Introduction to SAPM Flashcards
What is Security Analysis?
Security analysis deals with the process of analysing and selecting individual securities such as stocks, bonds, etc. The output of security analysis is to forecast potential returns from owning individual securities.
What is the most widely used approach in Security Analysis?
The most widely used approach in fundamental security analysis is the top-down EconomyIndustry-Company (EIC) approach. Here, the future outlook for the economy, the industry and company-specific factors are analysed sequentially to assess the suitability of investing in a particular security under the prevailing macro-economic environment
What is an alternative method to the EIC Approach?
An alternative method is the bottom-up approach that basically concentrates on very in-depth company analysis and very little on macro-economic analysis. This approach can lead to an unintended over-concentration of investment in just a few industry sectors.
For example, bottom-up analysis may suggest that all property companies are attractive investments and result in a portfolio overly concentrated in property stocks.
Either way, both processes end with a valuation analysis s to ascertain if the stock, even if fundamentally suitable, is attractively priced or already too expensive.
What is the difference between Traditional Security Analysis and Modern Security Analysis?
Traditional security analysis emphasises the projection of future earnings, dividends and share prices based on a single, most likely scenario.
Modern security analysis builds on the traditional approach of forecasting returns based on future earnings, dividends and share prices by adding another layer of analysis. This involves estimating the risks attached to such forecasted returns. It looks at other possible scenarios, rather than just focusing on one most likely scenario.
What is Portfolio Management?
Portfolio management deals with:
- Broader asset allocation decision - how much funds to put into different asset classes such as stocks, bonds, real estate etc.
- Narrower decision - how best to combine individual securities within the chosen asset classes eg. which stocks to form the stock portion of the portfolio etc.
The output of portfolio management is to recommend the best (optimal) portfolio, taking into consideration the trade-off between return and risk when securities are combined.
What is the difference between Traditional and Modern portfolio planning?
Traditional portfolio planning focused mainly on return while attitude towards risk was often simplistic. It was common to assume that a young investor could afford to bear higher risk and thus expected to have a portfolio concentrated in dynamic and rapidly growing firms. However, we know that not all young investors are willing to assume high risk.
Risk was also simplistically assumed to be minimised through diversification by just holding a huge number of securities instead of, say, a single stock, even if the securities shared similar characteristics. The result was often a highly risky portfolio concentrated mostly in a single growth sector eg. mainly bank stocks.
Modern portfolio theory adopts a more scientific approach towards risk assessment. Attention is paid to the investor’s appetite for taking on risks, rather than making age-based assumptions and how a portfolio’s risks can be minimised with the right combination of securities whose performance are not well-correlated.
