Investments - Mba 825 - Chapter 5

Front 1

Portfolio

Back 1

is a collection of investments assembled to meet one or more investment goals.

Front 2

Growth-Oriented Portfolio

Back 2

primary objective is long-term price appreciation

Front 3

Income-Oriented Portfolio

Back 3

primary objective is to produce regular dividend and interest income

Front 4

Efficient portfolio

Back 4

- A portfolio that provides the highest return for a given level of risk

- Requires search for investment alternatives to get the best combinations of risk and return

Front 5

Portfolio Return and Risk Measures

Back 5

- The return on a portfolio is simply the weighted average of the individual assets’ returns in the portfolio

- The standard deviation of a portfolio’s returns is more complicated, and is a function of the portfolio’s individual assets’ weights, standard deviations, and correlations with all other assets

Front 6

Correlation

Back 6

is a statistical measure of the relationship between two series of numbers representing data

Front 7

Positively Correlated

Back 7

items tend to move in the same direction

Front 8

Negatively Correlated

Back 8

items tend to move in opposite directions

Front 9

Correlation Coefficient

Back 9

is a measure of the degree of correlation between two series of numbers representing data

Front 10

Correlation Coefficients

Back 10

- Perfectly Positively Correlated describes two positively correlated series having a correlation coefficient of +1

- Perfectly Negatively Correlated describes two negatively correlated series having a correlation coefficient of -1

- Uncorrelated describes two series that lack any relationship and have a correlation coefficient of nearly zero

Front 11

Why Use International Diversification?

Back 11

- Offers more diverse investment alternatives than U.S.-only based investing

- Foreign economic cycles may move independently from U.S. economic cycle

- Foreign markets may not be as “efficient” as U.S. markets, allowing true gains from superior research

- Study done between 1984 and 1994 suggests that portfolio 70% S&P 500 and 30% EAFE would reduce risk 5% and increase return 7% over a 100% S&P 500 portfolio

Front 12

International Diversification: Advantages and Disadvantages

Back 12

- Advantages:
*Broader investment choices
*Potentially greater returns than in U.S.
*Reduction of overall portfolio risk

- Disadvantages
*Currency exchange risk
*Less convenient to invest than U.S. stocks
*More expensive to invest
*Riskier than investing in U.S.

Front 13

Foreign company stocks listed on U.S. stock exchanges

Back 13

- Yankee Bonds
- American Depository Shares (ADS’s)
- Mutual funds investing in foreign stocks
- U.S. multinational companies (typically not considered a true international investment for diversification purposes)

Front 14

Diversifiable (Unsystematic) Risk

Back 14

- Results from uncontrollable or random events that are firm-specific

- Can be eliminated through diversification

- Examples: labor strikes, lawsuits

Front 15

Nondiversifiable (Systematic) Risk

Back 15

- Attributable to forces that affect all similar investments

- Cannot be eliminated through diversification

- Examples: war, inflation, political events

Front 16

Total Risk Formula

Back 16

Nondiversifiable (Systematic) Risk + Diversifiable (Unsystematic) Risk

Front 17

Beta: A Popular Measure of Risk

Back 17

*A measure of nondiversifiable risk
*Indicates how the price of a security responds to market forces
*Compares historical return of an investment to the market return (the S&P 500 Index)
*The beta for the market is 1.00
*Stocks may have positive or negative betas. Nearly all are positive.
*Stocks with betas greater than 1.00 are more risky than the overall market.
*Stocks with betas less than 1.00 are less risky than the overall market.

Front 18

Interpreting Beta

Back 18

*Higher stock betas should result in higher expected returns due to greater risk
*If the market is expected to increase 10%, a stock with a beta of 1.50 is expected to increase 15%
*If the market went down 8%, then a stock with a beta of 0.50 should only decrease by about 4%
*Beta values for specific stocks can be obtained from Value Line reports or online websites such as yahoo.com

Front 19

Capital Asset Pricing Model (CAPM)

Back 19

*Model that links the notions of risk and return
*Helps investors define the required return on an investment
*As beta increases, the required return for a given investment increases

Front 20

Capital Asset Pricing Model (CAPM) Formula

Back 20

Uses beta, the risk-free rate and the market return to define the required return on an investment

RR of Investment=RF rate+[Beta x (Expected market return - RF rate)]

Front 21

Constructing Portfolio: Traditional Approach:

Back 21

- Emphasizes “balancing” the portfolio using a wide variety of stocks and/or bonds

- Uses a broad range of industries to diversify the portfolio

- Tends to focus on well-known companies
*Perceived as less risky
*Stocks are more liquid and available
*Familiarity provides higher “comfort” levels for investors

Front 22

Constructing Portfolio: Modern Portfolio Theory (MPT)

Back 22

- Emphasizes statistical measures to develop a portfolio plan

- Focus is on:
*Expected returns
*Standard deviation of returns
*Correlation between returns

- Combines securities that have negative (or low-positive) correlations between each other’s rates of return

Front 23

Efficient Frontier

Back 23

- The leftmost boundary of the feasible set of portfolios that include all efficient portfolios: those providing the best attainable tradeoff between risk and return

- Portfolios that fall to the right of the efficient frontier are not desirable because their risk return tradeoffs are inferior

- Portfolios that fall to the left of the efficient frontier are not available for investments

Front 24

Portfolio Beta

Back 24

- The beta of a portfolio; calculated as the weighted average of the betas of the individual assets the portfolio includes

- To earn more return, one must bear more risk

- Only nondiversifiable risk (relevant risk) provides a positive risk-return relationship

Front 25

Interpreting Portfolio Betas

Back 25

- Portfolio betas are interpreted exactly the same way as individual stock betas.
*Portfolio beta of 1.00 will experience a 10% increase when the market increase is 10%
*Portfolio beta of 0.75 will experience a 7.5% increase when the market increase is 10%
*Portfolio beta of 1.25 will experience a 12.5% increase when the market increase is 10%

- Low-beta portfolios are less responsive and less risky than high-beta portfolios.

- A portfolio containing low-beta assets will have a low beta, and vice versa.

Front 26

Reconciling the Traditional Approach and MPT

Back 26

- Recommended portfolio management policy uses aspects of both approaches:
*Determine how much risk you are willing to bear
*Seek diversification between different types of securities and industry lines
*Pay attention to correlation of return between securities
*Use beta to keep portfolio at acceptable level of risk
*Evaluate alternative portfolios to select highest return for the given level of acceptable risk