PM Flashcards
What is the relationship between risk and return across major asset classes?
Back:
There is a tradeoff between risk and return:
Small-cap stocks have the highest returns but also the highest risk.
Treasury bills (T-bills) have the lowest returns and lowest risk.
Other asset classes fall in between, with bonds having lower returns and risk than equities.
How do large-cap and small-cap stocks compare in terms of risk and return?
Back:
Small-cap stocks: Higher average return (12.1%) but greater risk (31.7% standard deviation).
Large-cap stocks: Lower average return (10.2%) with lower risk (19.8% standard deviation).
Small-cap stocks offer higher potential rewards but come with greater volatility.
How do bonds compare to equities in risk and return?
Back:
Long-term corporate bonds: 6.1% return, 8.3% standard deviation.
Long-term government bonds: 5.5% return, 9.9% standard deviation.
Equities have higher returns and higher risk, while bonds offer more stability but lower returns.
What is the impact of inflation on asset class returns?
Back:
Inflation averaged 2.9% (1926–2017).
Real returns (adjusted for inflation) were lower than nominal returns.
Example: Large-cap stocks had a real return of 7.3%, while T-bills had only 0.5%.
Inflation risk must be considered in portfolio construction.
Why is liquidity important when selecting investments?
Back:
Liquidity affects pricing and expected returns.
Infrequently traded assets (e.g., emerging markets, low-quality corporate bonds) may have higher risk due to liquidity constraints.
Less liquid assets may experience larger price swings during market stress.
How do skewness and kurtosis affect investment returns?
Back:
Returns are not normally distributed.
Negative skew: Greater downside risk.
Excess kurtosis: More frequent extreme gains/losses.
These factors should be considered when evaluating investments.
What is risk aversion, and how does it affect investment choices?
Back:
A risk-averse investor dislikes risk and prefers lower-risk investments when expected returns are equal.
Financial models assume all investors are risk-averse.
A risk-averse investor will only take on more risk if compensated with higher expected returns.
How do risk-seeking and risk-neutral investors differ from risk-averse investors?
Back:
Risk-seeking investors prefer more risk to less and may choose riskier investments even without higher returns.
Risk-neutral investors are indifferent to risk and will focus only on expected returns.
Risk-averse investors require additional return to compensate for extra risk.
What are indifference curves, and how do they relate to risk aversion?
Back:
Indifference curves represent combinations of risk (standard deviation) and return that give an investor the same level of utility.
More risk-averse investors have steeper indifference curves, requiring higher returns for additional risk.
Less risk-averse investors have flatter curves and accept more risk for a given return.
What is the capital allocation line (CAL), and how is it constructed?
Back:
CAL represents the risk-return tradeoff from combining a risky asset portfolio with a risk-free asset.
Expected return: E(Rportfolio) = WA E(RA) + WB Rf (where Rf = risk-free rate).
Standard deviation: σportfolio = WA σA (because risk-free assets have zero standard deviation).
The CAL is a straight line showing possible portfolio risk-return combinations.
What is the two-fund separation theorem?
Back:
All investors will hold a combination of the risk-free asset and an optimal risky portfolio.
The mix depends on risk aversion:
More risk-averse investors hold more of the risk-free asset.
Less risk-averse investors hold more of the risky portfolio.
The optimal portfolio is found at the tangency point between an investor’s indifference curve and the CAL.
How does risk aversion affect portfolio selection along the capital allocation line?
Back:
More risk-averse investors choose a portfolio with a higher proportion of risk-free assets.
Less risk-averse investors select a portfolio with more exposure to the risky asset.
The investor’s optimal portfolio maximizes expected utility, balancing risk and return.
Which of the following statements about risk-averse investors is most accurate? A risk-averse investor:
A)
seeks out the investment with minimum risk, while return is not a major consideration.
B)
will take additional investment risk if sufficiently compensated for this risk.
Correct Answer
C)
avoids participating in global equity markets.
Explanation
Risk-averse investors are generally willing to invest in risky investments, if the expected return of the investment is sufficient to reward the investor for taking on this risk. Participants in securities markets are generally assumed to be risk-averse investors. (Module 83.2, LOS 83.b)
What happens to portfolio risk when asset returns are perfectly positively correlated (ρ = +1)?
