Question

1. Explain the investing process. What is asset allocation? What criteria are used to determine asset allocation decisions? Explain each criteria and how the criteria will influence the asset allocation decisions. Once an asset allocation decision is made, how do we proceed to security selection? That is, how do we determine which securities to include in our portfolio
2. Identify and briefly explain two of the behavioral biases we discussed in class and provide examples of how those biases influence your behavior or the behavior of others.
3. Explain how JP Morgan attempts to exploit investors’ behavioral biases. What two biases do they focus on. How do they implement strategies to take advantage of the biases? As JP Morgan’s behavioral offerings increase in size (amount of funds invested by investors), what would you expect to happen to the profitability of their investments? Will they become more or less profitable? How or why?
4. What is meant by valuation by comparables? What is the purpose of comparing valuation levels of multiple companies? Please provide an example of how you might use the valuation by comparables approach

Answer 1

Note: As per answering guidelines, only the first question can be answered.

Solution- 1

What is investing process?

In simplest words, investing process can be defined as the process of putting money to use with the objective of increasing its value (purchasing power) over time. If we keep money idle, it will not increase its value, in fact it would lose its purchasing power due to inflationary pressures. The investment activity is focused on putting money to the best possible use such that its purchasing power can be maximised over the tenure of investment.

Asset allocation

As part of the investment process, the most crucial decision is to decide the required rate of return and the risk that the investor is ready to take. Various asset classes offer different risk and return profiles. The job of the investor is to create a portfolio consisting of one or more types of assets such that the overall portfolio meets the objectives related to required return and acceptable risk. Therefore, asset allocation is that process of choosing which assets classes (Equities, bonds, metals, currencies, real estate, etc.) should form part of the portfolio and what should be the weightage of each asset class in the total portfolio.

Criteria for asset allocation

The primary criteria for asset allocation are as follows:

1) Risk and expected returns: The assets that an investor should include in the portfolio is dependent on the level of required rate of return and the level of risk that is acceptable to meet that objective. The assets that offer higher returns are also more risky and vice-versa. The investor must carefully include those assets that offer the required risk-reward scenarios. Also, there weightage should be appropriate, such that the overall portfolio can have the required rate of return while keeping risk to the acceptable levels. Further, there are many ways to reduce the risk of the portfolio which include the following:

• Diversification into different asset classes
• Diversification into assets in different geographies

2) Liquidity: Different assets offer different liquidity (i.e. the ability to liquidate when funds are required). While assets like equities are highly liquid, some asset classes like real estate, bonds may not be that liquid. The investor must carefully build a portfolio and chose the assets that offer the overall liquidity that is required in the portfolio.

3) Income vs capital appreciation: Some assets offer returns only in the form of income such as bonds, some only as capital appreciation such as growth stocks, while some offer both in the form of income and capital appreciation such as real estate. The investor must chose assets that offer returns n the form the investor's requirement.

4) Taxability: The tax provisions related to different assets must be carefully analysed while choosing to allocate assets to the portfolio.

Which securities to include in portfolio?

Once the investor decides which asset classes to include in the portfolio, the next step is to identify individual securities within those asset classes. There are many stocks that offer different returns and have different risks. Similarly, few bonds have lower interest rates and lesser risk while others have higher interest and higher risk.

The decision related to choosing individual securities among an asset class is based on the objective (risk & returns) that the investor is trying to achieve by investing in that asset class. E.g.- If he is looking for a very high return from equities, he would have to chose stocks that are smaller and less stable and vice-versa. Therefore, choosing individual securities is completely dependent on the objectives of investment in that asset class. The investor must make sure that the chosen securities are the ones that are expected to meet objectives set out for that asset class.