Topic 3 - Investment Choices

Question 1

Differentiate between the defensive and aggressive investor.

Answer 1

Defensive

• cautious, risk-averse
• more interested in preserving the value of what they have

Aggressive

• risk-tolerant
• a bit like a gambler: prepared to lose some of their money in the hope of gaining a lot

Question 2

What is the relative portfolio asset mix as you become more risk-tolerant?

Answer 2

Very conservative

• keep most wealth in cash (can only lose value in purchasing power due to inflation)
• invests in some property/shares to protect against inflation
• fixed interest investments are not generally preferred because they are fixed in money-terms, not purchasing-power terms

More risk-tolerant

• increase in the proportion of fixed-interest securities and shares
• time-frames lengthen

Question 3

1. What is the proportional asset mix of the very aggressive investor?
2. Differentiate between the investor and speculator

Answer 3

1. What is the proportional asset mix of the very aggressive investor?

• hardly any cash, overwhelmingly shares
• the only function of cash in the fixed-interest is to provide liquidity to enable quick financing of trading opportunities

2. Differentiate between the investor and speculator

Speculator

• like a gambler > the MOST aggressive investor is the day trader (time-frame = 1 day)
• does not want to wait for capital growth
• time-frame < 6 months
• only wants to convert bonds, shares and property into more cash

Investor

• longer time-frame > 6 months
• holds onto investments to generate income (rent, dividends, interest)
• wants both capital gain AND income

Question 4

What is a fixed-interest investment?

Who is the borrower and who is the lender?

Answer 4

• fixed-interest means that you’re buying a piece of paper with a limited life - it’s going to pay you interest while you hold it
• at maturity, you will receive your capital back
• interest means that there is a loan involved (always some risk of default)
• the company issuing the paper is the BORROWER
• you, as the buyer of the bond, are the LENDER

Question 5

What are the characteristics of cash?

Answer 5

• internationally, some currencies are safer than others
• in war, gold reemerges as the ultimate cash/safe haven (reliable)
• cash is the ultimate liquidity, but the return is zero (unless you have a savings account)
• some return (interest) on a savings account, but need 30 days notice to withdraw cash

(005)

Question 6

Describe both a term deposit and a bond.

Answer 6

• in order to withdraw money from a fixed-term deposit, you need to give notice - cannot be traded
• debenture (British) = bond (American)
• bonds are low risk because they have a fixed date until maturity when the borrower repays the lender the face value
• the original cash coming to the lender is almost always less than the face value of the bond itself

Question 7

1. What is the short definition of a hybrid instrument?
2. Why do fixed-interest investments have a stabilising effect on your portfolio?
3. What is a portfolio?

Answer 7

1. What is the short definition of a hybrid instrument?

• bonds (a loan with interest) can be converted into a share (convertible bond)

2. Why do fixed-interest investments have a stabilising effect on your portfolio?

• interest is fixed (stabilising effect)

3. What is a portfolio?

• a set of your investments

Question 8

Describe property as an investment class.

Answer 8

Question 9

What are the drawbacks in direct property investment?

Answer 9

Question 10

Why did listed property trusts fair so poorly during the GFC?

Answer 10

Question 11

1. Who is more suited to owning shares?
2. How have shares performed regarding the rate of inflation?

Answer 11

• suitable for more aggressive investors
• when the real economy is growing, stock prices rise
• mild inflation favours the stock market because everybody treats shares as a way of beating inflation

Question 12

1. Describe the short-term volatility of shares versus bonds and cash.
2. How do the laws of supply and demand apply to shares?

Answer 12

• supply is limited, e.g. issued shares
• increased demand increases share price
• what are the main factors driving demand?

Question 13

1. Where do returns on shares come from?
2. What are the downsides of buying international shares?

Answer 13

Question 14

Why is the exchange rate between currencies an important factor regarding international shares?

Answer 14

Question 15

1. What does the financial theory say about the risk and return relationship?
2. Why are we not interested in the nominal rate of a security?

