Chapter 14 Flashcards
Different Types of Asset Diversification
Within an asset class
Asset Allocation diversification
International Diversification
Diversification over time
Expected Vs. Realized Return
Realized: the return actually received during the holding period.
Expected: The return expected based on data given.
What is an Optimal Portfolio?
Minimizing Risk, Maximizing return
Risk Neutral Individuals make decisions based on…
Return alone.
Risk Averse Individuals make decisions based on…
trade-off between risk and return in making decisions.
Investors in terms of risk are usually…
Risk averse and prefer higher levels of terminal wealth. Risk appetite varies investor to investor.
Investment Risk Factors
Default Risk Interest Rate Risk Liquidity Risk Reinvestment Risk Inflation Risk
T-Bill Risk Profile
T-Bill’s will always return the risk free rate but they are exposed to inflation risk, though over short horizons there is very low risk.
Stand Alone Risk
Diversifiable Risk + Non-diversifiable risk (market). Measured by dispersion of return about the mean and is only relevant for assets held in isolation.
What is diversifiable risk?
Caused by company specific events.
Effects of these effects and associated risk can be eliminated by diversification.
What is Market Risk?
Stems from external events like war, inflation, recession, and interest rates.
All firms effected, cannot be diversified.
Also known as systematic risk.
What are some general statements regarding risk?
Most stock are positively correlated (0.65). Most stocks have average SD of 35%. Combining these together lowers risk. EQUATIONS FROM 14-34,36,31,25,41,42
What is the market model and how is it different than CAPM?
r=a + B + e
CAPM is an equilibrium model. Assumptions differ.
Total risk for an individual security is measured by
Its variance which consists of two parts: one part market, one part unique (firm specific, non systematic) Similar with portfolio mix.
Portfolio Market Risk is unique because..
Beta is an average of the beta of its securities. Unless deliberate, diversification will not cause the beta to go in a certain direction.
Why does risk reduce when random stocks are added and how many are needed to achieve diversification?
By randomly adding stocks the standard deviation of the portfolio decreases because the random stock is probably not correlated with the existing security. At about 40 stocks diversification is achieved.
Holding a single stock is a bad idea because
You are not compensated for the additional risk you take on.
What are the three forms of market efficiency?
Weak form - Past Prices
Semi-strong Form- Publicly available available info
Strong Form- All information, public and private.
How does fundamental analysis make the market more efficient?
Helps identify mispriced securities and drive those prices towards their true values.
What strategies should an investor use in a efficient market?
Reduce costs by using a strong holding strategy, trade less or use a discount broker.
Minimize taxes by using sheltered investments - CG, Div, Interest.
