23.26% PROPER TY FIXED INTERES T (BONDS) 16.76% 10.88% 3.28% 6.17% 7.42% 6.21% CASH CONSERVATI VE FUND BALANC ED FUND DIVERSIFI ED FUND

26.84% 0.96% 14.14% 18.15% 9.11% -4.54%

28.53% 9.97% 4.31% 11.91% 13.91% 14.85%

6.77% 5.11% 5.04% 5.58% 6.08% 4.66%

16.53% 10.40% 6.07% 9.80% 6.21% 1.54%

19.79% 15.08% 7.18% 13.09% 4.44% -3.26%

22.97% 17.74% 8.58% 16.09% 3.42% -7.13%

2003 2004 2005 2006 2007 2008 2009 2010 2011

EXPECTED RETURN= Actual returns/N Where n=15 i. e no of years

-1.61% 21.73% 26.03% 24.02% 29.21% -13.67% -20.34% 13.10% 11.90%

-18.28% 19.38% 0.57% 19.97% 8.23% -21.03% -16.31% 5.50% 3.00%

12.15% 17.24% 18.10% 18.05% 25.87% -36.35% -42.27% 20.40% 5.80%

9.78% 2.33% 7.79% 3.41% 3.99% 4.42% 10.82% 7.90% 5.50%

4.97% 5.30% 5.64% 5.76% 6.42% 7.34% 5.48% 3.90% 5.00%

3.70% 8.73% 9.57% 9.71% 10.14% -1.86% -1.09% 7.67% 6.05%

-0.60% 11.96% 9.61% 12.99% 11.80% -6.87% -6.18% 7.97% 6.05%

-4.06% 15.31% 10.93% 16.47% 14.50% -11.52% -11.48% 8.65% 6.49%

10.34%

4.93%

8.17%

7.11%

5.54%

6.88%

6.87%

7.13%

RISK

3.78%

4.85%

5.08%

0.95%

0.22% 1.20%

1.99%

2.76%

MAF101: FUNDAMENTALS OF FINANCE Standard Deviation is the same as risk. Therefore we use the following formula, workings have been attached on a separate excel spreadsheet.

Question 2 Diversification in finance is having various categories of investments in your portfolio in order to reduce risk. With a diversified portfolio an investor is always sure that should one combination fail, the other will always cushion the risk of having all of them fail hence the need to diversify. Usually, diversification is regarded as a high risk affair since one is not sure of what the outcome of the investment will be. Therefore it is expected that an investor with a diversified portfolio will have high returns. This I the basic risk-return trade off. On this table, it is clear that a well diversified portfolio which is a combination of all asset categories will bring a high return to the investors. Except for Global Shares and cash, the rest of the assets have a relatively high rate of return. Investors usually diversify In order to spread the risk. This contradicts the principle suggested by in rich dad poor dad that put all your eggs in one basket and guard the basket. A highly diversified portfolio will mean a high risk to the investors hence a possibility of high returns.

MAF101: FUNDAMENTALS OF FINANCE From table one above,looking at the various degrees of risks of the assets, a combination of Australian shares,global shares and property is likely to give a high return because they have the highest risk percentage.In the table, cash has the least risk hence a portfolio with cash as an investment is likely to yield very low returns. For the other moderately risky ones like the diversified and balanced fund, the returns are just moderate and not as high as the high risk ones. Question 3 A defensive asset is one that has a very minimal risk of loosing capital and gains maximum returns from its income proportions. Examples of defensive assets are cash, fixed interest investments, term deposits, government bonds,cash management trusts mortgages and debentures and unsecured deposit notes. Investors prefer defensive asset as they offer a more stabilized form of return than growth assets. A growth asset on the other hand is a high risk investment with a potential for high returns. Growth assets are assets that generally capital gain through generating increased profits or asset value. Examples of growth assets are shares, property and private equity. They are asserts from which investors get high capital gains hence very high returns, Using the risk return trade off we can see that they therefore have a very high degree of uncertainty hence the high risk-return prospect. Question 4 Some of the risks that you may face by choosing to invest in managed funds are. There is a possibility of not getting the expected return on investment. This will solely depend in what the fund manager chooses to invest in. If he chooses a portfolio that does not do well, then the investor will have to accept the outcome of the investment made on their behalf by the various fund managers.Also,another risk one faces when they decide to invest in managed funds is the possibility of legal obligations that may arise from time to time. For example, in the insurance industry, the government may decide to increase taxes and

MAF101: FUNDAMENTALS OF FINANCE premiums and this will definitely be felt by investors who will have no choice but to abide by the statutory obligations put in place. This sometimes eats into investors profits. Finally, another risk is that since managed funds are run by professionals, they must be paid for their services since they are the experts in their field and an investor has to pay them when they have a fund manager managing their investment portfolio. Normally, the fund managers take a specific percentage realized as profit on investments, this of course reduces an investors returns. Question 5 If I had $50,000 to invest, where I would invest it first of all would depend on my risk appetite. Investors are usually classified into three types. The high risk, risk averse and risk neutral. In this scenario, I will assume I am an investor with a risk averse appetite. I will therefore go for a low risk portfolio as opposed to a high risk investor who will go for a high risk one. I would therefore choose to invest in the following combination of assets fixed interest(bonds),cash, conservative fund, balanced fund and diversified fund. From the table we can see that they have a low risk that means a low standard deviation of the actual return from the expected return. A combination of such low risk assets will give me a low return.

References

MAF101: FUNDAMENTALS OF FINANCE .Elton, E. J., & Gruber, M. J. (1995). Modern portfolio theory and investment analysis (5th ed.). New York: Wiley. Gardner, D., & Gardner, T. (2009). The Motley Fool million dollar portfolio: how to build and grow a panicproof investment portfolio. New York: Collins Business. Reilly, F. K. (2000). Investment analysis and portfolio management (2nd ed.). Chicago: Dryden Press. Houston, K. (2001). Investment and Portfolio Analysis. Mason,Ohio: Thomson South-Western Lumby, S. (2011). Corporate Finance. Hampshire U.K: Cengage

MAF101: FUNDAMENTALS OF FINANCE