chap 5 Flashcards
portfolio
is a collection of investments assembled to meet one or more investment goals.
Growth−oriented portfolio:
primary goal is long−term price appreciation
Income−oriented portfolio:
designed to produce regular dividends and interest payments.
Correlation and Diversification
As a general rule, the lower the correlation between any two assets, the greater the risk reduction that investors can achieve by combining those assets in a portfolio:
Assets with +1 correlation eliminate no risk
Assets with less than +1 correlation eliminate some risk
Assets with less than 0 correlation eliminate more risk
Assets with −1 correlation eliminate all risk
–Assets that are less than perfectly positively correlated tend to offset each others movements, thus reducing the overall risk in a portfolio
Methods of International Diversification
Direct Investment Abroad
Investment in stock or bonds of foreign companies/governments listed on U.S. exchanges
International mutual fund
What about a portfolio of U.S. based multinational corporations? (for international diversification)
A portfolio of U.S. multinationals is more diversified than a portfolio of wholly domestic firms.
–Investors still won’t enjoy the full benefits of international diversification since a disproportionate share of revenues and costs generated by these firms is still in the U.S.
–To fully realize benefits of international diversification, it is necessary to invest in firms located outside the U.S
Components of risk for portfolios
Diversifiable (Unsystematic) Risk
Undiversifiable (Systematic) Risk:
Total risk:
Diversifiable (Unsystematic) Risk:
results from factors that are firm−specific.
Examples: whether a new product succeeds or fails, the performance of senior managers, or a firms’ relationship with its customers and suppliers
Undiversifiable (Systematic) Risk:
the inescapable portion of an investment’s risk that remains even if a portfolio is well diversified.
Associated with broad forces such as economic growth, inflation, interest rates, and political events.
Also called market risk
Total Risk
sum of undiversifiable and diversifiable risk
Beta:
a number that quantifies undiversifiable risk, indicating how the security’s return responds to fluctuations in market returns
Interpreting Beta:
The beta for the overall market is 1.0.
Stocks may have positive or negative betas, although nearly all investments have positive betas.
The positive or negative sign in front of the beta number merely indicates whether the stock’s return moves in the same direction as the general market (positive beta) or in the opposite direction (negative beta).
Most stocks have betas that fall between 0.50 and 1.75.
Capital Asset Pricing Model (CAPM)
A model that uses beta to quantify the relation between risk and return for different investments.
Limitations of CAPM
CAPM generally relies on historical data since the value of beta used in the model is typically based on calculations using historical returns.
–Betas estimated from historical data may or may not accurately reflect how the company’s stock will perform relative to the overall market in the future.
The Traditional Approach (for creating portfolios)
Traditional portfolio management: emphasizes balancing the portfolio by assembling a wide variety of stocks and/or bonds.
interindustry diversification: typical emphasis uses securities of companies from a broad range of industries to diversify the portfolio.
Tends to focus on well−know companies
–Perceived as less risky
–Stocks are more liquid and available
–Familiarity provides higher “comfort” levels for investors “window dressing”
