Chapter 4 - Investment Planning Flashcards
Degree by which two assets are RELATED to each other?
Correlation Coefficient (R)
+1 indicates:
0 indicates:
-1 indicates:
+1 indicates: Perfect Correlation
0 indicates: No Correlation
-1 indicates: Negative Correlation
Formula for standard deviation:
Sq Root of Variance
How do you calculate variance?
(Sum of squared differences between actual and expected return) / (Total # of observations - 1)
When do the greatest diversification benefits occur?
When portfolio is perfect -1 opposite correlation
Represents all possible portfolios that can be constructed?
Efficient Frontier
Indifference curve placement here indicates higher utility
Up and to the left
Modern Portfolio Theory combines the efficient frontier with 2 components?
RFR and Beta
What is beta?
Measure of a portfolios risk
What is the risk free rate?
Current Return on Treasury Bills
Measures the risk/return relationship for efficient portfolios of securities?
Securities Market Line
What are the 3 assumptions under CAPM?
1) Investors are Rational
2) Investors can borrow and lend at the RFR
3) Assume Taxes & Fees @ 0%
To the left of Point of Tangency on the efficient frontier of the Capital Market Line?
Lending Portfolios
All investments into a market portfolio?
Point of Tangency
To the right of the point of tangency on the capital market line?
Borrowing Portfolios
What is the CML Capital Money Line Formula?
(RFR + Standard Deviation of Portfolio) X (Market Return - RFR) / Standard Deviation of Market
What is the Sharpe Ratio formula?
(Market Return - RFR) / Standard Deviation of Market
Relative measure of portfolio performance in which total risk is measured by standard deviation is used to estimate risk adjusted performance.
Sharpe Ratio
This ratio is only meaningful when compared to alternative investments.
Sharpe Ratio
Sharpe Ratio measures what?
Risk adjusted performance (based on standard deviation)
What is the formula for risk premium?
(Market Return - RFR)
As risk premium decreases CML slope __________ .
Decreases
Measure of how much 2 assets MOVE together?
Covariance
Securities market line OR CAPM Formula:
RFR + Beta (Market Return - RFR)
How is variance calculated?
Standard Deviation Squared
What does CAPM calculate?
Required Return
Asset pricing model describes relationship between risk and return takes into account changes in inflation and GDP
APT - Arbitrage Pricing Theory
This theory states that perfect substitutes must sell for the same price.
Law of One Price
Measures the ability of an investor to stay invested when prices rise.
Risk Tolerance
8 Major Factors to Consider when determining investors risk tolerance.
- Loss Aversion
- Available Liquidity
- Savings
- Psychographics
- Insurance
- Time Horizon
- Goals
- Phase of Life cycle
When an investor has experienced too many losses and “calls it quits.”
Loss Aversion
Least risk for highest return
Efficient Portfolio
Another word for “willingness”
Propensity
What is the ideal allocations for a client age 65-death?
- Relatively liquid investments, enough to fund 5 years of expenditures
- Rest of portfolio - moderate growth
3 common approaches to asset allocation?
1) Strategic
2) Tactical
3) Mean Variance Optimization
Risk /Return Trade-off considering investor goals
Strategic
Approach to asset allocation that seeks to outperform market?
Tactical
Allocation style that seeks to maximize return for selected level of risk?
Mean variance
Strategy that uses index funds to fulfill the core components of the desired asset allocation?
Core Satellite
Trying to predict where an economic cycle is heading in the future and timing it.
Sector Rotation
Occurs when a mutual fund begins to diverge from its stated objective.
Style Drift
