Portfolio Management Flashcards
What is the portfolio approach to investments?
The portfolio approach involves evaluating all assets in an investment portfolio collectively, focusing on the overall expected return and risk.
How does the portfolio approach help reduce risk?
The portfolio approach helps reduce risk through diversification, selecting a variety of assets to include in the portfolio.
What is an example of the benefits of portfolio diversification?
Investing all savings in a single company’s shares can lead to total loss if the company goes bankrupt, whereas investing only a portion reduces the impact of such a loss.
Why is diversification important in the portfolio approach?
Diversification protects investors from significant losses that can occur with a non-diversified portfolio.
How Investments in individual securities and portfolios are primarily characterized?
Characterized by: Expected return and risk.
How is risk defined from a neutral perspective in finance?
Risk is seen as the unknown outcome of a project, focusing on volatility and measured by standard deviation and variance.
What is the expected return on a portfolio?
It is the weighted average of the expected returns on individual assets in the portfolio.
How is portfolio risk measured and why is it usually lower than individual asset risks?
Portfolio risk is measured by standard deviation and is usually lower due to the correlation between assets.
What is the diversification ratio and what does a ratio of 80% indicate?
The diversification ratio is the standard deviation of an equally weighted portfolio divided by the standard deviation of a randomly selected asset. A ratio of 80% indicates the portfolio’s risk is 20% lower than that of a randomly selected security.
How does diversification reduce investment risk?
By spreading investments across different assets, the overall risk is reduced, as the impact of any single asset’s poor performance is minimized.
Why is the correlation between assets important for diversification?
The lower the correlation between assets, the stronger the effect of diversification, which helps mitigate risk.
What happens to asset correlations during market downturns?
During market downturns, correlations between assets tend to increase, reducing the benefits of diversification.
How does a weak and declining market affect diversification?
In weak and declining markets, the effect of diversification is diminished, and the possibility of loss becomes more dependent on the overall economic situation.
Do asset correlations remain constant over time?
No, the correlation between assets changes over time.
What does the risk-return trade-off represent?
The risk-return trade-off represents the relationship between expected return and risk for both individual assets and portfolios.
How can portfolios benefit from the risk-return trade-off?
By combining assets in the right proportions, investors can create portfolios with the same expected return but lower risk compared to individual assets.
Why is the selection of asset proportions important in portfolio management?
Proper selection of asset proportions helps achieve the desired expected return while minimizing risk, demonstrating the benefits of the portfolio approach.
Who formally defined Modern Portfolio Theory (MPT)?
Harry Markowitz formally defined MPT in 1952 with his article “Portfolio Selection.”
What is the main focus of Modern Portfolio Theory?
The main focus is on choosing the best investments based on the expected rate of return and risk, emphasizing the importance of asset correlation.
How should rational investors minimize risk according to MPT?
Rational investors should minimize risk through portfolio diversification.
What well-known model is based on Modern Portfolio Theory?
The Capital Asset Pricing Model (CAPM) is based on Modern Portfolio Theory.
Who are the main market participants in financial markets?
Cash surplus entities (investors), deficit entities (seeking funding), and financial intermediaries (institutions facilitating contact).
How are investors categorized?
Investors are categorized into individual investors and institutional investors.
What are some examples of institutional investors?
Examples include pension plans, endowments, banks, insurance companies, and investment companies.
What is the role of financial markets?
Financial markets are places where transactions in financial instruments occur, allowing participants to exchange capital.
What does portfolio management involve?
Portfolio management involves selecting and managing a mix of investment assets to meet the needs and limitations of market participants.
What are some examples of individual investors’ objectives?
Purchasing a new car, funding children’s education, and securing retirement through a pension plan.
Why do investment portfolios need to be tailored for individual investors?
Because different investment objectives require specific structures that meet a person’s current needs and financial goals.
What is a defined contribution pension plan?
It is a pension plan where individuals have control over their portfolios and emphasize diversification to achieve their investment goals.
What categories can be used to define individual investors?
Risk tolerance, time horizon for investments, income needs, and liquidity needs.
Why is it difficult to generalize the needs of individual investors?
Because each individual’s investment objectives and financial circumstances are unique.
What is the first step in the portfolio management process?
The planning step, which involves defining investment objectives, risk tolerance, constraints, and developing an investment policy statement.
What occurs during the execution step of portfolio management?
The execution step involves making actual investment decisions, selecting assets, allocating resources, and making trades to build the portfolio.
What is the purpose of the feedback step in portfolio management?
The feedback step involves monitoring the portfolio’s performance, comparing results to objectives, and making necessary adjustments to stay aligned with the investor’s goals.
What is the purpose of the planning step in the portfolio management process?
To thoroughly plan each fund for effective management and accountability of the fund manager
What should a manager understand about their client during the planning step?
The manager should understand the client’s investment objectives, financial situation, and risk profile.
What is an Investment Policy Statement (IPS)?
An IPS is an agreement between the client and the manager that documents the investment plan and characteristics, serving as a reference for managing the portfolio.
Why is it important to document investment characteristics in the planning step?
Documenting investment characteristics forms the basis of the agreement and ensures clarity and alignment between the client’s expectations and the manager’s actions.
What are the three substeps in the execution step of portfolio management?
Asset allocation, analysis of particular securities or individual assets, and creating the portfolio.
What is asset allocation and why is it important?
Asset allocation determines the overall portfolio construction based on major asset classes and reflects the risk and expected return. It’s important for achieving the desired rates of return and managing risk.
What does the analysis of particular securities or individual assets involve?
It involves researching market sectors and selecting companies or commodities that are expected to provide the desired rate of return as per the investment policy.
What is the focus when creating the portfolio?
The focus is on selecting assets that ensure the best possible diversification and minimize risk while meeting the client’s expected rate of return.
What are the two substeps in the feedback step of portfolio management?
Monitoring the portfolio and assessing the performance of portfolio management.
Why is it important to monitor the portfolio?
To introduce appropriate alterations in response to changing economic conditions and to adjust the portfolio to the client’s requirements.
How is the performance of portfolio management assessed?
By periodically evaluating the portfolio’s performance over a certain period, usually in comparison with a benchmark, and summarizing the performance for the investor.
How can a manager’s compensation be linked to portfolio management?
The manager’s compensation is often based on how effectively they manage the portfolio.
Why should portfolio performance be summarized and presented to the investor?
To keep the investor informed about how their portfolio is performing and to ensure transparency in the management process.
