Portfolio Theory Flashcards
Standard deviation
Measure of risk and variability of returns
Higher the st dev higher the riskiness
Can be used to determine the total risk of an undiversified portfolio
Normal distribution, +/- 1, 2, 3 standard deviations from the average
1 st. dev = 68%
2 st. dev = 95%
3 st. dev = 99%
Coefficient of variation
Determining which investment has more relative risk when investments have different average returns
Coefficient of variation tells us the probability of actually experiencing a return close to the average return
The higher the coefficient of variation the more risky an investment per unit of return
CV = standard deviation / average return
Normal distribution
Appropriate for an investor considering a range of investment returns
Lognormal distribution
Not a normal distribution
Appropriate if an investor is considering a dollar amount or portfolio value at a point in time
Looking for a trend line or ending dollar amount
Skewness
Skewness refers to a normal distribution curve shifted to the left or right of the mean return
Commodity returns tend to be skewed
Kurtosis
Variation of returns
If there is little variation of returns the distribution will have a high peak and positive kurtosis
If returns are widely dispersed the peak of the curve will be low and have a negative kurtosis
Leptokurtic distribution
High peak and fat tails (higher chance of extreme events)
Platykurtic distribution
Low peak and thin tails (lower chance of extreme events)
Mean variance optimization
The process of adding risky securities to a portfolio but keeping the expected return the same
Finding the balance of combining asset classes that provide the lowest variance as measured by standard deviation
Covariance
The measure of two securities combined and their interactive risk
How price movements between the two securities are related to each other
Covariance is a measure of relative risk
If the correlation coefficient is known or a given, covariance is calculated as the st deviation of investment A times the st deviation of investment B time the correlation of investment A to B
Correlation/correlation coefficient
Measure movement of one security relative to that of another
Covariance and correlation coefficient are both relative measures
Correlation ranges from +1 to -1 and provides the investor with insights as to the strength and direction two assets move relative to each other
A correlation of +1 denotes that two assets are perfectly positively correlated
0 denotes completely uncorelated
-1 denotes perfect negative correlation
Diversification benefits begin anytime correlation is less than 1
The most diversification benefits received when correlation is equal to -1
Beta
The beta coefficient is a measure of a securities volatility relative to that of the market
Is best used to measure the volatility of a diversified portfolio
It measures systematic risk
The beta of the market is 1
A stock with a beta of 1 will be expected to mirror the market in terms of direction return and fluctuation
A stock with a beta higher than 1 means the stock fluctuates more than the market
A beta lower than one means the security fluctuates less relative to market movements
Beta is the slope of the line that represents a securities return when plotted relative to market returns
An appropriate level of risk for a diversified portfolio
Coefficient of Determination or R-Squared (r^2)
A measure of how much return is due to the market or what percentage of a securities return is due to the market
Calculate r^2 by squaring the correlation coefficient
The higher it is, the higher percentage of return is from the market (systematic risk) and less from unsystematic risk - which means it’s more diversified
If r^2 is greater than or equal to .70, then Beta is an appropriate measure of total risk.
Modern portfolio theory
The acceptance by an investor of a given level of risk while maximizing expected return objectives
Efficient frontier
The curve that illustrates the best possible returns that could be expected from all possible portfolios
Indifference curves
Constructed using selections made based on this highest level of return given an acceptable level of risk
Efficient portfolio
Occurs when an investor’s indifference curve is tangent to the efficient frontier
Optimal portfolio
The one selected from all efficient portfolios
The assumption is made that investors are risk adverse
Information ratio
A relative risk adjusted performance measure
Measures the excess return and the consistency provided by a fund manager relative to a benchmark
The higher the excess return (or information ratio) the better
Tracking error of active reruns = st dev of the difference between portfolio returns and index returns
Treynor index
A measure of how much return was achieved for each unit of (systematic) risk
Variability is measured by
Deviation (how far a return varies from what is expected as in the mean average)
Volatility is measured by
Beta (relative relationship between a benchmark and a return of some investment relative to that market)
NPV
NPV = PV of cash flows - initial cost
Used to evaluate capital expenditures that will result in differing cash flows over the useful life or investment period
Efficient market hypothesis (EMH)
Investors cannot consistently achieve above-average market returns
Prices reflect all information that is available and change very quickly to new information
Stock prices will follow a “random walk”
Investors who believe in the efficient market hypothesis believe in a passive investment strategy