Answer 15

1. The higher the risk that you take on when investing, the bigger the return you will require
2. Only interested in the real rate of return because inflation is a permanent reality and, so, needs to be taken into account

real rate of return = nominal rate / inflation rate

• the real rate of return is ALWAYS less than the nominal rate

Question 16

What is the definition of risk?

Answer 16

Question 17

The expected return from the portfolio of investments is the weighted average of returns.

What are the averages weighted by?

Answer 17

• weighted by the market value in dollars

Question 18

What is a fundamental assertion in financial theory regarding diversification?

Answer 18

• reduces risk
• when one kind of share/industry is going up, you diversify with another that’s going down and vice versa: they correlate inversely with each other

> reduces the variability of your portfolio

Question 19

Share A and Bond B might have a correlation coefficient of 50% in 2019, 65% in 2018, and -12% in 2012.

What is the big danger with correlation information?

Answer 19

• it can be time-specific/period-specific
• you don’t want the false security of one period when deciding on your sustainable correlations into the future
• you want as much negative (inverse) correlation as possible in order to minimise the variability of your portfolio

Question 20

Why would you not want a positive correlation coefficient for returns between two different shares?

Answer 20

Question 21

How does property, bonds, shares and cash correlate between each other?

Answer 21

• in general, property positively correlates with shares
• the correlation between bonds and shares tends to be low-positive or even negative
• the correlation between cash and the other asset classes tends to be nearly zero
• a diversified portfolio, therefore, minimises variability by including reasonably significant cash and fixed-interest securities

Question 22

What does a diversified portfolio in finance mean?

What is an efficient portfolio?

Answer 22

• a diversified portfolio in finance theory is efficient (max. productivity/out for min. waste/in)
• an efficient portfolio is one that delivers the biggest possible return for a given amount of financial risk (variability)
• mixing the different investments in such a way that you minimise the variability and get the most return you can for that variability = an efficient portfolio

Question 23

What is covariance?

What is the correlation coefficient?

What is the Sharpe ratio?

Answer 23

• the risk-return ratio (smallest risk/biggest return) can be optimised by combining securities with a minimised covariance
• covariance is the correlation coefficient x ingredients
• the covariance of shares A and B is variance in A times variance in B, times correlation coefficient between them
• covariance is affected by the size of A and B, whereas a correlation coefficient (between -1 and +1), isn’t
• covariance is in dollars

when it comes to reducing portfolio variability (risk), it’s covariance, NOT correlation, that counts!!

• correlation is inside covariance, but it’s not the end of it
• the absolute dollar amount of variability, however, IS relevant
• the Sharpe ratio is a measure of return per unit of risk

Question 24

Describe the efficient frontier.

Answer 24

Y-axis = rate of return (the different shares, bonds & property in the portfolio)

• each point along the efficient frontier is giving you the maximum return for the given risk

X-axis = standard deviation/covariance/financial risk/variability

• efficient frontier unites all points on available investments
• the best investment you can get is one on the efficient frontier because it contains the maximum available return per unit of risk (most risk-return efficient portfolios)
• if a risk-free investment existed (blue line - 90 day Treasury bill), then combining the risk-free investment with an investment on the efficient frontier would be better than the efficient frontier by itself
• the Sharpe ratio identifies the best possible proportions of these securities to use in a portfolio

(026)

Question 25

Describe the capital asset pricing model (CAPM).

Answer 25

• CAPM uses the efficient frontier diagram
• systematic risk is measured by beta (covariance of the individual portfolio with the whole market index
• in financial theory, the market doesn’t reward you for undertaking unsystematic alpha risk because it expects you to get rid of it through diversification
• in practice, within weak-form efficient markets, undertaking some elements of alpha risk IS rewarded and gives you high returns

Question 26

What is the most important investment strategy?

Answer 26

• diversify into investments with the biggest negative correlation/the smallest positive correlation, with the existing investments you have

Question 27

What is risk tolerance affected by?

Answer 27

Risk tolerance is affected by:

• mostly your personality
• circumstances
• peer pressure (trading on an open floor)
• the richer you are, the more risk-tolerant
• important to know people’s previous financial experiences: once bitten, twice shy

Question 28

What does the Efficient Market Theory assert?

