Asset Allocation Flashcards
The larger the standard deviation the [higher or lower] the investment risk.
Higher
True or False
Asset allocation attempts to diversify away market risk without compromising return
False; Market risk cannot be eliminated
Describe how the Capital Asset Pricing Model (CAPM) works
CAPM states that the expected return of a security/portfolio equals the rate of return on a risk premium
(expected return of security = rate of return on a risk premium)
(Basically, if investors assume risk of holding stock, they demand a premium rate of return beyond the risk free rate)
How does CAPM measure the covariance between a stock and the market (ie benchmark)?
CAPM uses Beta
Formula to find Beta
Beta = (correlation coefficient x standard deviation of the security) ÷ standard deviation of the market
Formula to calculate the weighted portfolio Beta
Stock Weight A x beta = weighted beta A
Stock Weight B x beta = weighted beta B
Stock Weight C x beta = weighted beta C
weighted β A +
weighted β B +
weighted β C =
weighted portfolio β
Capital Asset Pricing Model Formula
rᵢ = rf + (rₘ - rf) βᵢ
rᵢ - expected return of investment
rf - risk free rate of return
rₘ - Risk premium of market
βᵢ - Beta of the investment
What is the Random Walk Theory (RWT)?
Market and security price movements are totally random; The movement of one stock has no bearing on another.
Past stock price movements of any particular stock should not be considered as an indicator of possible movement of same stock ESPECIALLY IN THE SHORT TERM
What is the Efficient Market Hypothesis (EMH)?
All available information regarding a security is fully and rapidly reflected in the security’s price.
Can’t expect to outperform market on a risk adjusted basis
No technical analysis to outperform market
Weak form of Efficient Market Hypothesis
Superior performance may be generated through fundamental analysis using publicly available info
(You can crush it with public info and insider info)
Semi-strong form of Efficient Market Hypothesis
Superior results can be produced only by using private insider info
(security prices reflect all publicly available knowledge)
Strong form of Efficient Market Hypothesis
Not even insider information can be used to generate superior investment returns
(security prices fully reflect all public and private info)
Explain some anomalies or strategies that go against Efficient Market Hypothesis
Behavioral Finance
- January Effect (Jan is high return month)
- Weekend Effect (small cap prices rise on fridays and fall on mondays)
Low P/E stocks - companies with low P/Es have shown higher average risk adjusted returns
True or False:
The Capital Asset Pricing Model assumes the market is efficient
True
True or False:
The key message of the Capital Asset Pricing Model is that there is a direct relationship between risk and behavior
False; …direct relationship between risk and return
What is the difference between the Capital Market Line and the Security Market Line?
(3 big contrasts)
CML - x axis is standard deviation
SML - x axis is beta
CML - measures all risk
SML - only measures systemic risk
CML - valid for all portfolios
SML - only valid for well-diversified portfolio
What does alpha refer to?
Alpha compares the expected return of a stock portfolio (based on its beta) to its actual return
Generally speaking alpha is used as a measure of the ____ to the performance of the portfolio
Portfolio’s Manager’s contribution
The ___ your alpha, the better your portfolio.
Higher
R² = Coefficient of Determination
What does this even mean?
The coefficient of determination (R²) explains the degree to which changes in a portfolio’s value or security’s price are driven by changes in a benchmark index (the market).
True or False
Changes in the benchmark index (the market) are caused predominantly by nonsystematic risk
False; systematic risk
R² ranges from ___% to ___%
In general, the ___ the R², the more reliable a portfolio’s alpha and a beta measurements will be.
0% - 100%
Higher
Alpha and Beta are generally considered valid risk measurement tools on the CFP exam only when R² equals or exceeds ___%
70%
What are 4 reasons Capital Asset Pricing Model kinda sucks?
- Limited to equities
- Assumes an efficient market (aka no company research; price is all that matters)
- Ignores underlying company
- Assumes future is like the past
Arbitrage Pricing Theory is an alternative to CAPM. What is its fundamental belief?
APT believes pricing inefficiencies are quickly corrected in today’s market.
According to Arbitrage Pricing Theory, the following 4 factors explain unexpected changes in security returns:
- Unexpected Inflation
- Unexpected changes in Industrial Production
- Unexpected changes in Interest Rates
- Unexpected changes in Risk Premiums
Another term for Nonsystematic Risk is…
Specific Risk
What is the logic behind the Modern Portfolio Theory?
Risk is bad. So investors must be paid a premium for taking risk.
Therefore, the goal should be to find the most effective risk-return profile given the securities available to an investor.
What is the “Mean-Variance?”
The variance of each security around the average return.
(aka a measure of the risk associated with the security)
3 inputs are required to discern the Mean-Variance Optimization. What are they?
- Expected returns for each asset
- Return volatility (or standard deviation) of each asset
- Correlation Coefficient for every pair of assets in the portfolio
For Mean-Variance Optimization to give correct results, all ___ must be correct.
Otherwise the whole model falls apart.
3 inputs
(ie expected returns, correlations, and standard deviations)
Describe generally how Monte Carlo Sensitivity Analysis works
Software randomly generates numbers for uncertain variables (interest rates, investment volatility, life expectancy rate, etc.)
Does this a bunch to figure out how your plan can withstand certain scenarios
Gives realistic perspective on viability of plan
What is Strategic Asset Allocation?
Designed for a longer-term perspective
Buy, Hold, Rebalance
What is Tactical Asset Allocation?
Seeks to capitalize on short term market conditions and anticipated market moves
More active shifting
