NET PRESENT VALUE
An investor may calculate the net present value (NPV) of an income-producing investment by discounting the series of future payments produced by the investment into the current value of one lump sum. When calculating the current value of a future stream of dividend or interest payments, the investor will take into consideration the amount of time until the payments are received as well as the overall interest rate environment. Payments that are made further out on the time horizon are discounted more heavily than payments received sooner and are therefore less valuable. The interest rate environment in which the NPV is calculated has a large influence on the present value of a future payment. If a higher interest rate is used in the NPV calculation, it will cause a greater discount to be applied to the future payment. Higher interest rates will cause future payments to be less valuable, whereas lower rates will cause the future payments to be discounted less and to be more valuable. The formula for calculating an investment's NPV is as follows:
NPV = NPV of future cash flows - NPV of cash outflows
The cash outflow in the above calculation equals the amount of money required to be invested to purchase the investment. If the NPV calculation results in a positive number, the investment should be made.
INTERNAL RATE OF RETURN
The internal rate of return (IRR) is the annualized average return expected during the life or holding period of an investment. Like an NPV calculation, it is a discounted cash flow method used to determine the merits of an income-producing investment. The IRR is the rate that would make the discounted present value of future cash flows equal to the current market price of the investment.
MODERN PORTFOLIO THEORY
As money management developed over the last century, analysts began to shift their focus from the returns available from individual investments to the returns available from an entire portfolio. This approach became known as modern portfolio theory. Modern portfolio theory is based on the concept that investors are risk adverse. Through diversification of investments and asset classes, portfolios can be constructed with higher levels of expected return for each unit of risk assumed. Asset classes are divided into three main categories: stocks, bonds, and cash and cash equivalents. Portfolio managers, through modern portfolio theory, can construct portfolios based on various allocations over the three main asset classes whose return will be the greatest given each unit of risk. This level of optimal performance is known as the efficient frontier. Any portfolio whose returns are expected to be less than optimal are said to be operating behind the efficient frontier. Optimal portfolio performance will be achieved by constructing a portfolio whose securities' prices move independently of one another or whose prices move inversely to one another. Allocating a client's assets over various asset classes to achieve a given investment objective is known as strategic asset allocation. As the investment results of the different asset classes vary over time, the assets may have to be rebalanced. Asset rebalancing can be divided into two categories: systematic rebalancing and active rebalancing. Systematic rebalancing is designed to keep the original asset allocation model in place. For example, if a client's portfolio is designed to be 70 percent, 25 percent, and 5 percent in stocks, bonds, and cash, respectively, as the percentages shift, the portfolio manager would rebalance the assets to maintain the original percentages. Systematic rebalancing can be done at regular intervals, such as quarterly, or whenever the asset allocation shifts by a certain percentage, such as by 5 percent or more. Active rebalancing assumes that a portfolio manager can effectively shift the asset allocation to take advantage of shifts in the performance of the various asset classes. If an investor has the same original portfolio allocation of 70/25/5 and the portfolio manager thinks that the bond market will outperform all other investments, the portfolio manager may use tactical rebalancing to rebalance the portfolio as 40/55/5. Alternatively, investors may elect to employ a buy-and-hold strategy and let the allocations go where they may. This buy-and-hold strategy would reduce transaction costs and tax consequences.