Equity Risk & Return Flashcards
common stock
ownership
company management
ownership
common stockholders represent an ownership interest in the business
company management
the Company’s C-suite wants to increase common share price, as that is largely what drives their bonus
as a result, companies prioritize taking actions which will increase common stock price, and thus returns for shareholders
sources of return in equity
dividends
price appreciation
dividends
optional quarterly cash payments, made from the company to the shareholders
price appreciation
increases in stock price
S&P 500 returns
the S&P 500 is an index comprised of 500 large companies listed on stock exchanges in the united states
sources of risk in equity
price declines
price declines
a decline in the share price over the holding period would reduce aggregate returns
equity has
variable returns *unlike every other security
equity returns are driven by
quarterly dividends and stock price movements
equity analysis
as a result, equity analysis is largely focused on estimating the return from investing in a stock
inversely, fixed income analysis is based almost entirely on estimating the required return
expected return can be calculated two ways:
by taking a weighted average of the possible outcomes
by looking at the simple average of returns (not geometric average, simple average)
individual security volatility
the most widely accepted measure of volatility is a security’s standard deviation. this is meant to measure how much the price, or return generated, from a security moves from year to year
sharpe ratio
sharpe ratio is used to measure risk adjusted return
= (expected return- risk free rate)/ standard deviation
two security portfolio- one risky, one free
expected return: the weighted average of the expected returns of the two securities
standard deviation: the standard deviation of the risky asset, times the weight of the risky asset
covariance
measures the extent at which two variables (in this instance returns on two securities) move together
please note: if you only have a sample of available data the numerator is N-1, unless specified, assume that we are using the population formula noted below
correlation
a number between -1 and 1, which in general notates how two securities move in relation to one another
covariance/ standard deviation x y
perfect positive correlation
correlation +1, which means that the two security will move nearly in lockstep
perfect negative correlation
a correlation of -1 which means that when one rises in value the other one falls in value
efficient frontier
you want portfolio with lowest standard deviation- investing in low correlated or negatively correlated securities
diversification
as can be seen on the prior slides, investing in stocks which have low correlation of returns results in lower volatility (meaning lower risk) without lower returns
this is known as the positive impact of diversification
the positive impact of diversification
this impact of diversification is the key tenet of modern portfolio theory, which is used when investing for retirement
the lower the correlation of the returns of assets in a portfolio, the lower the volatility (aka risk) of that portfolio
types of risk in investing
market risk
idiosyncratic risk
market risk
the risk that an investment loses value as a result of a market wide movement
-equity investors are compensated for taking market risk, as they cannot effectively reduce this risk through diversification
idiosyncratic risk
the risk that an investment loses value as a result of company specific issues (example: earnings release are below expectation )
the market portfolio
the aggregate of all investors’ risky portfolios
-as a result, this includes every share of every outstanding stock at its current market price
the market portfolio risk premium
the difference between the expected return on the market portfolio and the risk free rate
a company’s Beta
a measure of how exposed that company is to systemic risk
it is a measure of correlation between the individual stock price movements and aggregate market movements