Answer 28

• neoliberal means belief in free markets, capitalism and free trade
• the dominant view in Australia is that investors are rational and that markets ARE efficient and that they allocate resources accordingly
• the efficient market theory says that the stock market processes news accurately and quickly (rationally)
• efficiency in an efficient market is the accurate and quick interpretation of the news

Question 29

Behavioural finance theorists say that people often display irrational behaviour.

What type of irrational behaviour is considered a biased judgement?

Answer 29

• because people don’t like learning detailed algorithms and formulae, they prefer rules of thumb

Question 30

What are investment scams?

Answer 30

• fraud/deceit
• scams always involve promise of high returns - beating the stock market and getting rich quick
• everything is a scam until it’s proven otherwise - we need to see reliable auditable results

(032)

Question 31

Assuming that you’re investing and not speculating, what counts more than anything else is the economic fundamentals?

Why? What key questions should be asked?

Answer 31

A good investment ALWAYS has good economic fundamentals - particularly shares and property, but not bonds)

1. What industry are the firms in?
2. What are their financial results?
3. What are the margins like?
4. What’s the demand and supply like?
5. What’s the supply chain reliability like?
6. What’s the economic outlook for the industry like?

Question 32

What are the most important take-home points from the Topic 3 - Investment Choices lecture?

Answer 32

• efficient frontiers, risk and return, different asset classes, and the difference between aggressive and conservative investors in terms of their needs for a portfolio
• in the exam, one or two questions will be about advising someone on their choice of investments based on their attitude to risk
• we have to avoid being too dogmatic (generalising too much)

Question 33

Beta risk of a share or a portfolio

Select one:

a. varies inversely with whole market risk
b. is reducible through high negative correlated diversification
c. is as variable and volatile as the associated share price on the stock market
d. is unaffected by diversification at most levels of market efficiency

Answer 33

c. is as variable and volatile as the associated share price on the stock market

Question 34

Fixed-interest investments have the following characteristics:

Select one:

a. They cannot be traded on the secondary market before their maturity if an investor needs to convert their investment to cash.
b. Interest is usually paid on a regular basis, but with some investments, the interest amount is factored into the final payment and offered as a discount security or with accumulated interest paid on maturity.
c. They are not subject to credit risk.
d. Both a and b.

Answer 34

b. Interest is usually paid on a regular basis, but with some investments, the interest amount is factored into the final payment and offered as a discount security or with accumulated interest paid on maturity.

Interest on fixed-interest investments is usually paid on a regular basis, but with some investments, the interest amount is factored into the final payment and offered as a discount security or with accumulated interest paid on maturity. Non-government fixed-interest investments are subject to credit risk.

(Learning objective 4.2 ~ explain the broad investment classes)

Question 35

With regard to listed property as an asset class, nominate the correct statement below:

Select one:

a. Both listed property trusts known as real estate investment trusts (A-REITs) and unlisted property trusts are pooled investments which hold a basket of properties in one or more of the property sectors and offer units to be purchased by investors.
b. Listed property trusts do not have similar risks to shares.
c. Property is a long-term investment with higher risk than fixed-interest investments but slightly lower risk, historically, than shares.
d. Both a and c.

Answer 35

d. Both a and c.

Listed property trusts in fact have similar risks to shares.

(Learning objective 4.2 ~ explain the broad investment classes)

Question 36

Facts common to most investment scams include:

Select one:

a. investors being provided with a product disclosure statement.
b. the promise of returns equivalent to bank deposits.
c. both a and b.
d. none of the above.

Answer 36

d. none of the above.

None of the above issues listed is common to most investment scams as rarely are product disclosure statements provided to investors and the promised (but rarely realised) investment returns are typically much greater than that for bank deposits in order to attract investors (to part with their money).

(Learning objective 4.8 ~ develop an awareness of investment scams)

Question 37

Cash investments aim to provide:

Select one:

a. a capital guarantee.
b. returns that fully offset the investor from the impacts of inflation.
c. income, liquidity and stable returns.
d. both b and c.

Answer 37

c. income, liquidity and stable returns.

