Chapter 2

The Investment Process

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ter?session=MBAA545S22

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 Weekly comments on
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 Know Your Client

Planned
Retirement Investment
Advisor Name Surname Liquidity requirements Age Age Family income Other significant assets knowledge Investor Type Tax rate Special circumstances
Antony James Jameson Plans to spend $75k on travel in 5 years 43 60 $170,037 Home, $600k Significant Methodical 33% Would like to create and endowment for grandchildrens' education worth $1m
Agarwal, Umang Susan Yu Needs $45k for daughters education in 5 years 48 65 $102,464 Apartment $800k Average Cautious 32% Doesn't invest in oil, gas
Agarwal, Daksh Vijay Sharma Plans home renovations costing $120k before retirement 34 62 $181,683 Business, home $1.25m Limited Spontaneous 33% None
Ahuja, Shaurya Shaurya Ahuja Dan Jones Wants to buy a recreation property worth $300k in 2 years 40 58 $173,215 None None Individualist 32% None
Akwii, Maria Maria Akwii Rebecca Stevens Needs $25k for son's education in 3 years 55 67 $177,846 Coin collection $100k None Methodical 31% Doesn't invest in tobacco, alcohol
Baba, Takashi Takashi Baba Daisy Yuen None 51 63 $118,056 Home, $800k Significant Cautious 34% Would like to create a family trust worth $1m
Bandukwala, Hussain Hussain Bandukwala Stan Martinez Plans home renovations costing $120k in 5 years 35 61 $151,008 Home $1.2m Average Spontaneous 33% None
Baradaran Sadat, Elmira Will Rogers None 42 69 $110,885 Dental practice, $1m Limited Individualist 34% Would like to create and endowment for grandchildrens' education worth $1m
Bi, Brian Brian Bi Peter Lee Needs reserve of $200k for mother's medical care 34 60 $123,917 Home, $900k None Methodical 35% Doesn't invest in oil, gas
Budhiraja, Hetul Hetul Budhiraja Phillip Li Plans to invest $280k in home business in 2 years 27 69 $85,582 Home $1.2m None Cautious 32% None
Chang, Yanming Genevieve Shaw None 42 68 $108,668 Business $1m Significant Spontaneous 39% None
Chief, Ben Ben Chief Ali Lopez Plans to buy a home for $400k in 2 years 44 61 $96,951 Recreational property $400k Average Individualist 36% Doesn't invest in tobacco, alcohol
Deshpande, Shivjit Shivjit Deshpande Chanda Brown None 40 68 $104,092 Apartment $700k Limited Methodical 33% Would like to create a family trust worth $1m
Dsouza, Aditya Sam Chen Plans to spend $95k on travel in 4 years 34 66 $118,513 None None Cautious 30% None
Duan, Demin Manoj Khanna Needs $55k for daughters education in 5 years 51 60 $168,829 Home, business $1.8m None Spontaneous 36% None
Dutta, Adrita Poonam Shah Plans home renovations costing $150k before retirement 44 61 $109,582 Home $350k Significant Individualist 36% Would like to create and endowment for grandchildrens' education worth $1m
Goulard, Don Fatima Side Wants to buy a recreation property worth $350k in 2 years 52 68 $147,667 Home, $500k Average Methodical 34% Doesn't invest in oil, gas
Guo, Dingjiu Dingjiu Guo Brad Wu Needs $65k for son's education in 5 years 51 65 $143,015 Medical practice, home $1.7m Limited Cautious 40%
Guo, Kuraki Kuraki Guo Joy Zhao None 54 58 $136,215 Apartment, $600k None Spontaneous 33%
Gupta, Chandni James Smith Plans to spend $75k on travel in 5 years 34 59 $167,750 Home, $600k Significant Methodical 34% Would like to create and endowment for grandchildrens' education worth $1m
Habib, Tazkia Gary Carter Needs $45k for daughters education in 5 years 34 63 $92,202 Apartment $800k Average Cautious 36% Doesn't invest in oil, gas
He, Haozhi Carter Smith Plans home renovations costing $120k before retirement 34 65 $154,150 Business, home $1.25m Limited Spontaneous 39% None
Jahan, Ishrat Ishrat Jahan Nedima Chen Wants to buy a recreation property worth $300k in 2 years 50 66 $135,299 None None Individualist 38% None
Jain, Ishaan Takashi Watanabe Needs $25k for son's education in 3 years 46 67 $121,262 Coin collection $100k None Methodical 34% Doesn't invest in tobacco, alcohol
Joseph Benedict Malar, Gideon Hussain Side None 49 69 $143,477 Home, $800k Significant Cautious 32% Would like to create a family trust worth $1m
Joshi, Vaibhav Vaibhav Joshi Yanming Duan Plans home renovations costing $120k in 5 years 40 62 $80,075 Home $1.2m Average Spontaneous 40% None
Kamble, Aniket Aniket Kamble Don Jones None 55 65 $183,732 Dental practice, $1m Limited Individualist 33% Would like to create and endowment for grandchildrens' education worth $1m
Khan, Abdussalaam Abdussalaam Khan Chandni Deshpande Needs reserve of $200k for mother's medical care 46 65 $185,512 Home, $900k None Methodical 30% Doesn't invest in oil, gas
Khan, Rahila Rahila Khan Demin Guo Plans to invest $280k in home business in 2 years 30 69 $123,778 Home $1.2m None Cautious 33% None
Khanna, Kashish Brian Best None 34 69 $126,888 Business $1m Significant Spontaneous 36% None
Ky Phuoc, Lam Lam Ky Phuoc Alonso Lopez Plans to buy a home for $400k in 2 years 39 59 $129,635 Recreational property $400k Average Individualist 35% Doesn't invest in tobacco, alcohol
Li, Jiayi Jiayi Li Ali MohammedNone 32 69 $162,727 Apartment $700k Limited Methodical 30% Would like to create a family trust worth $1m
Malik, Chetna Jes Edokpolo Plans to spend $95k on travel in 4 years 31 63 $148,792 None None Cautious 36% None
Mehta, Vruti Anupam Chauhan Needs $55k for daughters education in 5 years 36 67 $88,203 Home, business $1.8m None Spontaneous 35% None