Back:
The portfolio’s standard deviation is a weighted average of the individual assets’ standard deviations.
No risk reduction occurs because the assets move perfectly together.
Formula: σportfolio = w1σ1 + w2σ2
What is the effect of adding assets with low or negative correlation to a portfolio?
Back:
Lower correlation means greater diversification benefits.
If ρ = 0, portfolio risk is reduced compared to individual asset risks.
If ρ < 0, portfolio risk is further reduced and can even be eliminated with the right weights.
How does diversification impact portfolio risk?
Back:
Diversification reduces portfolio risk unless assets are perfectly correlated (ρ = +1).
The lower the correlation, the greater the risk reduction.
This principle explains why investors diversify across stocks, bonds, real estate, and international assets.
Why do investors seek assets with low or negative correlation?
Back:
To reduce portfolio risk while maintaining expected return.
Drives investment in bonds, foreign stocks, real estate, commodities, etc.
If assets were perfectly negatively correlated (ρ = -1), a risk-free portfolio could be created.
📌 Concept: Capital Allocation Line (CAL)
💡 Definition: The CAL represents all possible combinations of a risk-free asset and a risky portfolio, showing risk-return trade-offs.
✅ Key Takeaway: The optimal CAL maximizes investor utility by offering the best possible risk-return combinations.
📌 Concept: Role of Borrowing and Lending in Portfolio Construction
💡 Explanation: Investors can move beyond the market portfolio by:
Lending (risk-free asset investment) → Less risk, lower return.
Borrowing (leveraged risky portfolio) → More risk, higher return.
✅ Key Takeaway: Investors can customize their risk exposure by adjusting their mix of the risk-free asset and the market portfolio.
📌 Concept: Passive vs. Active Portfolio Management
💡 Explanation:
Passive investors hold the market portfolio and allocate between it and a risk-free asset.
Active investors try to outperform by overweighting undervalued securities and underweighting overvalued ones.
✅ Key Takeaway: Passive investing follows the market portfolio, while active investing seeks to exploit mispricings.
📌 Concept: Risk-Return Tradeoff in Combining Risk-Free and Risky Assets
💡 Graphical Representation: A straight line from the risk-free rate through the risky asset portfolio on a risk-return graph.
✅ Key Takeaway: Adding a risk-free asset to a risky portfolio improves the risk-return profile, allowing investors to achieve an optimal balance.
Q: What are the key assumptions of CAPM?
A:
Risk Aversion – Investors require higher returns for higher risk.
Utility Maximization – Investors choose portfolios maximizing expected utility.
Frictionless Markets – No taxes, transaction costs, or trading restrictions.
One-Period Horizon – All investors share the same investment time horizon.
Homogeneous Expectations – Investors have the same return and risk expectations.
Divisible Assets – Assets can be infinitely divided.
Competitive Markets – Investors are price takers.
Q: What is the Security Market Line (SML), and how does it differ from the Capital Market Line (CML)?
A:
SML: Graphs expected return vs. beta (systematic risk). All correctly priced securities lie on the SML.
CML: Graphs expected return vs. total risk (standard deviation). Only efficient portfolios lie on the CML.
Q: How can CAPM be used to identify mispriced securities?
A:
Stock plots below SML: Overvalued (expected return < required return).
Stock plots above SML: Undervalued (expected return > required return).
Stock plots on SML: Properly valued (expected return = required return).
Trading Strategy: Short overvalued stocks and buy undervalued stocks.
Q: What is the portfolio perspective in investing?
A: The portfolio perspective evaluates investments based on their contribution to the overall portfolio’s risk and return rather than in isolation. Diversification reduces risk without necessarily lowering expected returns.
Q: What is the diversification ratio, and how is it calculated?
A: The diversification ratio is the risk of an equally weighted portfolio of n securities divided by the risk of a randomly selected single security. A lower ratio indicates greater risk reduction benefits from diversification.
Q: What are the three major steps in the portfolio management process?
A:
Planning: Assess investor objectives and constraints, then create an Investment Policy Statement (IPS).
