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Personal Investment > MIDTERM 2 > Flashcards

MIDTERM 2 Flashcards

1
Q

Expected return

A

expected return = anticipated outcome
mean = average
median = middle number in series
mode = most common return

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2
Q

Expected Return (single asset)

A

sum of the individual weighted scenario returns

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3
Q

Mean

A

distance less-than-the-average and greater-than-the-average are the same. describes the point of “central tendency”; however, it does not describe the dispersion of results around that point

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4
Q

Variance

A

describes the dispersion around the mean

variance = sum of the squared individual dispersions around the mean times the probability

risk is defined as the chance that the expected return will not be realized, variance or dispersion of actual returns around the expected return is how risk is usually quantified

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5
Q

Standard Deviation

A

square root of variance, normalizes the dispersion of a normal distribution around the mean
allows for a direct comparison of the standard deviation with the mean because same “un-squared” units of observation

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6
Q

Measure of Dispersion

A

spread of data, reference to the measure of central tendency, variance of sample = sum squared differences / (N-1)

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7
Q

Semi-Variance (downside risk)

A

risk includes observations that deviate from mean; however, investors are not concerned about out-performance
-only measures dispersion for data points that fall below the mean (threshold)
- most relevant when distribution exhibits skewness
-semi-standard deviation is square root of semi-variance

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8
Q

Coefficient of Variation

A

relative risk-to-return statistic
- CV = standard deviation/mean return
- lower CV preferred
- used to compare to securities

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9
Q

Moments of a Probability Distributions

A

1st moment = mean
2nd moment = variance/stdev
3rd moment = skewness
4th moment = kurtosis

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10
Q

Normal Distribution

A

standard deviation normalized dispersion around mean
- 68.26% is +- 1 std dev
- 95.44% is +- 2 std dev
- 99.74% is +- 3 std dev

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11
Q

Skewness

A

cubed dispersions: distributions with different means, medians, and modes, one tail will be longer than the other

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12
Q

Kurtosis

A

raise dispersion to 4th power, answers how much of the distribution is in the tail

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13
Q

Expected Return (two-asset portfolio)

A

expected return = sum of the weighted returns of the assets

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14
Q

Variance (two-asset portfolio)

A

variance of a 2-asset portfolio is NOT simply the weighted average of the individual asset deviations because variance of a 2-asset portfolio depends on how the assets move relative to one another (covariance)

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15
Q

Covariance

A

describes how two assets move relative to each other, key to the power of diversification

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16
Q

Standard Deviation (two-asset portfolio)

A

creates a 2x2 matrix, can increase to any NxN size

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17
Q

Correlation Coefficient

A

adds clarity about the strength of the relationships by normalizing the co-movement between 1 and -1.

statistical relationship between returns, which describes the direction of the linear relationship and magnitude of move.

adding any two securities with correlation coefficient less than perfect +1 will dampen volatility

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18
Q

Coefficient of Determination

A

correlation coefficient squared, measures the proportion of asset a’s price movement that is explained by asset b

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19
Q

Practical Applications of R^2

A

-identifying appropriate benchmark
- benchmark tracking
- active management
- risk relative to benchmark

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20
Q

Asset Allocation

A

you could hold a risky-asset component and a risk-free component in your portfolio

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21
Q

Adding Risk-free Security

A

adding a risk-free security will bring down the standard-deviation and decreases portfolio volatility

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22
Q

Mean-variance Portfolio Theory

A

assuming mean variance is sufficient to describe the market minimization techniques (calculus) can be used to determine portfolio combinations that offer lowest level of risk for a given level of return

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23
Q

Efficient Frontier

A

describes highest return combinations for a given level of risk, any portfolio lying on the efficient frontier has the optimal return to variability payoff.

an efficient frontier can be generated for any set of assets and constraints given assets 1) expected return 2) standard deviation 3) correlation coefficients

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24
Q

Capital Allocation Line

A

adding a risk-free asset with a risky portfolio increases the risk-return profile in every case but one and that is the point of tangency

once a risk-free asset is introduced the slope represents the constant reward to variability profile. there can be numerous CALs (one for each risky asset) and the investor just decides what allocation to make between the portfolio and the risk-free rate

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25
Q

Slope = reward to variability ratio

A

slope (rise over run) describes the amount of extra return for each unit of additional risk

26
Q

Sharpe Ratio

A

the reward-to-variability (slope of the CAL) is referred to as the Sharpe Ratio, additional units of return for additional units of risk

27
Q

Risk Theory

A

Risk lover (A < 0)
Risk Neutral (A=0)
Risk Averse (A > 0)
risk averse investors demand a higher level of return to hold a higher level of risk, risk neutral investors focused just on expected return

28
Q

Utility Theory

A

suggests that risk-averse investors compare risky assets based on their expected utility (welfare), not on nominal return

29
Q

Indifference Curve

A

graphically depicts the unique preferences for individuals in terms of risk and reward. every point along the curve depicts the same risk/return ratio: therefore, the investor is indifferent about any combination (same level of utility)

30
Q

Capital Market Line (CML)

A

CML is a special case of the capital allocation line. rather than unique portfolio, everyone holds the same risk portfolio = broad domestic stock market index, only decision is about allocation between risky asset (market index) and risk-free asset