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 Learning Objectives
Don’t sell yourself short. Instead, learn about these key
investment subjects:

1. The importance of an investment policy statement.

2. The various types of securities brokers and brokerage
accounts.
3. How to trade on margin, including calculating the initial
and maintenance margins.
4. The workings of short sales.

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 Investing Overview
 Fundamental Question: Why invest at all?
 We invest today to have more tomorrow.
 Investment is simply deferred consumption.
 We choose to wait because we want more to spend later.

 Investors have their own investment objectives and

strategies.

 The Investment Policy Statement (IPS)

 Designed to reflect your objectives and strategies
 Two parts: 1) Objectives, 2) Constraints

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 Objectives: Risk and Return

 In formulating investment objectives, the individual

must balance return objectives with risk tolerance.
 Investors must think about risk and return.
 Investors must think about how much risk they can handle.

 Your risk tolerance is affected by:

 Your ability to take risk
 Your willingness to take risk

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 Investor Constraints

 Resources. What is the minimum sum needed? What are the

associated costs?

 Horizon. When do you need the money?

 Liquidity. Can you sell the asset quickly without a big price
reduction?

 Taxes. After-tax returns matter. Which tax bracket are you in?

 Special circumstances. Does your company match your

investments? Do you face any restrictions on what stocks you can
buy? Do you have a conflict of interest?

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 Investment Strategies and Policies

 Investment management. Should you manage your

investments yourself or hire someone else to do it?

 Market timing. Should you try to buy and sell to anticipate

the future direction of the market?

 Asset allocation. How should you distribute your investment

funds across the different classes of assets?

 Security selection. Within each asset class, which specific

securities should you buy?

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 Asset Allocation or Security Selection?