Cash investments aim to provide income, liquidity and stable returns. Despite its relative safety, cash investments do not typically offer a capital guarantee and there is the risk that capital will not keep pace with inflation and hence lose value in real terms.

(Learning objective 4.2 ~ explain the broad investment classes)

Question 38

With regard to shares as an asset class, nominate the correct statement below:

Select one:

a. Shares are generally considered a relatively high-risk and high-return investment
b. Shares have similar risks to listed property trusts.
c. bonds are riskier than shares
d. Both a and b.

Answer 38

d. Both a and b.

Question 39

Standard deviation:

Select one:

a. is equal to the variance squared.
b. measures the variability of returns around the expected return.
c. is found by taking the square root of expected return.
d. all of the above.

Answer 39

b. measures the variability of returns around the expected return.

Question 40

In terms of loss aversion theory, it is generally accepted that investors:

Select one:

a. consider losses far more undesirable than equivalent gains.
b. have a degree of aversion to losses which is counter to efficient market theory.
c. are more likely to sell losing stocks than winning stocks.
d. both a and b.

Answer 40

d. both a and b.

In terms of loss aversion theory, it is generally accepted that investors consider losses far more undesirable than equivalent gains and this degree of aversion to losses is counter to the expectations of the efficient market theory.

(Learning objective 4.7 ~ be aware of investor behaviour)

Question 41

In finance, risk may be defined as:

Select one:

a. the chance of a loss of capital.
b. the chance of loss of purchasing power.
c. the variability of returns.
d. all of the above.

Answer 41

d. all of the above.

Question 42

The efficient frontier shows

Select one:

a. the highest available returns for various levels of risk.
b. the boundary below which no investments are currently available
c. the highest possible return conceivable for different risks
d. the investments to be combined with the risk-free investment

Answer 42

a. the highest available returns for various levels of risk.

The mean and expected returns on an investment are directly proportional to their risk

Question 43

The expected return on a portfolio is calculated as the:

Select one:

a. average return of individual shares in the portfolio, as a fraction of the number of individual shares in the total portfolio.
b. weighted average return of individual shares in the portfolio, weighted by the risk of each share forming part of the total portfolio.
c. weighted average return of individual shares in the portfolio, weighted by the fraction of the total portfolio invested in each share.
d. none of the above.

Answer 43

c. weighted average return of individual shares in the portfolio, weighted by the fraction of the total portfolio invested in each share.

The expected return on a portfolio is calculated as the weighted average return of individual shares in the portfolio, weighted by the fraction of the total portfolio invested in each share.

(Learning objective 4.4 ~ understand the benefits of diversification)

Question 44

The relative investment performance of the major asset classes in the last 10 and 20 years as included in the text shows:

Select one:

a. Australian shares to have underperformed listed property.
b. Australian bonds to have underperformed listed property.
c. hedged international shares to have outperformed unhedged international shares.
d. all of the above.

Answer 44

c. hedged international shares to have outperformed unhedged international shares.

Question 45

The enterprising or aggressive investor is characterised by:

Select one:

a. speculation.
b. their willingness to devote time and care to the selection of sound and attractive investments even though they may not be fully trained experts in the field.
c. the conservation of capital.
d. both a and b.

Answer 45

b. their willingness to devote time and care to the selection of sound and attractive investments even though they may not be fully trained experts in the field.

The enterprising or aggressive investor is characterised by their willingness to devote time and care to the selection of sound and attractive investments even though they may not be fully trained experts in the field.

(Learning objective 4.1 ~ consider the general attributes of investors)

Question 46

When selecting suitable products for investment, personal investors often are attracted to property as an asset class because:

Select one:

a. returns are expected to keep pace with inflation.
b. it is a tangible investment, unlike the other asset classes.
c. both a and b.
d. none of the above.

Answer 46

c. both a and b.

Personal investors often are attracted to property as an asset class because returns are expected to keep pace with inflation and it is a tangible investment.

