investments, risk and return Flashcards
what are the two main types of investment
financial and non finacial
examples of financial investments
direct and indirect:
- money market instruments
- capital market instruments
- mutual funds - collective invesments
- derivative assets - futures, options, currencies (eg. bitcoin)
what are examples of non financial investments
real estate
collectibles
other investments assets
what are the most popular investment option
fixed deposits money market accounts listed ordinary shares listed bonds unit trust
what are fixed deposits?
fixed lump sum is deposited with a bank at a fixed rate for a fixed period of time
ad and disadvantages of fixed deposits
–Advantages: Returns tend to be higher than the more flexible savings accounts. Also, you benefit if interest rates in the market decrease.
–Disadvantages: Lack of access to the money makes them illiquid. Also, you loose if interest rates in the market increase.
what are money market accounts
types of bank deposit accounts that pay higher interest rates than savings accounts, but require higher minimum deposits such as R500 000. The higher the deposit, the higher the interest rate
ad and disadvantages of money market accounts
–Advantages:Higher deposits attract higher interest rates than the savings accounts. The money is available on demand –making them a liquid investment.
–Disadvantages:The large minimum deposit is a barrier to investment by many individual investors.
what does it mean to invest in listed ordinary shares
Unlike bonds, shares represents an ownership interest in a company and shareholders are entitled to: voting rights (at the AGM) and dividends (when declared).
ad and disadvantages of investing in shares
Advantages: In the long-term, they outperformbonds and money market instruments, easy to buy and sell (being listed), information is easily available (annual reports and share prices), hundreds of firms to choose from.
•Disadvantages: The risk is higher than that of bonds and MM instruments. Dividends are not guaranteed and you could loose the original investment.
what are listed bonds
companies and government want to borrow from the public and then they offer financial securities
•Bond issuers have an obligation to pay bondholders (a) fixed interest amounts (or coupons) annually or semi-annually; & (b) the principal sum on maturity. –Hence, they are ideal for investors who desire current regular income and capital preservation.
ad and disadvantages of bonds
Advantages: Are safer (less risky) than shares (interest & capital sum guaranteed).
•Disadvantages: The return on bonds is less than the return on shares.
what are unit trust
collective investments
allow investors to pool their small monies together into a single fund - the money is then invested into bigger investment instruments
advantages and disads of unit trust
•Advantages:
–They allow ordinary people to invest in shares that would normally be out of their financial reach had their monies not been pooled with that of other investors
–They reduce investment risk through diversification
–They are flexible. One can invest either a lump-sum or small monthly amounts
–They are liquid –one can sell part or all the investment at any time.
Disadvantages:
Returns are earned in the long-term rather than short-term. Like any investment, the market may collapse and investors may loose their investments
Investments are made in order to earn a RETURN (i.e., a benefit an investor receives from an investment). This return could be:
- INCOME ONLY –such as interest on fixed deposit account.
- CAPITAL GAINS ONLY (benefit from appreciation in the value or price of an asset) –for example, the return on treasury bills
or both
what is the return on shareholder investment/ total holding period return?
(p1-p0+dividends)*100/p0
capital gains component - (p1-p0)/p0
income comp - Dividends/p0(as a percentage)
why the greater the risk the greater the return
investors require compensation for bearing that risk
what is risk
refers to the degree of uncertainty or variability in year to year returns on investments
how is the risk on an investment measured
sd and var - sd preferred
the greater the variance the…
greater the risk
variance and mean of historical data
normal calculator way
mean - add and divide
mean of forecast data
expected value
Σpi*Ri
probability of that amount * that amount
variance of forecast data
Σpi(Ri-E(R))^2 [E(R)] ==> expected value
what is the coefficient of variation
e.g. if Z has lower risk and return than y
measure the amount of risk per unit of expected return
cv = σ/(E(R))
higher CV = high risk
what is a portfolio of assets?
a collection or group of assets that are held by an investor
ensures that not all your assets are put in the same basket
what is covariance
measure of how returns on two assets move together or co-vary - correlation coeff is used
what does the correlation coeff measure
the strength of the relationship between the return on two shares in a portfolio
value between -1 and +1
what does a positive correl coeff mean
if asset A increases then asset B will also increase
what does a negative correl coeff mean
if asset A increases then asset B deacreses
what does a zero correl coeff mean
the assets are independent
so what does the riskiness of a portfolio depend on
the riskiness of each of the assets in the portfolio and the relationship between their returns
what is diversification
By investing in two or more assets whose returns are not perfectly positively correlated, an investor can reduce the risk (or the standard deviation) of the portfolio.
Diversification tells us that spreading an investment across assets of different classes or from different sectors reduces total risk by eliminating unsystematic risk.
what is the purpose of diversification
The purpose of diversification is to reduce portfolio risk or portfolio standard deviation.
(not recommended to do over too many assets)
what makes up total risk
systematic and unsystematic risk
sd of returns is a measure of the total risk
what is systematic risk?
cannot be eliminated through diversification and it effects assets in the entire market
- market risk, non-diversifiable risk
- examples of things that could cause this type of risk
announcements of: a decrease in the GDP, increase in interest rates or inflation rate
what does the total risk of a diversified portfolio consist of
- The total risk of a diversified portfolio comprise only systematic risk
what is unsystematic risk?
This is the risk that can be eliminated through diversification and it affects either specific assets or a limited number of assets. Hence:–It is also known as diversifiable risk, unique risk, or asset-specific risk.–For a well diversified portfolio, unsystematic risk is zero.
examples of events that can give rise to unsystematic risk
–The CEO of a company is fired.
–The directors of Bid Widget die in a plane crush
.–Five construction firms are fined for price collusion by the Competition Tribunal.
what are the factors that limit portfolio diversification
- systematic risk cannot be eliminated through diversification
- cost to diversify - transaction costs, taxes etc.
- The benefits of diversification become incrementally smaller as you add more assets to your portfolio.–The first asset added to your portfolio provides the biggest decrease in risk and the addition of more assets will result in increasingly smaller reductions in portfolio risk.
