unit 15 | introduction to the portfolio approach Flashcards
Portfolio
A basket of securities:
Stocks
Bonds
Cash
Real estate… currency…
Risk & Return
- 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
Securities in the order of low risk to high risk
Treasury bills
Bonds
Debentures
Preferred shares
Derivatives
Derivatives
- Derives its value from a underline security
- The value of an option (Google stock)
Returns
Total returns when you own a security = sum of
Interest or dividends received when you own it (cash flow yield)
Capital gain (price change)
% return formula
% return = [cash flow + (ending value - beginning value)]/beginning value
Cash flow → interest/dividends received
Ending - beginning value → capital gain
Real Rate of Return
- 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%
Inflation risk
Inflation erodes the future value of security’s cash flow (prices fall with an increase in inflation)
Business risk
The risk to that particular business or industry
Political risk
The risk of doing business in a particular country
Liquidity risk
Can I monetize my investment quickly & easily
- Lots of buyers & sellers
Interest rate risk
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…)
Foreign exchange risk
How the strength/weakness of the C$ will affect investment returns if investing in foreign securities
Default risk
The risk that a company goes bankrupt or defaults on its debt obligations (not good → esp for equity holders)
Systematic (market) risk
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
Non-systematic (non-market) risk
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
How do we measure risk?
Variance
Standard deviation (square root of variance)
Beta
- 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
Asset allocation
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)
Determination of asset allocation
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)
The expected return of a portfolio will depend on…
…the expected return of each asset in portfolio & the weighting of each asset
Why do we diversify?
- 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
What does Correlation measure?
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
What does perfect correlation mean?
- 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
