lecture 3

Question 1

 Risk and return

Answer 1

o Assume we are in a perfect capital market
o Assume investors are rational and have unlimited wealth and demand
o Risk averse = demand reward for risk

Question 2

 Investment asset classes

Answer 2

o Defensive
 Cash
 Fixed interest bonds

o Growth
 Shares, domestic international
 Property

o Other
 Commodities
 Currency
 Derivatives

Question 3

 How do we measure returns?

Answer 3

o Expected return on a security is a probability weighted average of the returns given all possible scenarios

o Same with expected portfolio return

Question 4

 How do we measure the risk of an investment?

Answer 4

o The chance of loss of capital

o Chance of loss of purchasing power

o Variability of returns – variance, STD, expected mean

Question 5

 Covariance

Answer 5

o Measures the degree to which returns on a pair of assets are expected to move together

o A positive covariance indicates returns move together

o Negative covariance = returns move in opposite directions

o 0 covariance means there is little or no relationship between the returns

o A relative measure of how assets or portfolios covary with each other

o -1 = largest risk reduction

o +1 = no risk reduction

Question 6

 CAPM

Answer 6

o Cost of equity

o Perfect capital market

o Expected return of a security equals risk free + risk premium

Question 7

 Sensitivity to systematic risk: Beta

Answer 7

o Expected percent change in the excess return of a security for a 1% change in the excess return of the market portfolio

Question 8

 Expected return of a portfolio

Answer 8

o Weighted average of the individual components

o Risk is also the way the assets in the portfolio
interact e.g. covariance or correlation

o practice

Question 9

 Financial planning and risk

Answer 9

o Manage portfolios through rebalancing

o Clients need to consider taxes

o Preferences:
 Income/growth
 Risk tolerance
 Others?

o Know your client

Question 10

 5 levels of asset allocation

Answer 10

o Passive -> Active

o Index portfolio to a nominated benchmark

o Strategic asset allocation
 Investment in asset classes over long term

o Tactical asset allocation
 Re-weighting portfolio over shorter period, e.g. month
 Believe performance in asset class

o	Investing sectors of that asset class
	A proportion of portfolio invested in particular asset class e.g. equity

o Asset selection
 What particular company, bond or equity to buy

Question 11

 Risk profiling – Stock like vs bond-like

Answer 11

o Thinking holistically
 Risk you expose your financial capital to should consider the risks of your human capital

o	Labour and wage income – as an investment
	Flexibility
•	Extra house?
•	Overtime?
•	Second job?
•	Allow delayed retirement?

 Sensitivity to general market conditions
• How does employment correlate with the economy?
• Professional investment manager (stock like)
• Public servant (bond like)

Question 12

 Risk profiling – Risk set point

Answer 12

o Finance theory is very optimization based

o Categorise profile into needs and wants
 Needs are not exposed to risky assets
 To meet needs invest in ….

o Identify goals and objectives

o Where safety zone ends and risky zone begins = risk set point

Question 13

 Risk profiling – risk profile questionnaire

Answer 13

o Life stage

o Financial resources

o Emotional risk tolerance

o Disadvantages
 Self reporting on behavior and self-evaluating on financial knowledge / literacy
 Depth
 Understandability

Question 14

 Preferences other than risk

Answer 14

o Socially responsible investing
 Social goals into the investment decision making process

o SRI investment suggests fully diversified portfolio is not possible

o Many arguments that suggest constraints could be good or bad for investment return

Question 15

 Barrier funds

Answer 15

o Invests on companies within industries that have significant barriers to entry
 Natural barriers
 Steady demand regardless of economic condition
 Global marketplace
 Potentially high profit margins

Question 16

 Measuring SRI

Answer 16

o	How performance is measured?
o	Measure risk exposure to assets
o	Can’t use a standard model as it doesn’t apply filters
o	SRI does out perform
o	Critique everything

Question 17

 What can affect decision making and preferences

Answer 17

o Not an ideal world

o Biases, emotions get in the way

Question 18

 Kahneman

Answer 18

o Argues that activities of the mind can be approximated by two systems

o System 1 ‘operates automatically and quickly, involuntary’

o System 2 ‘allocates attention to complex computations’
 Monitors thought and action proposed by system 1

o System 1 employs heuristic for immediate goals
 Leads to biases in decision making
 E.g. mental shortcuts that don’t arrive at the right decision

Question 19

 Availability Bias

Answer 19

o Remember and react more strongly to events that are recent, relevant and dramatic

o E.g. anchoring on to stock market crash and take more conservative approach

o E.g. over-reacting to good or bad news because it is dramatic

o Generalizing information

Question 20

 Representativeness

Answer 20

o Judgement based on stereotypes

o Will shares in a high-profile, reputable company deliver strong returns in the future?

Question 21

 Herd behavior

Answer 21

o Individuals follow group behavior – fall in line

o Herding e.g. frenzied buying or selling