Module 6: Types of Investment Risk and Quantitative Investment Concepts Flashcards
Investment Risk
The uncertainty that an investment’s actual, or realized, return will be different from its expected return.
How to eliminate Investment Risk?
Asset allocation and diversification
How to use diversification to minimize risk and maximize return?
- Structure a portfolio that contains assets with lw correlation to eachother
- have a longer investment time horizon or
- both
How much is enough for diversification?
Studies have shown that an investor needs only about 15-20 large-caps in different industries to fully diversify their portfolio
4-7 mutual funds in different asset classes optimize diversification benefits
25-30 mid or small cap securities in different industries
Different views of Risk
- loss of pricipal/variability of returns
- volatility of securities prices
- the possibility of not achieving an expected rate of return
- nonmatching cash flows
- uncertainty associated with future returns
Absolute Risk
Unsystematic, or diversifiable risk + systematic or nondivesrifiable risk
Measured by standard deviation
Systematic Risk Measure
Beta
Unsystematic Risk
Known as diversifiable risk, that affects only a particular company, country or sector and its securities. It’s not correlated with stock market returns
Types of Unsystematic Risk
- Business Risk
- Financial Risk
- Default Risk
- Political Risk
- Tax Risk
- Investment Manager Risk
- Liquidity Risk
- Marketability Risk
Systematic Risk
nondiversifiable risk, reflects the uncertainty of returns associated with an investment in any type of asset, inescapable because the risk of the overall investment market may not be completely avoided.
Types of Systematic Risk
- Purchasing Power Risk
- Reinvestment Rate Risk
- Interest Rate Risk
- Market Risk
- Exchange Rate Risk
Beta
A relative measure of systematic risk or volatility. Beta may be used as a measure for the risk associated with a particular security; however, it is better used as a measure of risk within a diversified portfolio or a portfolio that has little to no unsystematic risk.
Standard Deviation
An appropriate measure of risk for all assets, including nondiversified portfolios
Beta Formula
Beta = correlation coefficient between the investments and the market * Standard deviation of the investment / standard deviation of the market
Where Beta Can be misleading
Because of the way the formula is calculated the Beta of a specific stock does not make it less volatile than the overall market. Gold typically has a low beta, but is more volatile than the stock market, as correlation falls, so does the reliability of Beta
Negative Beta
According to CFP, a negative Beta can protect the investor from a significant decline in the value of the portfolio in a bear market.
Weighted Beta
This is the beta of a portfolio of securities, meaning that the portfolio beta is calculated by weighting the individual asset betas and adding the results.
Weighted Average Return
represents the return for a set of securities, such as a portfolio, where each return is weighted by the proportion of the security to the entire group or portfolio.
Standard Deviation
Also known as variance, is an absolute measure of the variability of the actual investment returns around the average or mean of those returns. Since most accepted measure of total, or absolute, risk in investment theory and tells an investor how far from the mean the investment’s actual return is likely to vary.
Calculating Sample Standard Deviation on Calculator
Put in each historical rate of return followed by the E+, then shift, 8 (Sx,Sy)
Calculating the Population Standard Deviation
The denominator is N, not N-1, in the real world, finding the standard deviation of an entire population is generally unrealistic. Although S (population standard deviation) tends to eliminate the statiscial bias associated with Sample standard deviation, it is likely that I will only be asked to compute Sample SD on the exam.
Normal Probability Distribution
Perfectly symmetrical, is characterized by a single peak in the center, which is the location of the arithmetic mean of the series of observations.