Part 5. Portfolio Risk and Return: Part I Flashcards
Gross return
The total return on security portfolio before deducting fees for the management and administration of the investment account.
Net return
The return after these fees have been deducted, where commissions on trades and other costs that are necessary to generate investment returns are deducted in both gross and net measures.
Pre-tax nominal return
This refers to return prior to paying taxes, where dividend income, interest income, ST capital gains, and LT capital gains may all be taxed at different rates.
After-tax nominal return
This refers to the return after the tax liability is deducted.
Real return
The nominal return adjusted for inflation, measuring the increase in investors purchasing power.
e. g. consider an investor who earns nominal return of 7% over a year when inflation is 2%, the investors approx. real return is simply 7-2 = 5%.
- the investors exact real return is slightly lower, 1.07/1.02 - 1 = 0.049 = 4.9%.
purchasing power:
- if invests $1,000 and earns nominal return of 7%, she will have $1,070 at the end of the year.
- if price of goods she consumes has gone up 2%, from $1.00 to $1.02, she will be able to consumer 1,070/1.02 = 1,049 units.
- she has given up consuming 1,000 units today, but instead able to purchase 1,049 units at end of 1 year, so PP risen by 4.9% = real return.
Leverage return
This refers to a return to an investor that is a multiple of the return on underlying asset, calculated as gain or loss on investment as % of investors cash investment.
Investment in a derivative security, such as futures contract, produces leveraged return as cash deposited is only a fraction of value of assets underlying futures contract.
e.g. common in real estate; investors pay for only part cost of property with own cash, and rest of amount is paid for with borrowed money.
Money weighted return
The internal rate of return on a portfolio, taking into account all cash inflows and outflows.
The beginning value of account is an inflow, as are all deposits into account, and all withdrawals from account are outflows as the ending value.
Time-weighted rate of return
This measures compound growth, the rate at which $1 compounds over a specified performance horizon; the process of averaging a set of values over time.
This is the preferred method of performance measurement, as it is not affected b y the timing of cash inflows and outflows.
Things to consider when forming portfolios
- ER and variance return is a simplification as returns do not follow normal distribution, they are negatively skewed, with greater kurtosis (fatter tails) than normal.
- negative skew means tendency to large downside deviations, and positive excess kurtosis reflects frequent extreme deviations on both upside and downside.
- liquidity can affect price and therefore ER of security, a major concern in emerging markets and for securities that trade infrequently, such a low quality corporate bonds.
Covariance
This measures the extent to which 2 variables move together over time.
+ve covariance = the variables (e.g. RoR of 2 stocks) tend to move together.
-ve covariance = the two variables tend to move apart/opposite direction.
zero covariance = no linear relationship between 2 variables, so return for next period on one of the assets tells you nothing about return of other asset for the period.
How should you interpret the correlation coefficient?
- CC of +1 - deviations from mean or expected return are always proportional in same direction.
- CC of -1 - deviations from mean or expected return are always proportional in opposite direction.
- CC of 0 - there is no linear relationship between stock returns, where in any period knowing actual value of one variable tells you nothing about value of the other.
Risk types
Risk averse = the investor dislikes risk (e.g. prefers less risk to more risk), given 2 investments have equal expected returns, they will choose the one with less risk (std dev).
Risk seeking = the investor prefers more risk to less, so given equal expected returns, they will choose more risky investment.
Risk neutral = investor has no preference regarding risk, and would be indifferent between 2 such investments.
Minimum variance portfolios
For each level of expected portfolio return, we can vary portfolio weights on individual assets to determine portfolio with least risk, and those with lowest std dev. of all portfolios with given expected return.
THEY TOGETHER MAKE UP MINIMUM-VARIANCE FRONTIER.
Efficient frontier
Portfolios that have greatest expected return for each level of risk (standard deviation), coinciding with the top portion of minimum-variance frontier.
Global minimum - variance portfolio
The portfolio on efficient frontier that has the least risk.