Key Principles of Investing

Question 1

Where are assets listed on a company’s balance sheet?

How are they valued?

Answer 1

Left side

Fair Market Value

Question 2

What are the 3 categories of assets when listed on a balance sheet?

Answer 2

1. Cash/cash equivalents
2. Investments
3. Personal use assets

Question 3

What is a NOW account?

Answer 3

Negotiable Order of Withdrawal

-Interest paying checking account

Question 4

What are Money Market Mutual Funds?

Answer 4

Not bank products (not FDIC insured)

-Short term low risk securities
-Taxed at ordinary income rates

Question 5

True or False

Interest earned on Treasury Bills is included in federal, state, and local gross income

Answer 5

False; federal only

Question 6

What is Commercial Paper?

Answer 6

-Type of cash/cash equivalent

-Short term unsecured debt issued by corporations

Question 7

What are Equity Securities?

Answer 7

Investments

Shares of ownership in a corporation

STOCKS

Question 8

What are Fixed Income securities?

Coupons?

Principal?

Answer 8

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

Question 9

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)

Answer 9

True

Question 10

What are commodities?

Answer 10

Raw materials

e.g. grain, oil, cattle, gold, etc.

Question 11

What the heck are derivatives?

Answer 11

-Basically contracts betting on the value of another thing (e.g. commodity, stock price, etc.)

-Not direct trade

Question 12

Describe what “yield” means

Answer 12

A type of return. It’s the flow of cash from an investment

Question 13

In terms of yield, stocks have ____ / bonds have ____

Answer 13

dividends

interest

Question 14

What is Total Return formula?

Answer 14

Yield of investment + Growth of investment = Total return

Question 15

2 ways to calculate average return?

Answer 15

1. Arithmetically
2. Geometrically

Question 16

Formula to calculate Holding Period Return

Answer 16

(Sales Price + yield - purchase price) ÷ purchase price

Question 17

Investment Risk is driven by these 2 forces

Answer 17

1 Systematic Risk
2 Non-systematic Risk

Question 18

What is the formula for Total Investment Risk?

Answer 18

Systematic risk + Non-systematic Risk = Total Investment Risk

Question 19

Generally speaking, what is systematic risk?

Answer 19

AKA Non-diversifiable risk

Broad macro-economic factors influence this type of risk

(war, pandemic, inflation, interest rates, etc.)

Question 20

The P.R.I.M.E. acronym for systematic risk

Answer 20

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)

Question 21

How do you arithmetically calculate a rate of return (arithmetic mean)?

What is the major con?

Answer 21

Basically find average rate by adding and dividing

The problem is this method of finding an average rate of return hides volatility

Question 22

Generally speaking, what is non-systematic risk?

Answer 22

Can be diversified away;

specific to business, industry, security, etc.

Question 23

5 common Non-systematic Risks

Answer 23

1. Management Risk - bad business strategy/leadership
2. Financial Risk - bad books (eg too much debt)
3. Default Risk - not paying up
4. Liquidity Risk - no buyers when time to sell
5. Concentration Risk - all eggs, 1 basket

Question 24

What does “beta” mean?

Answer 24

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

Question 25

# True or False Beta is the measure of systematic, non-diversifiable risk

Answer 25

True

Question 26

# True or False Investments with large standard deviations are considered riskier than those with small standard deviations

Answer 26

True

Question 27

What does covariance mean?

Answer 27

The absolute measure of the extent to which two assets move together

Question 28

Covariance formula

Answer 28

ab = Pab x σa x σb ab = covariance Pab = correlation coefficient σa = standard deviation a σb = standard deviation b

Question 29

# True or False A positive covariance means the securities' returns tend to move together; negative covariance means the returns offset one another

Answer 29

True

Question 30

What is the "correlation coefficient?"

Answer 30

Measures how securities move **against** each other

Question 31

Correlation Coefficient Formula

Answer 31

Pab = covarianceab ÷ (σa x σb) Pab = correlation coefficient covarianceab = covariance σa = standard deviation a σb = standard deviation b

Question 32

How is the coefficient of determination denoted in a formula?

Answer 32

r²

Question 33

What does the coefficient of determination do? (2 things)

Answer 33

1. Builds upon the correlation coefficient 2. Measures the variance of returns in a portfolio in relation to a market

Question 34

How do you find the coefficient of determination?

Answer 34

Take the square of the correlation coefficient

Question 35

# True or False Beta is considered an appropriate risk measurement tool ONLY when r² is higher than .3

Answer 35

False; use beta when r² is higher than .7

Question 36

What is coefficient of variation?

Answer 36

The measure of relative variability used to compare investments with widely varying rates of return and standard deviations

Question 37

How do you calculate a security's coefficient of variation?

Answer 37

Divide Standard deviation by its mean

Question 38

Describe "risk premium"

Answer 38

It's the additional compensation investors receive for taking risk (eg cheaper stock price)

Question 39

What is the Bond Horizon Premium?

Answer 39

The **excess return** bond investors expect to earn **on long-term US government issues** over their **shorter term Treasury Bills**.

Question 40

What is Equity Risk Premium?

Answer 40

The **excess return** investors expect to earn **in stocks** over **risk-free securities** such as Treasury Bills

Question 41

Marketability refers to...

Answer 41

The ease or difficulty with which a security can be resold in the secondary market

Question 42

What is a marketable security?

Answer 42

A security for which there is an active market in which the security can be sold (eg stock; NOT real estate)

Question 43

What is liquidity?

Answer 43

The ease with which assets can be quickly converted to cash without a substantial loss in value