Portfolio Theory (L2) Flashcards
Standard Deviation (total risk)
- A measure of risk and variability of returns
- HIGHER the SD = the HIGHER the riskiness of the investment
- Can be used to determine TOTAL RISK of an UNDIVERSIFIED portfolio
- Probability of Returns Graph (pg. 18)
Calculating Standard Deviation
- Will vary depending on your financial calculator. Use SAMPLE SD for the CFP Exam
- EXAMPLE:
○ Dan has 2 stock in his portfolio, calculate the SD
for both stocks, given the following returns of the
past 5 years…
§ Stock A - 10%, 13%, 8%, -2%, 14%
§ Stock B - 6%, -3%, 4%, -5%, 7%
○ Answers:
§ Stock A
□ 10[Sigma +], 13 [Sigma +], 8 [Sigma +].
-2[Sigma +], 14 [Sigma +]
□ [ORANGE] [Sx,Sy]
□ = 6.3875
§ Stock B □ 6 [Sigma +], -3 [Sigma +], 4 [Sigma +], -5 [Sigma \+], 7 [Sigma +] □ [ORANGE][Sx,Sy] □ = 5.4498
**Stock A is consider MORE RISKY
Coefficient of Variation
CV = SD / Average Return
- Useful in determining which investment has more RELATIVE RISK when investments have different average returns
- Tell 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
Normal Distribution
Appropriate if an investor is considering a range of investment returns, as we covered above
Lognormal Distribution
○ NOT a Normal Distribution
○ Appropriate if an investor is considering a DOLLAR AMOUNT or PORTFOLIO VALUE at a point in time
For Example, if an investor invests $1 into the market 60 years ago, it would be worth $60 today. With a LOGNORMAL DISTRIBUTION you are looking for a trend line or ending dollar amount
Skewness
○ Refers to a normal distribution curve shifted to the left or right of the mean return.
○ Commodity returns tend to be skewed
○ Positive vs Negative Skewness Graph (pg. 22)
Kurtosis
○ Refers to variation of returns
○ POSTIVIE Kurtosis ==> LITTLE VARIATION of returns = distribution will have a HIGH PEAK (Treasuries)
○ NEGATIVE Kurtosis ==> LARGE VARIATION (widely dispersed) of returns = distribution will have a LOW PEAK
Leptokurtic
○ HIGH peak, FAT Tails
○ Higher chance of extreme events
Platykurtic
○ LOW peak, 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
○ Its finding the balance of combining asset classes that provide the LOWEST VARIANCE as measured by SD.
Monte Carlo Simulation
A spreadsheet simulation that gives a probabilistic distribution of events occurring.
Covariance
(Provided on CFP formula sheet)
- The measure of 2 securities combined and their interactive risk. (how price movements between 2 securities are related to each other)
- Measure of RELATIVE RISK
- If the correlation coefficient is known, or given, covariance is calculated as the deviation of investment “A” times the deviation of investment “B” times the correlation of investment “A” to investment “B” thus:
Correlation/Correlation Coefficient
- Correlation and the covariance measure movement of one security relative to that of another
- Covariance and correlation coefficient are BOTH RELATIVE MEASURES
- Correlation Coefficient is calculated as follows:
○ Correlation Coefficient = Covariance / (SDa)(SDb) - Correlation ranges from +1 to -1
○ Provides the investor with insight as to the
strength and direction two assets move relative
to each other
○ +1 = perfectly POSITIVE correlation
○ 0 = completely uncorrelated
○ -1 = perfectly NEGATIVE correlation - Diversification Benefits
○ Risk is reduced
○ BEGIN anytime correlation is LESS THAN 1
Beta (market risk)
- Beta coefficient is a measure of an individual security’s volatility TO THAT OF THE MARKET
- Best used to measure the volatility of a diversified portfolio
- Also, a measure of MARKET RISK (systematic risk)
- Measure SYSTAMTIC RISK dependent on the volatility of the security relative to that of the market
○ Market Beta = 1 - The GREATER the Beta Coefficient of a given security = the GREATEER THE SYSTEMATIC RISK associated with that security
- BETA may also be calculated = Security Risk Premium / Market Risk Premium
Coefficient of Determination of R-Squared
- Calculated by squaring the correlation coefficient (R)
- R-Squared is a measure of how return is due to the market OR what % of a security’s return is due to the market
- Also provides the investor insight into how well-diversified a portfolio is, because the HIGHER the r-squared, the HIGHER the % of return is from the market (systematic risk) and the less from unsystematic risk
- Tell the investor if Beta is an appropriate measure of risk
- If R^2 is GREATER THAN or EQUAL to 0.70
○ Beta is an appropriate measure of total risk - If R^2 is LESS THAN 0.70
○ SD is an appropriate measure of total risk
Portfolio Risk
(Provided in CFP formula sheet)
- The risk of a portfolio can be measure through determination of the interactivity of the SD and Covariance of securities in the portfolio
- The process also utilizes the weight of both securities involved, the deviations of the respective securities, and the correlation coefficient of the 2 securities.
- Formula = PORTFOLIO DEVIATION FORMULA or SD OF A 2 ASSET PORTFOLIO