 Is asset allocation or security selection more

important to the success of a portfolio?

 Most people are inclined to think security selection is the

more important element for successful investing.

 Research shows that asset allocation is more important.

 About 90% of portfolio performance stems from asset allocation.
 So, only 10% of portfolio performance comes from security selection.

 How is this result possible? Consider the Crash of 2008.

 Bonds outperformed stocks in 2008.
 Even those elusive “skilled stock pickers” might underperform bonds
because stocks tend to move together.

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 Choosing a Broker/Advisor

 Types of broker/advisor from:

 full-service brokers
 discount brokers (Canada: commission based)
 deep-discount brokers

 These three groups can be distinguished by the level of service

provided, as well as the level and type of compensation
charged.

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 Canadian Investor Protection Fund
(CIPF), I
 CIPF provides limited protection for property held by a member
firm on behalf of an eligible client, if the member firm becomes
insolvent.
 Member firms are investment dealers that are members of IIROC
(Investment Industry Regulatory Organization of Canada). These
investment firms are also automatically members of CIPF.
 CIPF coverage is custodial in nature. CIPF does not provide
protection against any other type of risk or loss. If you have an
account with a member firm, and that firm becomes insolvent, CIPF
works to ensure that any property being held for you by the firm at
that time is given back to you, within certain limits. Client property
can include securities and cash. In certain circumstances, CIPF’s role
may involve requesting the appointment of a trustee in bankruptcy.

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 Canadian Investor Protection Fund
(CIPF), II
 Limits for Individuals
For an individual holding an account or accounts with a member firm,
the limits on CIPF protection are generally as follows:
 $1 million for all general accounts combined (such as cash accounts, margin
accounts and TFSAs), plus
 $1 million for all registered retirement accounts combined (such as RRSPs,
RRIFs and LIFs), plus
 $1 million for all registered education savings plans (RESPs) combined where
the client is the subscriber of the plan.

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 Canada Insurance Deposit Corporation
(CDIC)
 Federal Crown Corporation that insures eligible deposits that are held with CDIC member
institutions. Many people deposit money into more than one account or financial product. We
insure eligible deposits SEPARATELY (up to $100,000, including principal and interest) for
EACH of the following seven categories:

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 Advisor-Customer Relations

 There are several important things to remember when you

deal with any broker/advisor:

 Any advice you receive is not guaranteed.

 Your broker works as your agent and has a legal duty to act in your best
interest (Fiduciary Duty)
 Brokerage firms, however, do make profits from brokerage commissions
and/or annual fees.

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 Types of Non-Registered Accounts

 A Cash account is a brokerage account in which securities

are paid for in full.

 A Margin account is a brokerage account in which, subject to

limits, securities can be bought and sold short on credit.

(more on selling short later)

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 A Cash Account

(a) Open the account

(b) Deposit $10,000

(c) Buy 100 Shares

of Stock at $80 per share

(d) Pay Commission,

say $50

(e) Cash Account has:

$1,950 in Cash
$8,000 in Stock

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 Margin Accounts, I.

 In a margin purchase, the portion of the value of an

investment that is not borrowed is called the margin.

 Of course, the portion that is borrowed incurs an interest

charge.

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 Example: Margin Accounts,
The Balance Sheet

• You buy 100 Walgreens Boots Alliance (WBA) shares at $80 per share.

• You put up $5,000 and borrow the rest.

• Amount borrowed = $8,000 − $5,000 = $3,000

• Margin = $5,000 / $8,000 = 62.5%

Liabilities and
Assets Account Equity
100 Shares, WBA $ 8,000 Margin Loan $ 3,000
Account Equity $ 5,000
Total $ 8,000 Total $ 8,000

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 Margin Accounts, II.