Execution: Allocate assets and select securities using top-down and bottom-up approaches.
Feedback: Monitor, rebalance, and evaluate performance against benchmarks.
Q: How do different types of investors vary in risk tolerance and investment horizon?
A:
Individuals: Varies based on personal circumstances.
Endowments: High risk tolerance, long horizon, low liquidity needs.
Banks & Insurance Companies: Low risk tolerance, need liquidity for obligations.
Mutual Funds: Varies by fund type.
Pension Plans: High risk tolerance, long horizon, low liquidity needs.
Q: What is the key difference between defined contribution and defined benefit pension plans?
A:
Defined Contribution: Employer contributes a set amount, but the employee assumes investment risk.
Defined Benefit: Employer promises a fixed payout in retirement and assumes investment risk.
Q: Why does diversification provide less risk reduction during financial crises?
A: During market turmoil, asset correlations tend to increase, reducing the benefits of diversification as assets move in the same direction.
Q: What is the difference between buy-side and sell-side firms in the asset management industry?
A: Buy-side firms manage investments for clients (e.g., asset managers), while sell-side firms (e.g., broker-dealers, investment banks) facilitate securities trading and offer investment banking services.
Q: What is the difference between active and passive asset management?
A: Active management aims to outperform a benchmark using research and analysis, while passive management seeks to replicate a benchmark’s performance, often through index tracking or smart beta strategies.
Q: What are the key trends in the asset management industry?
A:
Growth of passive management due to lower fees and skepticism of active outperformance.
Increasing use of big data and technology for investment decisions.
Rise of robo-advisors, lowering entry barriers for investors and firms.
Q: What is the key difference between open-end and closed-end mutual funds?
A: Open-end funds issue and redeem shares at NAV, while closed-end funds trade like stocks, with prices that can differ from NAV due to market demand.
Q: How do ETFs differ from mutual funds?
A: ETFs trade like stocks with intraday pricing, lower capital gains taxes, and can be shorted or margined. Mutual funds trade at NAV once per day and often reinvest dividends automatically.
Q: What are hedge funds and private equity funds?
A: Hedge funds are lightly regulated investment pools for wealthy investors, often using complex strategies. Private equity funds invest in companies with the goal of selling them later, often through IPOs.
Q: What are the reasons for having a written Investment Policy Statement (IPS)?
A: A written IPS ensures clear communication of investor goals, risk tolerance, and constraints, providing a structured framework for investment decisions and performance evaluation. It helps align investor expectations with realistic outcomes.
Q: What are the major components of an Investment Policy Statement (IPS)?
A: The IPS typically includes:
Client Description (circumstances, objectives)
Purpose of the IPS
Duties & Responsibilities (manager, custodian, client)
Procedures for updates
Investment Objectives & Constraints
Investment Guidelines (asset types, leverage, execution)
Performance Evaluation (benchmark, assessment)
Appendices (strategic asset allocation, rebalancing).
Q: How are risk and return objectives developed for an investor?
A: Risk objectives can be absolute (e.g., “no more than 5% probability of a loss greater than 5% in a year”) or relative (e.g., “returns should not fall more than 4% below the MSCI World Index”). Return objectives can be absolute (e.g., “6% annual return”) or relative (e.g., “exceed S&P 500 by 2% per year”). Risk and return objectives must be compatible.
Q: What is the difference between willingness and ability to take risk?
A:
Ability to take risk depends on financial factors like wealth, liabilities, investment horizon, and job security.
Willingness to take risk is based on psychological factors and attitudes toward risk.
If willingness and ability conflict, the lower of the two typically prevails.
Q: What are the key investment constraints in an IPS?
A: R-R-T-T-L-L-U:
Risk tolerance
Return objectives
Time horizon (longer allows for more risk)
Tax concerns (tax-efficient investing)
Liquidity needs (access to cash)
Legal & regulatory restrictions
Unique circumstances (e.g., ESG preferences, ethical considerations)
Q: How does asset allocation relate to portfolio construction?
A: Asset allocation is based on an investor’s risk and return profile from the IPS. It involves selecting asset classes with low correlations to enhance diversification. Strategic asset allocation establishes baseline weights, while tactical asset allocation allows short-term deviations based on market conditions.
