Ch.8 Investing and portfolio diversification

Question 1

Calculating total return on an investment

Answer 1

made up of income returns and capital gain returns
return on a fixed-income security= interest earned+ capital gain (or loss) on the sale of the bond - original price / original price
return on a share= dividend income received + capital gains (loss) on sale of the investment - original price / original price

Question 2

Risk versus return trade-off

Answer 2

risk versus return, or the trade-off between risk and return
Lower levels of risk are associated with lower potential returns, while higher levels of risk are associated with higher potential returns
Investments are priced based on their risk and the return to compensate for this risk.

Question 3

Expected return on a single security

Answer 3

expected return on an investment represents the average of possible returns for next year, weighted by their probabilities.

Question 4

Measurement of risk for a single security

Answer 4

Volatility is an indication of how much the return on an investment increases or decreases within a specified period of time
Higher volatility and more risk is represented by a larger spread between an investment’s lowest possible return and its highest possible return
amount of risk for an investment is measured by the variance and standard deviation (the square root of the variance) of these possible returns

Question 5

Covariance and correlation between returns on two securities

Answer 5

Covariance and correlation are used to measure the relationship between the returns of two investments
Covariance is a statistical measure of the degree to which two random variables move together
Correlation is a statistical measure of the degree to which the movements of the two variables are related.
The correlation will fall between –1 and +1. The higher the number, the more correlated the returns of the two investments.

Question 6

correlation

Answer 6

• If the correlation is positive, the returns of the two investments move in the same direction (positive correlation) — that is, when one security has a higher-than-average return, the other security will also have a higher-than-average return at the same time.
• If the correlation is negative, the returns on the two investments move in opposite directions (negative correlation) — that is, when one security has a higher-than-average return, the other security will have a lower-than-average return at the same time and vice versa.
• If the correlation is zero, then there is no relationship between the returns of the two investments — that is, when one security has a higher-than-average return, no conclusion can be made as to what the return of the other security will be at the same time.
• If the correlation is equal to one, there is a perfect positive correlation between the returns of the two investments. This means diversification benefits are not available, as both securities will have the same rate of return.

Question 7

Basics of portfolio theory

Answer 7

combination of several investments, the expected return and standard deviation of the portfolio can be calculated. The actual returns on individual investments will be above or below their expected values, but the average of the actual returns will be close to the expected return on the portfolio
holding a sufficiently large number of investments with returns that are not perfectly positively correlated ensures that the realized average of returns will be close to the expected return. Consequently, knowing the statistical properties of an investment is essential for determining which combination of investments to include in a portfolio.

Question 8

Portfolio diversification

Answer 8

There are two main advantages of considering diversification in an investment portfolio: risk management and portfolio optimization.

Question 9

Risk management

Answer 9

Portfolio diversification is an investment strategy that involves combining a variety of different assets into one investment portfolio to reduce the overall risk of that portfolio. Diversification allows risk to be minimized without adversely affecting the portfolio’s expected return.
• If all the securities in a portfolio are perfectly positively correlated (that is, +1), then there is no reduction in portfolio risk, since all investments will move in the same direction.

• If all the securities have no correlation, there is some reduction of risk, but it is not totally eliminated.
• If the securities are perfectly negatively correlated (that is, –1), then portfolio risk can be eliminated.

Question 10

Portfolio optimization

Answer 10

efficient portfolio is a portfolio in which:
• the portfolio risk is the smallest for a given level of expected portfolio return; or
• it has the highest expected return for a given level of risk.

Question 11

Total risk, unsystematic risk, and systematic risk

Answer 11

Total risk as measured by the standard deviation is made up of systematic risk and unsystematic risk.
Unsystematic risk (also known as diversifiable risk, unique risk or asset-specific risk) is the portion of total risk that is unique to the security. Factors that create this type of risk include management decisions, the firm's financial and operating leverage, labour problems, raw material availability, competition, and other factors specific to the company or industry. Unsystematic risk can be eliminated by combining the security with others.

Question 12

The Capital Asset Pricing Model

Answer 12

investors need to be compensated for the pure time value of money represented by the risk-free rate, and for additional risk. As a result, the return on any investment is a function of the risk-free rate plus a risk premium
The risk premium depends on:
• the price of risk, which is represented as the spread between the expected market return and the risk-free rate (the spread is known as the market risk premium)
• the amount of risk, which is the ratio of the portfolio’s risk compared to the degree of risk of the market as measured by beta

Question 13

Making the investment decision

Answer 13

• Capital preservation — The investor wants to ensure that the original amount invested in the portfolio is not lost.
• Annual income — What level of income is required annually by the investment? The income will be in the form of dividend income or interest income. How guaranteed is this income? Interest income is an obligation of the issuer and must be paid. Dividends are only paid when declared, so there is no guarantee dividend income will be received.
• Growth of capital — How much growth does the investor want to achieve annually? The growth of capital will be in the form of capital gains.
• Liquidity of investments — How easily does the investor want (or need) to be able to liquidate the investments for immediate cash?
• Time horizon — How long will the investment be made before it must be liquidated. Is the time horizon for the long term or the short term?
• Income tax minimization — Income tax rates differ depending on whether the income is dividends, interest, or capital gains. Income tax rates on these sources of income also vary depending on whether the investor is an individual (and in this case, which tax bracket), a corporation, or a not-for-profit entity.

Question 14

Bottom-up versus top-down investing

Answer 14

bottom-up investing, which is just another way of saying that you look at the company itself and make your investment decision based on your opinion of that company and its future prospects.
top-down investing. In this approach, the macroeconomic environment is considered first.