 The Investment Industry Regulatory Organization of Canada (IIROC) is the

national self-regulatory organization which oversees all investment dealers
in Canada. It has clear rules regarding margin trading through Rule 5310
 IIROC margin rules allows investors to borrow up to 70 percent of the
price of the securities to be purchased on margin
 Brokers also set their own minimum margin requirements called "house
requirements“
 The percentage of the purchase price of securities that an investor must
pay for is called the margin requirement. To buy securities on margin, the
investor must first deposit enough cash or eligible securities with a broker
to meet the margin requirement for that purchase.
 When the margin drops below the maintenance
requirement/margin, the broker can demand more funds. This is known
as a margin call.

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 Example: The Effects of Margin, I.
 You have $30,000 in a margin account; 60% initial margin
required.
 You can buy $50,000 of stock with this account (why?).
 Your borrowing rate from your broker is 6.00%.
 Suppose you buy 1,000 shares of Verizon (VZ), for $50/share.
 Assume no dividends, and that your borrowing rate is still
6.00%. What is your return if:

 In one year,VZ is selling for $60 per share?

 In one year,VZ stock is selling for $60 per share, but you did not
borrow money from your broker?

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 Example: The Effects of Margin, II.

 VZ is selling for $60 per share.

 Your investment is worth $60,000.

 You owe 6% on the $20,000 you borrowed: $1,200.

 If you pay off the loan and interest, your account balance is:
$60,000 − $21,200 = $38,800.

 You started with $30,000.

 Your return is $8,800 / $30,000 = 29.33%.

 Practice Question: Suppose Verizon stock was selling for $40 per
share instead of $60 per share? What is your return?

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 Example: The Effects of Margin, III.

 Verizon stock is selling for $60 per share, but you did not borrow from
your broker.

 You started with $30,000, which means you were able to buy $30,000 / $50
= 600 shares.

 Your investment is now worth $36,000.

 Therefore, your return is $6,000 / $30,000 = 20.00%.

 Practice Question: Suppose Verizon is selling for $40 per share instead
of $60 per share. What is your return in this case?

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 Example: Annualizing Returns
on a Margin Purchase, I.
 You buy 1,000 shares of Verizon (VZ) at $60 per share.

 Your initial margin is 50%.

 You borrow at the 9 percent call money rate plus 2 percent (variable rate)

 You sell your Verizon shares 3 months later for $63 per share.

 There were no dividends paid (and suppose the prices above are net of
commissions).

What is your holding period percentage return

and your EAR?

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 Annualizing Returns on a
Margin Purchase, II.
Answer: First, you have to repay the 3-month loan, so t = (3/12 = .25)

Amount Repaid = Amount Borrowed × (1 + interest rate per year)t

Amount Repaid = $30,000 × (1 + .11).25
= $30,000 × 1.02643
= $30,793

Your Sale Proceeds = Cash from Sale − Amount Repaid

= $63,000 − 30,793
= $32,207

Your Profit = Your Sale Proceeds − Your Investment

= $32,207 − $30,000
= $2,207

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 Annualizing Returns on a
Margin Purchase, III.
$32,207.10 - $30,000
Holding Period Percentage Return =
$30,000
$2,207.10
=
$30,000
= 0.0736, or 7.36 percent.

1 + EAR = (1 + Holding Period Percentage Return)m

= (1 + 0.0736) 4
Note that there are 12/3 =
= 1.3285 4 three-month holding
periods in a year.

So your EAR is about 32.85%. Therefore, m = 4.

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Hypothecation and Street Name Registration

 Hypothecation is the act of pledging securities as a

collateral against a loan.

 This pledge is needed so that the securities can be sold

by the broker if the customer is unwilling or unable to
meet a margin call.

 Street name registration (Nominee in Canada) is

an arrangement under which a broker is the registered
owner of a security. (You, as the account holder, are the
“beneficial owner.”)

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 Short Sales, I.

• Short Sale is a sale in which the seller does not actually own the
security that is sold.

Borrow Sell the Buy Return

shares shares shares the
from in the in the borrowed
someone market market shares

Today In the Future

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 Short Sales, II.

