Type of Investment Risk Flashcards
What is investment risk?
The uncertainty that an investment’s actual or realized return, will be different from its expected return.
What is diversification?
The structuring of an individual’s investment portfolio to minimize risk and maximize return.
- Use of low correlation (asset diversification)
- Use of time horizon (time diversification)
What is unsystematic risk?
This is diversifiable risk. It is risk that only affects a particular company, country, and/or sector. Using non-correlated assets can mitigate this risk.
Examples:
Business risk: uncertainty of income
Financial risk: how a businesses financial structure affects value
Default risk: a business can’t pay its debts
Political risk: the political environment affects investment values
Tax risk: the country tax laws can affect business values
Investment manager risk: poor investment managing
Liquidity risk: the ability to sell an asset
Marketability risk: the ability to find a buyer for an asset
What is portfolio diversification?
The commitment to an array of separate investments that are not correlated with each other in order to offset risks that when one investment goes down, the others could go up.
What are the four asset classes for diversification?
Cash and cash equivalents
Fixed income (bonds)
Equities (stocks
Real assets (land, collectibles, precious metals)
What is expected return?
An investor’s estimate of a return, given the economic and market prospects for an investment.
What is total risk?
Systematic + unsystematic risks
For systematic risks, remember PRIME. What is it?
Purchasing power risk Reinvestment rate risk Interest rate risk Market risk Exchange rate risk
What is Beta?
A measure of SYSTEMATIC risk.
The market has a Beta of +1.0. Therefore, any assets that have less than 1.0, are less risky. Assets with more than 1.0, are more risky.
In the measurement calculations, what do the following symbols mean? β = σi = σm = ρim = COVim = W = σp =
β = beta σi = standard deviation of the investment σm = standard deviation of the market ρim = correlation coefficient between the investment and the market COVim = covariance between the investment and the market W = weighting or percentage of a portfolio σp = standard deviation of a portfolio
What is covariance?
COVij = ρijσiσj
Covariance measures the extent to which two variables (two investment returns in this case), either move positively, (together) or negatively (opposite).
COVij = covariance between assets i and j ρij = correlation coefficient between assets i and j σi = standard deviation of asset i σj = standard deviation of asset j
What is standard deviation?
It is an absolute measurement of the variability of the actual investment returns around the average or mean of those returns.
In other words, it tells the investor how far from the mean, they could expect the investment’s actual return, to likely vary. The higher the number, the wider the variable.
What is normal probability distribution?
It is the location of the arithmetic mean of a series of observations.
What is the mean, median, and mode?
The mean is an absolute: the sum of all observations, divided by the number of observations.
The median is the central value in a series of values (4, 7, 8, 11, 13 = median 8)
The mode is the observation value with the greatest frequency.
What is normal probability distribution?
Given the mean,
One observation will occur 68% of the time within one standard deviation
One observation will occur 95% of the time within two standard deviations
One observation will occur 99% of the time within three standard deviations.
Anything outside that, is an outlier.
Ex: 10% return with 5% standard deviation
1 standard deviation = 5% and 15%
2 standard deviations = 0% and 20%
3 standard deviations = -5% and 25%