Key Principles of Investing Flashcards
Where are assets listed on a company’s balance sheet?
How are they valued?
Left side
Fair Market Value
What are the 3 categories of assets when listed on a balance sheet?
- Cash/cash equivalents
- Investments
- Personal use assets
What is a NOW account?
Negotiable Order of Withdrawal
-Interest paying checking account
What are Money Market Mutual Funds?
Not bank products (not FDIC insured)
-Short term low risk securities
-Taxed at ordinary income rates
True or False
Interest earned on Treasury Bills is included in federal, state, and local gross income
False; federal only
What is Commercial Paper?
-Type of cash/cash equivalent
-Short term unsecured debt issued by corporations
What are Equity Securities?
Investments
Shares of ownership in a corporation
STOCKS
What are Fixed Income securities?
Coupons?
Principal?
Fixed Income Securities are debt obligations issued by corporations, governments, and government entities
Coupon is interest paid
Principal is original loan repaid at the date of maturity
True or False
Natural Resources have historically had a low correlation with domestic stocks (ie do not increase/decrease in value at the same time)
True
What are commodities?
Raw materials
e.g. grain, oil, cattle, gold, etc.
What the heck are derivatives?
-Basically contracts betting on the value of another thing (e.g. commodity, stock price, etc.)
-Not direct trade
Describe what “yield” means
A type of return. It’s the flow of cash from an investment
In terms of yield, stocks have ____ / bonds have ____
dividends
interest
What is Total Return formula?
Yield of investment + Growth of investment = Total return
2 ways to calculate average return?
- Arithmetically
- Geometrically
Formula to calculate Holding Period Return
(Sales Price + yield - purchase price) ÷ purchase price
Investment Risk is driven by these 2 forces
1 Systematic Risk
2 Non-systematic Risk
What is the formula for Total Investment Risk?
Systematic risk + Non-systematic Risk = Total Investment Risk
Generally speaking, what is systematic risk?
AKA Non-diversifiable risk
Broad macro-economic factors influence this type of risk
(war, pandemic, inflation, interest rates, etc.)
The P.R.I.M.E. acronym for systematic risk
Purchasing Power Risk (inflation)
Reinvestment Rate Risk (rates decreased since original investment; not worth reinvestment)
Interest Rate Risk (changes value of security)
Market Risk (risk in overall market; e.g. war)
Exchange Rate Risk (currencies)
How do you arithmetically calculate a rate of return (arithmetic mean)?
What is the major con?
Basically find average rate by adding and dividing
The problem is this method of finding an average rate of return hides volatility
Generally speaking, what is non-systematic risk?
Can be diversified away;
specific to business, industry, security, etc.
5 common Non-systematic Risks
- Management Risk - bad business strategy/leadership
- Financial Risk - bad books (eg too much debt)
- Default Risk - not paying up
- Liquidity Risk - no buyers when time to sell
- Concentration Risk - all eggs, 1 basket
What does “beta” mean?
Beta is the measure of the volatility of a particular security’s rate of return or price relative to overall market
.3 = less risky than market
1.0 = good & in line with market
3.0 =RISKY
True or False
Beta is the measure of systematic, non-diversifiable risk
True
True or False
Investments with large standard deviations are considered riskier than those with small standard deviations
True
What does covariance mean?
The absolute measure of the extent to which two assets move together
Covariance formula
ab = Pab x σa x σb
ab = covariance
Pab = correlation coefficient
σa = standard deviation a
σb = standard deviation b
True or False
A positive covariance means the securities’ returns tend to move together;
negative covariance means the returns offset one another
True
What is the “correlation coefficient?”
Measures how securities move against each other
Correlation Coefficient Formula
Pab = covarianceab ÷ (σa x σb)
Pab = correlation coefficient
covarianceab = covariance
σa = standard deviation a
σb = standard deviation b
How is the coefficient of determination denoted in a formula?
r²
What does the coefficient of determination do?
(2 things)
- Builds upon the correlation coefficient
- Measures the variance of returns in a portfolio in relation to a market
How do you find the coefficient of determination?
Take the square of the correlation coefficient
True or False
Beta is considered an appropriate risk measurement tool ONLY when r² is higher than .3
False; use beta when r² is higher than .7
What is coefficient of variation?
The measure of relative variability used to compare investments with widely varying rates of return and standard deviations
How do you calculate a security’s coefficient of variation?
Divide Standard deviation by its mean
Describe “risk premium”
It’s the additional compensation investors receive for taking risk
(eg cheaper stock price)
What is the Bond Horizon Premium?
The excess return bond investors expect to earn on long-term US government issues over their shorter term Treasury Bills.
What is Equity Risk Premium?
The excess return investors expect to earn in stocks over risk-free securities such as Treasury Bills
Marketability refers to…
The ease or difficulty with which a security can be resold in the secondary market
What is a marketable security?
A security for which there is an active market in which the security can be sold
(eg stock; NOT real estate)
What is liquidity?
The ease with which assets can be quickly converted to cash without a substantial loss in value
