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AFM 121 > Chapter 15: Portfolio Approach > Flashcards

Chapter 15: Portfolio Approach Flashcards

1
Q

What does portfolio management focus on

A

risk and return

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2
Q

what does financial decisions revolve around

A

risk-return trade off

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3
Q

what is the risk return trade off

A
  • reducing risk to reduce returns, and vice versa
  • greater risk = greater return
  • low risk, low return
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3
Q

what kind of investment will investors prefer

A

Investors will prefer an investment that generates the greatest return for a given level of risk

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3
Q

what riskier assets will investors who prefer greater very risk invest in

A
  • riskier stocks
  • like Tesla, Amazon, Google
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4
Q

what is the order of securities based on their risk level, starting with the least risky

A
  • treasury bills
  • bonds
  • debentures
  • preferred shares
  • common shares
  • derivatives
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4
Q

what very safe assets will investors who are very risk averse invest in

A
  • low risk, low return assets
  • like GICs, Canada Savings Bonds
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5
Q

how do you calculate % return

A

(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
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6
Q

how do you calculate the total return when you own a security

A

the sum of:
- interest or dividends received when you own it (cash flow yield)
- capital gain (price change)

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7
Q

what is the real rate of return

A

how much an investment has increased in real terms, after adjusting for inflation

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8
Q

what is the formula for calculating the approximate real rate of return

A

= nominal rate - inflation rate

  • nominal rate = % return calculated earlier
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8
Q

what is nominal rate

A

the actual rate of return

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9
Q

what is inflation risk

A
  • 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
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9
Q

what is business risk

A

the risk to that particular business or industry

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9
Q

what are the different types of risk

A
  • inflation risk
  • business risk
  • political risk
  • liquidity risk
  • interest rate risk
  • foreign exchange risk
  • default risk
  • systematic (market risk)
  • non-systematic (non-market risk)
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10
Q

what is political risk

A
  • 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
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10
Q

what is liquidity risk

A
  • 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)
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10
Q

what is interest rate risk

A
  • 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
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11
Q

what is foreign exchange risk

A

how the strength / weakness of the C$ will affect investment returns if investing in foreign securities

11
Q

what is default risk

A
  • the risk that a company goes bankrupt or defaults on its debt obligations
  • Never a good thing – particularly for equity holders
12
Q

what is systematic (market) risk

A
  • 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
13
Q

what is non-systematic (non-market) risk

A
  • 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
14
Q

who will these different types of risks affect

A

Some of these risks affect all securities / others affect only specific securities or those in particular countries or industries

14
Q

how do we measure risk

A
  • Variance
  • Standard deviation (square root of variance)
  • these are measurements of a security’s returns that help in measuring risk
15
Q

what is beta

A
  • 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
16
Q

what are the different types of assets that money can be distributed as

A
  • cash
  • fixed income
  • equities
17
Q

what do the different types of risk do the different assets have

A
  • 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)
17
Q

what is asset allocation

A
  • allocating assets
  • deciding where to put your capital (money)
18
Q

what kind of risk does cash provide

A

provides safety

18
Q

how do you determine asset allocations

A

depends on:
- who the investor is
- what their investment objectives and risk tolerances (such as when do they want the money by)

18
Q

what kind of risk does fixed income assets provide

A

income and a reasonable level of safety

19
Q

what is correlation

A

measures how the returns of 2 securities are related

19
Q

how do you calculate the overall expected return of a portfolio

A
  • 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
19
Q

what does perfect correlation mean

A

means that the 2 securities’ returns are move perfectly together 100% of the time

19
Q

what kind of risk does equity provide

A

provides the greatest growth potential

20
Q

what kind of correlation do you want for an ideal portfolio

A

An ideal portfolio will consist of securities with as much negative correlation as possible

20
Q

what is the best way to diversify a portfolio

A

purchase securities that move in opposite directions

20
Q

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?

A
  • 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)
21
Q

what are the different indications of correlation

A
  • +1.0 indicates perfect positive correlation
    – -1.0 indicates perfect negative correlation
    – 0.0 indicates no correlation
22
Q

how do we start constructing a proper portfolio

A
  • start with the investor’s objectives
  • their primary investment objectives
  • then secondary investment objectives
22
Q

what is something very important to know about portfolios and weighted averages

A
  • 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)
23
Q

what are the private investment objectives

A
  • Safety (can we lose some or all our money)
  • Income (typically from interest or dividends)
  • Capital growth (increases in the price of a security)
24
Q

what are examples of secondary investment objectives

A
  • Marketability / liquidity (I need my money and I need it fast…)
  • Tax minimization (increasingly important given 50+% taxes in Canada)
25
Q

what are some constraints related to objectives of investments & what is done because of it

A
  • We cannot minimize safety and maximize income and capital growth
  • Trade-offs are made depending on investor investment objectives and risk tolerances
26
Q

what is the order of investments in terms of safety from best to least

A
  1. short-term bonds are best
  2. long-term bonds are next best
  3. preferred shares are good
  4. common shares are least
27
Q

what is the order of investments in terms of income from very steady to variable

A
  1. both short-term and long-term bonds are very steady
  2. preferred shares are steady
  3. common shares are variable
28
Q

what is the order of investments in terms of growth from best to very limited

A
  1. common shares is the best
  2. preferred shares & long-term bonds are variable
  3. short-term is very limited

AFM 121 (12 decks)

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