(Learning objective 4.6 ~ understand general investment strategies)

Question 47

With regard to the benefits of diversification, nominate the incorrect statement:

Select one:

a. A correlation coefficient of –1 would indicate that the two companies move counter-cyclically to each other.
b. The expected (mean) return for the portfolio lies between the highest return for all assets in the portfolio and the lowest return for all assets in the portfolio.
c. The riskiness of a portfolio is simply a weighted average of the standard deviations of the individual shares in the portfolio.
d. Portfolio risk can be reduced to close to zero when the returns of the shares contained in the portfolio are perfectly negatively correlated, that is they have a correlation coefficient of –1.0.

Answer 47

c. The riskiness of a portfolio is simply a weighted average of the standard deviations of the individual shares in the portfolio.

The riskiness of a portfolio is not simply a weighted average of the standard deviations of the individual shares in the portfolio as they are also impacted by the statistical concept of diversification.

(Learning objective 4.4 ~ understand the benefits of diversification)

Question 48

Select one:

a. Insufficient information to make an informed decision.
b. Tee Enterprises
c. Bouble Holdings
d. Scamanda Trading

Answer 48

b. Tee Enterprises

Question 49

The importance of the efficient frontier lies in the fact that it:

Select one:

a. identifies where the most efficient portfolios are.
b. is a curve and shows how diversification lets investors improve their efficient risk/return ratio.
c. represents the optimal mix of return and risk for a portfolio of investments given a required level of risk.
d. all of the above.

Answer 49

d. all of the above.

The efficient frontier is a curved line that represents the optimal mix of return and risk for a portfolio of investments given a required level of risk. The first important aspect of the efficient frontier is that it identifies where the most efficient portfolios are. The second important aspect of the efficient frontier is that it is a curve.

(Learning objective 4.4 ~ understand the benefits of diversification)

Question 50

In terms of behavioural theory, overconfidence can result in:

Select one:

a. individual investors being mistakenly convinced that they can regularly beat the market.
b. sharemarket investors less likely to speculate by regularly trading in stocks.
c. people deviating from rational thinking in making judgements where there is an element of uncertainty.
d. both a and c.

Answer 50

d. both a and c.

Overconfidence as an element of behavioural theory can result in people deviating from rational thinking in making judgements where there is an element of uncertainty which may include investors being mistakenly convinced that they can regularly beat the market.

(Learning objective 4.7 ~ be aware of investor behaviour)

Question 51

What are the main differences between a ‘very conservative’ and a ‘very aggressive’ investor?

Answer 51

Question 52

What is the significance of a standard deviation and how would you explain its meaning to a client? Write your response as if you were drafting a letter to a client.

The content of the letter should include the following information:

Answer 52

• The Standard Deviation (S.D.) measures the variability in the pattern of returns on an investment. It is a significant measure of risk and it is widely used in industry as well as in academia.
• S.D. is an intuitive measure because it expresses the units of risk on the same scale as the units of return: percentage.
• The S.D is one of several methods to quantify the dispersion of returns relative to their expected average value.
• Whilst it is always expressed as a positive value, the Standard Deviation nevertheless indicates the magnitude of potential loss when returns fall below the expected return.
• Downside-risk is the term given to describe the potential losses an investor may expect to incur according to the S.D.
• On the other hand, Upside-risk is the positive side of return volatility. This means that an investor may equally expect to incur returns above the expected mean.
• Importantly, these statistical assumptions are valid under conditions of random, frequent events.

Question 53

Where there is an element of uncertainty ‘people deviate from rational thinking in making judgement’.

Provide an example when a person may exhibit a sign of overconfidence.

Answer 53

If a person believes they have market-timing ability they may attempt to capitalise on this by buying shares when they believe prices are about to go up and selling shares when they believe prices are about to fall.

Their assumed ability to predict share price movement is not supported by empirical evidence.

Random chance will make the person’s predictions occasionally correct.

But it will be the result of luck, and not of an ability to predict the future.

Question 54

What does the efficient frontier mean for an investor who is considering a number of investment choices?

Answer 54

The efficient frontier describes the set of optimal portfolios in terms of their risk and return function.

The frontier indicates the best, possible outcome an investor can achieve given the finite nature of risk and reward.

The efficient frontier describes a range of portfolios that give a maximum return for a given level of risk.

The investor should only choose a portfolio that sits on the frontier (see fig 4.4).

