PORTFOLIO MANAGEMENT

Portfolio Management



Portfolio Management

Introduction

Let's say that you have $1,000,000 in your hands right now, and that you would like to "invest" it so that it will earn a reasonable rate of return and grow over the next 10 years. Perhaps this $100,000 is a gift you received from your parents that is intended to help your 8 year old son go to college when he is 18. Here is a list of possible investing options - certainly not an exhaustively complete list, but a list of the most common options:

Your checking account

A normal "passbook savings account" at a bank

A money market account

A CD

A U.S. savings bond

A corporate or municipal bond

A bond mutual fund

Stock in some company, like IBM or GM

A stock mutual fund

That is a lot of options. If you are just starting out, it is a "bewildering array of options". The following sections describe, in English, the attributes, advantages and disadvantages of each of these investments. (Reinganum, 1981, 439-62)

A Money Market Account

A money market account at most banks works approximately like a savings account, but it gets a better rate of return. In addition there might be a few restrictions on a money market account, like a minimum balance or a maximum number of withdrawals per year. A money market account has the same advantages and disadvantages of a savings account. Current money market rates average 4%. For money that you plan to hold for a short period of time (three months to a year) and that needs to be liquid, a money market account is probably your best bet.

Certification of Deposit

A CD, or "Certificate of Deposit", is a bank account that earns a better rate in return for a fixed time commitment on your part. You deposit money into the account and receive a "certificate" that allows you to withdraw the money at some later date.

Certificates of deposit have several advantages. First and foremost, they are absolutely secure if they are held by an FDIC-insured bank and the account balance falls within the $100,000 limit. It is impossible to lose the money. They also pay a fairly reasonable rate of return that exceeds the inflation rate. Typical rates today for a one year CD are 5%. However, there are two disadvantages. First, they are not very liquid, so they are not good for money that you may need to use on a moment's notice. Also, they represent only a "holding action" - you generally do not make any money off a CD. Here's why: the current rate of return is 5%, and the inflation rate is 3.3%. Therefore, the real return rate is 1.7%. However, you must pay taxes on the money that the CD earns each year. The taxes essentially nullify the 1.7%. Therefore, the real rate of return from a CD is zero, and this is true almost always. (Hussman, 1993)

A U.S. savings bond

A U.S. savings has many of the same attributes as a ...