Chapter 15: Portfolio Approach Flashcards
What does portfolio management focus on
risk and return
what does financial decisions revolve around
risk-return trade off
what is the risk return trade off
- reducing risk to reduce returns, and vice versa
- greater risk = greater return
- low risk, low return
what kind of investment will investors prefer
Investors will prefer an investment that generates the greatest return for a given level of risk
what riskier assets will investors who prefer greater very risk invest in
- riskier stocks
- like Tesla, Amazon, Google
what is the order of securities based on their risk level, starting with the least risky
- treasury bills
- bonds
- debentures
- preferred shares
- common shares
- derivatives
what very safe assets will investors who are very risk averse invest in
- low risk, low return assets
- like GICs, Canada Savings Bonds
how do you calculate % return
(cash flow + (ending value - beginning value)) / beginning value
- cash flow is the interest or dividends received
- ending value - beginning value is the capital gain
- ending value is what you sold it for (would be the face value for a bond)
- beginning value is the amount you originally paid for
how do you calculate the total return when you own a security
the sum of:
- interest or dividends received when you own it (cash flow yield)
- capital gain (price change)
what is the real rate of return
how much an investment has increased in real terms, after adjusting for inflation
what is the formula for calculating the approximate real rate of return
= nominal rate - inflation rate
- nominal rate = % return calculated earlier
what is nominal rate
the actual rate of return
what is inflation risk
- inflation erodes the the future value of security’s cash flow
- So, prices fall with an increase in inflation
- affecting the purchasing power of money to decline
- interest rates are increased to reduce inflation
what is business risk
the risk to that particular business or industry
what are the different types of risk
- inflation risk
- business risk
- political risk
- liquidity risk
- interest rate risk
- foreign exchange risk
- default risk
- systematic (market risk)
- non-systematic (non-market risk)
what is political risk
- the risk of doing business in a particular country
- the economic stability of the country’s economy
- such as if the government is going to make new laws
what is liquidity risk
- can I monetize my investment quickly and easily?
- the risk of not being able to liquify the security (being able to sell it fast with no significant changes in the price)
what is interest rate risk
- how sensitive is a security’s return to an increase in interest rates
– If interest rates rise, in general a security’s value will fall
what is foreign exchange risk
how the strength / weakness of the C$ will affect investment returns if investing in foreign securities
what is default risk
- the risk that a company goes bankrupt or defaults on its debt obligations
- Never a good thing – particularly for equity holders
what is systematic (market) risk
- risk relating to the overall market or economy
- This risk cannot be diversified away
- You will always be exposed to general movements in the overall market or economy
- if you are investing in something within a stock market, there is a certain amount of risk that needs to be accepted
- you don’t have a choice to the overall level of risk
what is non-systematic (non-market) risk
- Risk relating to a specific firm (ie. The risk that a company goes bankrupt or revenues significantly decline because of a recall on its products)
- This risk can be diversified away by buying different stocks in different industries in different countries
- can choose what kind of risk to take on based on what you invested in
- Your portfolio will not be biased to a particular company / industry / country
who will these different types of risks affect
Some of these risks affect all securities / others affect only specific securities or those in particular countries or industries
how do we measure risk
- Variance
- Standard deviation (square root of variance)
- these are measurements of a security’s returns that help in measuring risk
what is beta
- measures a security’s returns relative to the overall market (volatility)
- the higher a firm’s beta, the greater the risk is relative to the overall market
- ex. if beta = 1.5%, that means if the market (like the S&P500) goes up by 10%, the stock return will go up by 15% and vice versa
what are the different types of assets that money can be distributed as
- cash
- fixed income
- equities
what do the different types of risk do the different assets have
- Each of these assets has risk / return characteristics (cash should be 100% safe but virtually no return)
- Within each of these assets are further risk / return characteristics (defensive stocks have much less risk than speculative stocks)
what is asset allocation
- allocating assets
- deciding where to put your capital (money)
what kind of risk does cash provide
provides safety
how do you determine asset allocations
depends on:
- who the investor is
- what their investment objectives and risk tolerances (such as when do they want the money by)
what kind of risk does fixed income assets provide
income and a reasonable level of safety
what is correlation
measures how the returns of 2 securities are related
how do you calculate the overall expected return of a portfolio
- look at the expected return of the asset in the portfolio and its weighting
- take the expected return % and multiply the weighting % of it
- do that for all of the different investments in the portfolio and add them all together
what does perfect correlation mean
means that the 2 securities’ returns are move perfectly together 100% of the time
what kind of risk does equity provide
provides the greatest growth potential
what kind of correlation do you want for an ideal portfolio
An ideal portfolio will consist of securities with as much negative correlation as possible
what is the best way to diversify a portfolio
purchase securities that move in opposite directions
Ex. if the overall expected return of a portfolio was around 10%, but the expected return for a single company is already 10%, why should we invest in other securities? or why don’t we just invest in the one that has the highest return?
- in case something bad happens to the company (ex. some kind of scandal)
- need to diversify the investments to eliminate the risk specific to one firm
- don’t want investments to move together (don’t buy from on singular industry)
what are the different indications of correlation
- +1.0 indicates perfect positive correlation
– -1.0 indicates perfect negative correlation
– 0.0 indicates no correlation
how do we start constructing a proper portfolio
- start with the investor’s objectives
- their primary investment objectives
- then secondary investment objectives
what is something very important to know about portfolios and weighted averages
- Portfolio returns will be the weighted average of returns for all securities
- However, the overall portfolio risk will be lower than the weighted average of risks for of all securities (because of Diversification)
what are the private investment objectives
- Safety (can we lose some or all our money)
- Income (typically from interest or dividends)
- Capital growth (increases in the price of a security)
what are examples of secondary investment objectives
- Marketability / liquidity (I need my money and I need it fast…)
- Tax minimization (increasingly important given 50+% taxes in Canada)
what are some constraints related to objectives of investments & what is done because of it
- We cannot minimize safety and maximize income and capital growth
- Trade-offs are made depending on investor investment objectives and risk tolerances
what is the order of investments in terms of safety from best to least
- short-term bonds are best
- long-term bonds are next best
- preferred shares are good
- common shares are least
what is the order of investments in terms of income from very steady to variable
- both short-term and long-term bonds are very steady
- preferred shares are steady
- common shares are variable
what is the order of investments in terms of growth from best to very limited
- common shares is the best
- preferred shares & long-term bonds are variable
- short-term is very limited
