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