What is the difference between cognitive errors and emotional biases?
Back:
Cognitive errors result from faulty reasoning, such as misunderstanding statistics or information processing errors. They can often be corrected with education.
Emotional biases stem from feelings, impulses, or intuition, making them harder to overcome.
Front: 🎭 Conservatism Bias
What is conservatism bias, and how does it impact investment decisions?
Back:
Investors underweight new information and stick to prior beliefs.
Example: Ignoring a major central bank policy change when forecasting recessions.
Implication: Holding onto investments too long due to reluctance to process new data.
Front: 🔍 Confirmation Bias
How does confirmation bias influence financial decision-making?
Back:
Individuals seek out information that supports prior beliefs and ignore conflicting data.
Example: Reading only positive articles about a stock already owned.
Implication: Overconfidence and poor investment choices.
What are the two types of representativeness bias?
Back:
Base-rate neglect – Ignoring general probability in favor of specific traits.
Sample-size neglect – Drawing conclusions from small datasets.
Implication: Misclassifying investments based on limited data.
What is illusion of control bias, and how does it affect investors?
Back:
Overestimating one’s ability to influence outcomes.
Example: Overweighting a stock from a company you work for.
Implication: Lack of diversification and excessive risk-taking.
How does framing bias impact investment decisions?
Back:
Decisions are affected by how information is presented (gains vs. losses).
Example: Investors become risk-averse when returns are framed as gains but risk-seeking when framed as losses.
Implication: Misjudging risk tolerance and making suboptimal investment choices.
How does loss aversion differ from risk aversion?
Back:
Loss aversion: Investors feel more pain from losses than pleasure from equivalent gains, leading to excessive risk-taking to avoid losses.
Risk aversion: Investors prefer lower-risk investments when two options have the same expected return.
Implications: Loss-averse investors may hold losing investments too long or trade excessively for small gains.
What are the key characteristics and consequences of overconfidence bias?
Back:
Overestimation of one’s predictive abilities.
Illusion of knowledge: Thinking one has better insights than they actually do.
Self-attribution bias: Taking credit for successes and blaming failures on external factors.
Consequences: Underestimating risk, overtrading, and lack of diversification
How does self-control bias impact financial decision-making?
Back:
Preference for short-term satisfaction over long-term goals.
Example: Insufficient retirement savings due to spending on immediate wants.
Mitigation: Setting a disciplined investment plan and budget, reviewing them regularly
What is status quo bias, and what are its consequences?
Back:
Resistance to change due to comfort with the current state.
Example: Staying in default investment options instead of optimizing allocations.
Consequences: Holding suboptimal investments and missing better opportunities.
How does endowment bias affect investment decisions?
Back:
Overvaluing assets simply because they are already owned.
Example: Holding inherited stocks despite poor performance.
Mitigation: Ask, “Would I buy this today with new money?”
How does regret-aversion bias influence investor behavior?
Back:
Fear of making a wrong decision leads to inaction.
Example: Avoiding risky but potentially profitable investments.
Consequence: Excess conservatism and missed opportunities.
Q: What are the three main steps of the risk management process?
A: 1) Identify the organization’s risk tolerance, 2) Identify and measure risks, 3) Modify and monitor risks.
Q: What is risk governance, and what is its primary goal?
A: Risk governance refers to senior management’s oversight of risk management, aiming to align risk exposure with organizational goals.
Q: What is risk budgeting, and why is it important?
A: Risk budgeting allocates firm resources based on risk characteristics to optimize risk-adjusted returns while staying within the organization’s risk tolerance.
Q: Give two examples of financial risks and two examples of non-financial risks.
A: Financial risks: Credit risk, Market risk. Non-financial risks: Operational risk, Regulatory risk.
Q: Name three methods used to measure risk in financial assets.
A: Standard deviation (volatility), Beta (market risk), Duration (interest rate sensitivity).
Q: What are the four main strategies for modifying risk exposures?
A: Avoiding risk, Preventing risk, Transferring risk (e.g., insurance), and Shifting risk (e.g., derivatives).