31
Q

Beta

A

measures systematic risk, describes the sensitivity of an asset’s return to the market, appropriate when considering a security for inclusion in a diversified portfolio

beta = (correlation of asset to market * risk of asset)/risk of market

quantifies an individual security’s price sensitivity to market’s price movement

Beta>1: greater sensitivity to market price changes
Beta=1: security exhibits the same volatility as the market
Beta<1: security has less sensitivity to market price changes

slope of the linear regression
scaling describes stock’s exposure to marker risk

32
Q

Significance of beta

A

when adding a security to a portfolio, you are not concerned about the total risk, rather the amount of systematic risk that the asset will add to the portfolio. adding a security with a higher beta will increase overall portfolio

33
Q

Security Market Line (SML)

A

Capital asset pricing model, beta replaces standard deviation as a measure of risk
Expected return = Rfree + [betasecurity*(Rmarket-Rfree)]
Rmarket-Rfree=market premium
slope of SML describes the proper theoretical pricing of financial assets

34
Q

Significance of SML

A

slope represents the market risk premium, recognizes that with portfolios you are concerned about the amount of systematic risk that the asset will add to the portfolio, suggests that theoretical pricing of securities is linked to the beta

35
Q

CAPM versus APT

A

capital asset pricing model: single factor model, pricing higher expected return required to hold higher expected risk
arbitrage pricing model, multi-factor model focused security’s sensitivity to various macroeconomic variables

36
Q

Factor Models

A

build factor models fro projecting stock return
- macroeconomic data
- fundamental data
- statistical
realized return of asset = expected return + beta sensitivity to the different firm specific characteristics

37
Q

Determinants of Portfolio Performance

A

asset allocation: 91% of portfolio performance is based on the asset allocation decision
other determinants: security selection, market timing, other factors

38
Q

Impact of Individual Factors on Asset Allocation

A

variables influencing the asset allocation decision: tolerance for risk, financial need and return objective, time horizon, financial capacity, investment knowledge, investing experience, preferences and constraints

39
Q

Assessing Risk Tolerance

A

risk tolerance cannot be measured with complete accuracy
- attitude
- financial capacity
- knowledge
- propensity

40
Q

Challenges with Portfolio Optimization for Individuals

A

challenges include multiple life goals, several forms of individual taxes, liquidity needs, behavioral issues, income needs from investment portfolio

41
Q

Life Cycle Investment Strategy

A

wealth = financial wealth + human capital wealth
- greater the human capital the greater focus on growth investments
- lower the human capital the more you focus on income-producing investments

equity allocation = 100 - age

42
Q

Other Approaches: 60/40 & Risk-return

A

60/40 adjustment: start from 60% growth and 40% income mix.
risk-return bucket approach: categorize based on individual factors
- conservative investor (50/50)
- moderate (60/40)
- assertive (70/30)
- aggressive (80/20)

43
Q

Strategic vs tactical allocation

A

strategic: establishing a long-term target strategic allocation, portfolio monitoring and periodic rebalancing to maintain target mix
tactical: overweighting of asset categories based on projected performance, minimum and maximum allocations might be established

44
Q

Portfolio Rebalancing

A
  • application of buying high and buying low
    -rules: fixed-percentage threshold rule, percent variance from threshold, calendar, after major market event
45
Q

Sector vs Industry

A

sector: broader economic groupings that include multiple industries (energy, real estate, utilities)
industry: group of companies with the same business activity (banking, defense)

46
Q

Diversifying by Investment Style

A

value investing: invest in companies that are underpriced or under-recognized
growth investing: invest in companies that are growing at faster rates than overall market

47
Q

Diversifying Concentrated Portfolios

A

concentrated portfolio positions occur when an individual or small number of securities represent a large percentage of the overall portfolio
- negative implications: lower risk-return profile, higher volatility impacts compounded growth, financial vulnerability

48
Q

utility vs prospect theory

A

utility describes how decisions under uncertainty should be made
prospect theory describes how decisions are actually made

49
Q

prospect theory

A

focus on loss or gain, change in wealth is reset to a reference point, more pain associated with losses

50
Q

loss aversion

A

tendency for risk-averse investors to place greater value on avoiding losses than acquiring gains

51
Q

Fast/slow brain

A

system 1 - fast, automatic unconscious thinking
system 2 - slow, conscious reasoning and thought
reptilian brain = caveman brain

52
Q

anchoring

A

decision makers begin from a reference point and then adjust

53
Q

representativeness

A

decision based on finding commonality between current situation and a prior experience, law of small numbers

54
Q

availability

A

decision based on available data

55
Q

affect

A

attitude impacts the decision

56
Q

hyperbolic discounting

A

tendency to overvalue immediate rewards at the expense of long-term goals

57
Q

mental accounting

A

assigning subjective value or emotional label to money based on its source

58
Q

availability vs selective recall

A

availability bias: reliance on recent data
selective recall: tendency to overweight recent information and successful trading experiences

59
Q

Cascading

A

make own assessment, observe actions of group, despite private contradictions, follow the group

60
Q

regret avoidance

A

make decisions that allow them to avoid the pain of monetary loss and loss of self-esteem
inaction: refusing to admit that the investment was a mistake results in tendency to hold losers in hope they recover
indecision: fear of loss can cause investor to remaining in cash equivalents for too long a period

61
Q

ambiguity aversion

A

make a decision that favors the familiar

Personal Investment (6 decks)

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