 An investor with a long position benefits from price

increases.
 Easy to understand
 Example:You buy today at $34, and sell later at $57, you profit!
 Buy low, sell high

 An investor with a short position benefits from price

decreases.
 Also easy to understand
 Example:You sell today at $83, and buy later at $27, you profit.
 Sell high, buy low

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 Example: Short Sales, I.
 You short 100 shares of AT&T (T) at $30 per share.

 50% initial margin (here you deposit $1,500) and a 40% maintenance margin on short sales.

 The market value of stock borrowed that is sold short is: $30 × $100 = $3,000.

 $3,000 is a liability:You are obligated to buy AT&T shares later at the market value.

Liabilities and
Assets Account Equity

Sale Proceeds $ 3,000 Short Position $ 3,000

Initial Margin Deposit $ 1,500 Account Equity $ 1,500

Total $ 4,500 Total $ 4,500

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 Example: Short Sales, II.
 AT&T stock price falls to $20 per share.

 Sold at $30, value today is $20, so you are "ahead" by $10 per share, or $1,000. The
market value of the shares is $2,000.

 You liability is now $2,000.

 Also, new margin: $2,500 / $2,000 = 125%

Liabilities and
Assets Account Equity

Sale Proceeds $ 3,000 Short Position $ 2,000

Initial Margin Deposit $ 1,500 Account Equity $ 2,500

Total $ 4,500 Total $ 4,500

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 Example: Short Sales, III.
 AT&T stock price rises to $40 per share.
 You sold short at $30, stock price is now $40, you are "behind" by $10 per
share, or $1,000. (“He who sells what isn’t his’n, must buy it back—or go to
prison.”)
 The market value of the shares is $4,000. The short position liability is $4,000.
 Also: new margin = $500 / $4,000 = 12.5% < 40%. Therefore, you are subject to
a margin call.

Liabilities and
Assets Account Equity
Sale Proceeds $ 3,000 Short Position $ 4,000

Initial Margin Deposit $ 1,500 Account Equity $ 500

Total $ 4,500 Total $ 4,500

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 More on Short Sales

 Short interest is the amount of common stock held in short

positions. Short interest summaries in Canada

 In practice, short selling is quite common and a substantial volume

of stock sales are initiated by short sellers.

 Note that with a short position, you may lose more than your total
investment, as there is no theoretical limit to how high the stock
price may rise.

 Short sellers face constraints.

 From government intervention (i.e., the SEC, IIROC)
 Also, there might not be enough shares available to borrow to short sell.
 Constraints reduce liquidity, increase volatility, and lead to inefficient pricing.

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Actual Short Positions for Tesla (TSLA)
(found at: [Link])

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 Forming a Real Investment Portfolio, I.
 We gave a Risk Tolerance Quiz to some employees at a well-known University.

 Possible quiz scores ranged from 10 (very risk averse) to 45 (little risk aversion).

 What type of portfolio do you recommend for each of them?

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 Forming a Real Investment Portfolio, II.
What do the scores mean?

 Marie: 21 year old accounting major.

 Long investment horizon to retirement (30+ years)
 Score of 40 indicates an aggressive approach: heavy weight on equity
 How much? Rule of thumb: 100 (or 110) minus age
 100 − 21 = 79% ; 110 − 21 = 89%

 Imelda: 59 year old college professor.

 Short investment horizon to retirement (5–10 years)
 Score of 18 indicates a conservative approach: smaller weight on equity
 100 − 59 = 41 % ; 110 − 59 = 51%

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 AAII Asset Allocation Models
Suggested Allocations by Investor Profile

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 Asset Allocation: Other Thoughts

 Recall that asset allocation is more important than security selection.

 As objectives change, investors modify their asset allocation.

 Strategic Asset Allocation:Your targeted asset allocation.
 Tactical Asset Allocation: Short-term changes to your strategic asset allocation.

 There are other ways to invest: one example is REITS.

 Real Estate Investment Trust
 A REIT is a company owning income-producing real estate.
 Apartments
 Shopping Centers
 REITS allow investors to diversify into real estate (without dealing with tenants).
 REITS might be risky: cash flows are not guaranteed.

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