Data processing: financial – business practice – management – or co – Automated electrical financial or business practice or... – Finance
Reexamination Certificate
1999-02-12
2002-03-19
Trammell, James P. (Department: 2164)
Data processing: financial, business practice, management, or co
Automated electrical financial or business practice or...
Finance
C705S035000, C705S037000, C705S038000
Reexamination Certificate
active
06360210
ABSTRACT:
BACKGROUND OF THE INVENTION
The present invention relates generally to methods and systems for managing portfolios of investments, and more particularly to a method and system for managing a portfolio of investments for smaller investors, in which the investor can manage and limit the risk inherent in the portfolio.
Investors increasingly understand the potential for long-term returns from investments in risky assets, i.e., risky investments can provide better returns over the long term as opposed to the returns from less risky assets. For example, an investment in relatively risky common stocks provides, on average and over the long term, a higher return than an investment in a money market account. Unfortunately, risky assets carry risk. Although over time and on average the returns on risky assets may be higher than those of less-risky assets, their returns are more volatile. An investor who wishes to ensure that a certain amount of investment will be preserved as of a specified time has no certainty with risky assets that such preservation will be achieved.
As an example, an investor that purchases a common stock for $100 has no assurance that in five years that share of common stock will be worth $100. By contrast, an investor that buys a 5 year Treasury note with a principal amount payable at maturity of $100 knows that (with almost 100% certainty), at the end of the five years, the note will pay precisely $100. For this reason, investors are frequently provided with advice to the effect that they should place their investments in different risk classes—usually short term (non-risky), intermediate term (some limited risk) and long term (risky). Under this structure the riskiness of long-term investments presumably provides a boost to overall expected returns while the probable preservation of value in the less risky part of the portfolio ensures that short-term cash needs can be satisfied. This advice attempts, at one level, to take into account the concept of risk, and reflects the general notion that risk is correlated with returns: the higher the risk, the higher the expected returns, and vice-versa.
There are a number of different ways of thinking about or characterizing types of risk. One type of risk is known as firm specific risk (which is relative to an individual company), which is closely related to firm credit and/or default risk. Very generally speaking, these are the risks that, if equity or debt, the share price will be highly volatile as opposed to relatively stable and the risk, if equity or debt, that the investment in the entity will not be repaid. Another type of risk, known as market risk (which is separate from the risk of any firm specific risk) is the risk that the relevant “market” as a whole will increase or decrease in value; the specific value of an investment may be correlated, to varying degrees, with “the market.” Yet another type of risk, known as liquidity risk is the risk that the investment can be paid or liquidated on short notice. There are many other risks as well, and different ways of thinking about these risks. While the present invention discusses these three types of risk, it is not limited in application to these three types of risk.
Assets suggested as short term investments generally are low risk from a variety of perspectives. First, the investment will be safe as to principal amount (e.g., the investment has low credit risk). Second, the investment will fluctuate little if at all relative to the market or to interest rates or other general economic variables (e.g., the investment has low market risk). Third, the investment will be available when needed on short notice (e.g., the investment has low liquidity risk).
Examples of short-term investments abound, ranging from traditional banking vehicles, such as passbook savings and interest-bearing checking accounts and short-term certificates of deposit, to short-term government bonds, to short-term highly rated corporate notes, to open-end mutual funds invested in such instruments (e.g., “money market mutual funds”) and funds investing in guaranteed bonds with short durations, etc. In this range of investments, rates of return are traditionally low, thus reflecting the low overall risk of the investments.
Medium and long-term investments generally have additional firm specific, market or liquidity risk. With higher levels of such risk, investors demand higher returns—which increases the cost of capital. Consequently, ever since investments were created efforts have been made to reduce these and other risks for investors. Such risk reduction would potentially attract a greater supply of capital to these investments, thereby lowering the returns demanded by investors and potentially lowering the cost of capital.
Firms can reduce liquidity risk by fostering a ready market for their securities. The advent of the traditional secondary trading markets has significantly reduced liquidity risk for publicly traded securities, which is part of the attraction of the public markets. Liquid secondary markets also reduce liquidity risk for various non-publicly-traded securities, such as open-end mutual fund shares. Specifically, liquid secondary markets enable open-end mutual funds—whose shares do not trade publicly—to provide liquidity to their shareholders (the individuals and institutions that invest through mutual funds). Because the fund can liquidate quickly some of its holdings to pay shareholders who wish to sell shares in the fund, the fund can, in essence, “make a market” in their own shares and guarantee liquidity to these holders by redeeming their interests in the fund for cash the next day at net asset value. If the funds faced an illiquid market for their own holdings, it would be much more difficult for them to guarantee liquidity to their own shareholders.
Efforts at reducing credit risk are extremely varied. Credit risk has been reduced by various types of credit enhancements, ranging from establishing trusts with collateral, to having larger institutions or more financially sound institutions guaranteeing the obligations of a more risky issuing entity, to limiting investments to those investigated and rated highly by others (such as S&P investment grade ratings), to imposing legal covenants and restrictions on the issuer designed to maintain credit-worthiness and, of course, the best credit enhancer of all, a direct or indirect U.S. government guarantee (such as the government guarantee in connection with federally-insured banks and savings institution deposits). These measures, to the extent credit risk is perceived as a major issue, are reasonably successful, even if, at times, they are not well priced. Of course, credit risk is also reduced somewhat by size, the larger and more profitable a firm, generally the less risky; and by the firm's own mix of businesses so that it may be less susceptible to a downturn in any one business area and thereby be less risky than if it was concentrated and focussed in just one business.
As discussed, firms embody a variety of firm specific risks. In addition to these mechanisms for reducing the credit/default type, liquidity and other risk associated with a specific firm, it has been generally well known and accepted that an investor can reduce firm specific risk—but not market risk—with regard to securities by creating a portfolio that is diversified.
Mutual funds have increasingly been the vehicle of choice through which smaller investors' have diversified their investments, but such funds have a number of significant disadvantages as compared to acquiring direct ownership of the securities themselves. (U.S. patent applications Ser. Nos. 09/038,158 and 09/139,020 filed by the same inventor discuss in detail the disadvantages of mutual funds, which applications are hereby incorporated by reference in their entirety, including the drawings, as if repeated herein.) Nevertheless, market risk in a portfolio of equities, for example, is not eliminated, even when diversification, whether through funds or in a directly-owned diver
Chung Chang Y.
Folio Trade LLC
Trammell James P.
LandOfFree
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