Choosing Between Assets Flashcards
(41 cards)
What environment makes the decision to invest in stocks easy?
When interest rates are low.
Why are bonds an easy choice in a high interest rate environment?
You can get a high return with the much lower risk of bonds compared to equities.
What spread helps us value stocks versus bonds?
The spread between the earnings yield on the S&P 500 and the 10 year bond
Can the dividend be used against the bond yield to compare assets?
Yes on its own, or added to the Earnings Yield to compare against bonds.
Can any other type of bond yield be used in this equation?
We could use the corporate bond yield instead of the long Treasury Bond?
Why are costs important in asset comparison?
As an eg Real Estate has management fees, maintenance costs, insurance, mortgages versus stocks just pay the commission going in and out.
Why should I consider reinvestment risk when comparing assets?
Some assets throw off cash which I then have to work out how to reinvest. Alternatively, stocks of good growing comparing can reinvest my earn earnings for me and throw off an increases stream of income.
What protections do Equities have against rising bond yields?
Earnings growth or a high enough level of dividend yields.
Which type of assets add the best diversification benefits?
non correlated assets. Means thans that one asset zigs while the other zags. Relationship not constant over time but more of a generalization.
What are 4 attractive attributes of diversification?
1) Reduces risk/volatility
2) Improves risk adjusted returns
3) Reduces max drawdown
4) reduces time in drawdown mode
Give an example of max draw down on a 6040 PF versus stocks using data back to 1950?
A notional 6040 PF going back to 1950 had a max draw down of only 29% versus 52% for stocks.
Does diversification work all the time?
No, often in a crisis all assets literally go to 1 and move together.
The case against investing in one single asset class and for diversifying.
Asset class returns can be extreme. Whether US equities late '20s, German in '40s, Japan 1990-2015, max drawdown can be so large that recover might take investors entire life.
What do studies say about where return variability comes from?
Studies show that 70% of return variability is derived from asset allocation, 20% from sub-asset allocation (country, size, style) and 10% from security selection.
When we think about the risk of one asset versus another, we have to consider the risk/volatility of different assets. What is beta?
beta - an assets sensitivity compared to a broad market. A beta of 1.2 is 20% more sensitive than the broad market
Another measure of volatility is called standard deviation. What is it?
measures the inherent volatility of the asset itself. Here we are looking at an assets volatility compared to its own performance over a period of time.
Govt bonds have a SD of 10, Large stocks 20, small stocks 30, Corp Bonds 9.5, Intermediate bonds 6.8
What important risk is not captured by either beta or standard deviation?
That the return will be bad.
Two other ways to think about risk?
Cumulative draw down over say a 2-3 year period or
Time to recovery of capital value.
Describe 3 different ways to think about equity or market risk premium?
They are the either
1) the historical market risk premium based on returns that have already occurred - typically equities v bonds. This can be seen to represent an excess return.
2) The more subjective expected market risk premium based on return projections
3) the premium required by investors to allocate capital to equities over bonds. Equities are inherently more risk than bonds which pay steady interest and return a known principal value.
What are 5 types of models used to estimate the ERP?
1) predictors that use historical mean returns only, 2) dividend-discount models, 3) cross-sectional regressions, 4) time-series regressions and 5) surveys.
What are long run estimates of the ERP level?
According to some sources, the equity risk premium ranges between 4% and 7% over the long term
Using a database of 21 countries going back to 1900 the realised equity risk premium over government bonds has been 3.4% annually (robecco)
What was the ERP estimated to be during the GFC? What was the reason for this?
10.5%.
Reason: global CB intervention and artifically low interest rates.
What about the ERP after the GFC?
According to the Federal Reserve Bank of New York, the equity risk premium reached abnormally high levels in 2012 and 2013 of about 12%, due to extremely low bond yields.
What other reasons have led to significant change in the ERP?
But the equity risk premium has experienced other periods of material shifts, with one early notable period being the post-World War era where the risk premium rose thanks to greater confidence and appetite for risk.
A more recent period of note was the higher-than-usual equity risk premium experienced after the tech bubble of the late 1990s.