However, whether they choose the high-risk point or the low-risk point of the frontier depends entirely on their risk-preference.

The curvature of the frontier graphically illustrates the trade-off that exists between risk and return, as well as the non-linear function of portfolio risk.

Question 55

What are the four main factors identified as common to all investment scams?

Four common attributes are:

Answer 55

1. they do not have a product disclosure statement
2. they promise high returns
3. the investments are often based overseas or must be kept secret
4. most require the prospective investee to provide a password or their bank account details.

Question 56

Benedict told his friend Henry that he expected to receive an investment return of 9.5%. Henry suggested to his friend that 9.5% might not actually be the real return or the investment. Henry told Benedict that he had forgotten to consider the effect of inflation.

(a) Calculate the real rate of return for Benedict if inflation was 3.4%.

(b) Suppose the rate of return of another investment that Benedict was considering was 4.5%. What then would be the real rate of return?

Answer 56

(a) Calculate the real rate of return for Benedict if inflation was 3.4%.

On page 133 the Real rate of return after adjusting for inflation is calculated as:

• R* real = (1 + R nom/1 + h) - 1 x 100
• R* nom = nominal rate
• h* = inflation rate

(or 5.9%)

(b) Suppose the rate of return of another investment that Benedict was considering was 4.5%. What then would be the real rate of return?

R real = (1.045/1.034) - 1 x 100 = 1.06%

Question 57

Assume a portfolio has two investment funds as per below.

Calculate the expected return for the portfolio (see page 137).

Answer 57

The expected return for the portfolio is the sum of the weighted averages of the expected return from each security in the portfolio. This means you need to sum up the weight of each share/security in the portfolio multiplied by the expected return from that share/security.

Apples comprise 60% of the portfolio and have an expected return of 8%. Oranges have a return of 12% and make up the remaining 40% of the portfolio. Therefore, the expected return for the portfolio

= weighted return from apples + weighted return from oranges

0.6(8%) + 0.4(12%) = Expected return 9.6%

Question 58

Given the figure below which indicates two different portfolio choices C and D, explain why portfolio D is the preferred option to portfolio C.

Answer 58

D is preferred as it provides the most efficient combination of investments.

C indicates a higher return but a higher level of risk.

Question 59

Xiaou got chatting with a man at the gymnasium who told him of a new motor engine that used revolutionary technology. Xiaou was interested in making money and gave his email to the man so he could get more information. In a few days, Xiaou received an email containing the business plan of the promoter and details of the revolutionary engine. Photos of the engine were attached along with details of how to invest in the new technology. The email gave a background of the development of the technology which was based on a powerful battery which needed charging only once a week and after 30 hours of driving. In addition, the engine would power a motor car at a top speed of 110 km per hour. The email also advised that the company behind the invention would soon list on the ASX and it was expected that share prices would rise quickly once the public was aware of the revolutionary technology. Xiaou decided to invest $5 000 in the company. After six months he had heard nothing from the promoter and decided to email the company. His email bounced back. Xiaou then contacted ASIC for advice.

Write a letter of advice that you could give someone who is faced with a similar tempting offer.

The letter may include the following information:

Answer 59

• In the first instance, seek advice from ASIC and your local state consumer protection authority before committing to any ‘secret’ investment scheme.
• Under the Australian Financial Services Reform Act, 2001, anyone seeking to sell an investment product must comply with some strict rules – in the first instance, ASIC can advise on these.
• If an investment looks too good to be true, it probably is. Apply a heavy dose of scepticism to any investment scheme that claims to get you ‘rich, quick’.
• Benchmark the investment with the market. How do the average returns compare? Now do the same with their risk. Higher returns can only be achieved with higher risk.
• Empirical evidence tells us that ‘beating the market’ by earning higher risk-adjusted returns on a continuous and sustained basis, is not possible.
• Behavioural finance proposes that people sometimes act irrationally and their capacity to judge an investment is impaired by their emotions and subjective biases.
• If a new product/investment claims to be a technological breakthrough, it still needs to find a market and to be financially viable. Not all inventions pass the test of market feasibility.
• Seek the assistance of a financial adviser.