4.b

Question 1

What is the main idea behind asset allocation?

Answer 1

Spreading portfolio funds among different asset classes (like stocks, bonds, and cash).

The core belief is that the mix of assets is more important for long-term returns than picking individual stocks.

Question 2

What is the difference between Strategic and Tactical Asset Allocation?

Answer 2

Strategic: A long-term, passive strategy where a portfolio’s proportions are set and rebalanced periodically.

Tactical: A short-term, active strategy that adjusts the portfolio mix to take advantage of current market conditions.

Think of the ‘100 minus age’ rule for stocks.

Question 3

What is the main goal of Modern Portfolio Theory (MPT)?

Answer 3

To design a portfolio that minimizes risk for a given level of expected return.

It does this by diversifying with assets whose prices are not correlated, which helps eliminate unsystematic (business-specific) risk.

Question 4

What does the Capital Asset Pricing Model (CAPM) try to determine?

Answer 4

It calculates the expected return an investment should achieve based on its level of systematic risk.

The basic idea is that investors should be rewarded with higher potential returns for taking on more non-diversifiable (market) risk.

Question 5

What does a security’s Beta measure? What does a Beta of 1.5 mean?

Answer 5

Beta measures a security’s volatility in relation to the overall market (its systematic risk). The market has a Beta of 1.0.

A Beta of 1.5 means the security is 50% more volatile than the market. If the market goes up 10%, this security would be expected to go up 15%.

Question 6

What does Alpha measure?

Answer 6

Alpha measures an investment’s actual performance compared to its expected performance, given its level of risk (its Beta).

Positive Alpha: The investment did better than expected. (Good)

Negative Alpha: The investment did worse than expected. (Bad)

A positive alpha indicates a ‘buy’ recommendation.