Chapter 1 and Notes: Lecture 3 Slides 35-54 Flashcards
Risk versus Return
Discuss investment return from the following investments: Equities - Stocks Fixed Income Securities - Bonds Short Term Investments - Cash Mutual Funds
Equities – Stocks 8% to 12% (8% to 10%) Fixed Income Securities – Bonds Treasury & Municipal Bonds – 1% to 5% Corporate Bonds – 4% to 6% Short Term Investments – “Cash” 1% to 3% Mutual funds will more or less (often less) reflect the underlying assets that they invest in
Discuss why stocks historically have done better than any other investment alternative.
Over the long term, equities (stocks) have produced the best returns
You must have a long term perspective and not freak out and sell out
Ride out the big bumps or drops
As the global economy continues to grow….corporations and big stock makes sense
What is the Risk Free Rate of Return?
This is the return on guaranteed short term investments.
Specifically, the return on 3 month U.S. Treasury Bills
What is Risk Premium?
It is the reward for bearing risk; the extra return on a risky asset over the risk free rate of return.
Subtract the risk free rate of return to calculate risk premium
Describe the investment risk premiums of the following investments: Large Company Stocks Small Company Stocks Long Term Corporate Bonds Long Term Gov't Bonds U.S. Treasury Bills
Large Company Stocks
Average Return 11.9%
Risk Premium 8.5%
Small Company Stocks
Average Return 16.2%
Risk Premium 12.8%
Long Term Corporate Bonds
Average Return 6.3%
Risk Premium 2.9%
Long Term Gov’t Bonds
Average Return 5.9%
Risk Premium 2.5%
U.S. Treasury Bills
Risk Free Rate of Return 3.4%
Investment risk premiums from 1926 to 2018. Inflation during this period ran at 3.0%. Note that if you kept your money in Short Term you barely broke inflation.
Discuss risk versus reward: risk versus return
Risk versus Reward; Risk versus Return
Investment return is very straight-forward
How much did you start with and how much did you end with? That is your return!
But measuring how much risk you took to receive that return is much more difficult
Each year, the investment community measures the average annual return and the amount of variance from the average return
Using statistics, the resulting measures of risk are called variance and standard deviation
What are variance and standard deviation used for?
They measure the risk in any investment. Suffice to say the higher the variance and standard deviation, the riskier the investment
i.e. The higher the variance and standard deviation, the more the investment return will deviate from the average annual return.
Define variance
The variance essentially measures the average squared difference between the actual returns and the average returns (Total Percent Return) . It is a common measure of volatility.
Define standard deviation
The standard deviation is the square root of the variance to determine how much the current return differs from the average in a typical year. What we are using is the historical variance to determine the standard deviation of returns. It would be different for projected future returns.
Define normal distribution
Investments over time tend to mirror a normal distribution or a bell curve. The usefulness of the normal distribution stems from the fact that it is completely described by the average and standard deviation. For example, with a normal distribution, the probability that we will end up within one standard deviation is 68% or 2/3. The probability of being within 2 standard deviations is 95%. The probability of 3 standard deviations away from the average is less that 1%. The issue is it is unforeseeable which way the standard deviation will land; positive or negative.
Just know the greater the standard deviation the wider the distribution the riskier the investment.
Just know the greater the standard deviation the wider the distribution the riskier the investment.
As the return goes up so does the standard deviation so does the risk of the investment not giving you the average annual return.
As the return goes up so does the standard deviation so does the risk of the investment not giving you the average annual return.
What is an investor?
An investor whose objective is to secure a steady return on their money at a good rate of interest.
What is a trader or speculator?
An in investor whose objective is to profit by the rise and or fall in the price of whatever they may be speculating in.
What is a realistic rate of return for me?
After you have taken this course, you will have a strong knowledge of the most popular types of investments
Stocks, Bonds, “Cash,” Mutual Funds, etc.
You will also know what levels of returns and what levels of risks you should reasonably expect to receive
And if you are a patient, long-term investor, it is realistic to expect 8% to 10%
