unit 15 | introduction to the portfolio approach

Question 1

Portfolio

Answer 1

A basket of securities:
Stocks
Bonds
Cash
Real estate… currency…

Question 2

Risk & Return

Answer 2

• Portfolio management focuses on risk & return
• Financial decision revolve around the risk-return trade-off
• Investors will prefer an investment that generates the greatest return for a given level of risk
• Investors who are very risk averse will own very safe assets
  > GICs, Canada Savings Bond (low risk, low return assets)
• Investors who prefer greater risk will own riskier assets
  > Riskier stocks: Tesla, Amazon, Google

Greater risk → greater return

Question 3

Securities in the order of low risk to high risk

Answer 3

Treasury bills
Bonds
Debentures
Preferred shares
Derivatives

Question 4

Derivatives

Answer 4

• Derives its value from a underline security
• The value of an option (Google stock)

Question 5

Returns

Answer 5

Total returns when you own a security = sum of

Interest or dividends received when you own it (cash flow yield)

Capital gain (price change)

Question 6

% return formula

Answer 6

% return = [cash flow + (ending value - beginning value)]/beginning value

Cash flow → interest/dividends received
Ending - beginning value → capital gain

Question 7

Real Rate of Return

Answer 7

• Real rate of return → how much an investment has increased in real terms, after adjusting for inflation
• Real rate of return (approximate) = nominal rate - inflation rate
• Nominal rate is your actual rate of return
  > Example: assume the inflation has been 1.5% for the past year
  > What is the real rate of return for an investment that provided a 6.5% nominal return
  > Real rate of return = 6.5% - 1.5% = 5.0%

Question 8

Inflation risk

Answer 8

Inflation erodes the future value of security’s cash flow (prices fall with an increase in inflation)

Question 9

Business risk

Answer 9

The risk to that particular business or industry

Question 10

Political risk

Answer 10

The risk of doing business in a particular country

Question 11

Liquidity risk

Answer 11

Can I monetize my investment quickly & easily
- Lots of buyers & sellers

Question 12

Interest rate risk

Answer 12

How sensitive is a security’s return to an increase in interest rates
- If interest rates rise, in general a security’s value will fall (TMV & discount rates…)

Question 13

Foreign exchange risk

Answer 13

How the strength/weakness of the C$ will affect investment returns if investing in foreign securities

Question 14

Default risk

Answer 14

The risk that a company goes bankrupt or defaults on its debt obligations (not good → esp for equity holders)

Question 15

Systematic (market) risk

Answer 15

Risk relating to the overall market/economy
- Cannot be diversified away → always exposed to general movements in the overall market/economy
- Stock market is inherently risky

Question 16

Non-systematic (non-market) risk

Answer 16

Risk relating to a specific firm → the risk that a company goes bankrupt or revenue significantly decline because of a recall on its products
- Can be diversified away → don’t put all your eggs in one basket → buy different stocks in different industries in different countries
- Your portfolio will not be biased to a particular company/industry/country

Question 17

How do we measure risk?

Answer 17

Variance
Standard deviation (square root of variance)

Question 18

Beta

Answer 18

• Measures a security’s return relative to the overall market
• The higher a firm’s beta, the greater its risk is relative to the overall market

Question 19

Asset allocation

Answer 19

Deciding where to put your capital (money):
Cash
Fixed income
Equities
- Each of these assets has risk/return characteristics (cash should be 100% safe but virtually no return)
- Within each of these assets are further risk/return characteristics (defensive stocks have much less risk than speculative stocks)

Question 20

Determination of asset allocation

Answer 20

Depends on who is the investor & what their investment objectives & risk tolerances (how long → long time should put in stock market to expect greater returns)

Question 21

The expected return of a portfolio will depend on…

Answer 21

…the expected return of each asset in portfolio & the weighting of each asset

Question 22

Why do we diversify?

Answer 22

• We need to diversify our investments to eliminate the risk specific to one firm (non-systematic risk elimination)
• The best forms of diversity to find securities that move in opposite directions
  > Don’t want investments that move together

If we own RBC, CIBC & Scotia as a portfolio → this is not much better than just owning TD on its own

Question 23

What does Correlation measure?

Answer 23

Correlation measures how the returns of 2 securities are related:
+1.0 indicates perfect positive correlation
-1.0 indicates perfect negative correlation
0.0 indicates no correlation

Question 24

What does perfect correlation mean?

Answer 24

• Perfect correlation means that the 2 securities’ returns move perfectly together 100% of the time
• An ideal will consist of securities with as much negative correlation as possible

Question 25

Combining Securities: Beta

Answer 25

Measures the volatility of a security’s return relative to the overall market

• The higher the beta, the riskier the security
• If company A’s beta = 2.0; if the market goes up 10%, Company A’s shares will increase 20% → vice versa
• Most company’s betas are positive; some company’s betas are negative…

Question 26

The Portfolio Management Process

Answer 26

• Portfolio returns will be the weighted average of returns for all securities
• However, the overall portfolio (firm specific) risk will be lower than the weighted average of risks for of all securities
  > Result of diversification
• To construct a proper portfolio, we need to start with the investor’s objectives

Question 27

Primary investment objectives:

Answer 27

Safety → can we lose some or all our money
Income → typically from interest or dividends (regular payments)
Capital growth → increases in the price of a security

Question 28

Secondary investment objectives may be:

Answer 28

Marketability/liquidity → I need my money & I need it fast
Tax minimization → increasingly important given 50+% taxes in Canada

Question 29

Can desired outcomes be completely achieved?

Answer 29

• We cannot minimize safety & maximize income & capital growth
• Trade-offs are made depending on investor investment objectives & risk tolerances