investments, risk and return

Question 1

what are the two main types of investment

Answer 1

financial and non finacial

Question 2

examples of financial investments

Answer 2

direct and indirect:

• money market instruments
• capital market instruments
• mutual funds - collective invesments
• derivative assets - futures, options, currencies (eg. bitcoin)

Question 3

what are examples of non financial investments

Answer 3

real estate
collectibles
other investments assets

Question 4

what are the most popular investment option

Answer 4

fixed deposits
money market accounts
listed ordinary shares
listed bonds
unit trust

Question 5

what are fixed deposits?

Answer 5

fixed lump sum is deposited with a bank at a fixed rate for a fixed period of time

Question 6

ad and disadvantages of fixed deposits

Answer 6

–Advantages: Returns tend to be higher than the more flexible savings accounts. Also, you benefit if interest rates in the market decrease.

–Disadvantages: Lack of access to the money makes them illiquid. Also, you loose if interest rates in the market increase.

Question 7

what are money market accounts

Answer 7

types of bank deposit accounts that pay higher interest rates than savings accounts, but require higher minimum deposits such as R500 000. The higher the deposit, the higher the interest rate

Question 8

ad and disadvantages of money market accounts

Answer 8

–Advantages:Higher deposits attract higher interest rates than the savings accounts. The money is available on demand –making them a liquid investment.

–Disadvantages:The large minimum deposit is a barrier to investment by many individual investors.

Question 9

what does it mean to invest in listed ordinary shares

Answer 9

Unlike bonds, shares represents an ownership interest in a company and shareholders are entitled to: voting rights (at the AGM) and dividends (when declared).

Question 10

ad and disadvantages of investing in shares

Answer 10

Advantages: In the long-term, they outperformbonds and money market instruments, easy to buy and sell (being listed), information is easily available (annual reports and share prices), hundreds of firms to choose from.

•Disadvantages: The risk is higher than that of bonds and MM instruments. Dividends are not guaranteed and you could loose the original investment.

Question 11

what are listed bonds

Answer 11

companies and government want to borrow from the public and then they offer financial securities

•Bond issuers have an obligation to pay bondholders (a) fixed interest amounts (or coupons) annually or semi-annually; & (b) the principal sum on maturity. –Hence, they are ideal for investors who desire current regular income and capital preservation.

Question 12

ad and disadvantages of bonds

Answer 12

Advantages: Are safer (less risky) than shares (interest & capital sum guaranteed).
•Disadvantages: The return on bonds is less than the return on shares.

Question 13

what are unit trust

Answer 13

collective investments
allow investors to pool their small monies together into a single fund - the money is then invested into bigger investment instruments

Question 14

advantages and disads of unit trust

Answer 14

•Advantages:
–They allow ordinary people to invest in shares that would normally be out of their financial reach had their monies not been pooled with that of other investors
–They reduce investment risk through diversification
–They are flexible. One can invest either a lump-sum or small monthly amounts
–They are liquid –one can sell part or all the investment at any time.

Disadvantages:

Returns are earned in the long-term rather than short-term. Like any investment, the market may collapse and investors may loose their investments

Question 15

Investments are made in order to earn a RETURN (i.e., a benefit an investor receives from an investment). This return could be:

Answer 15

• INCOME ONLY –such as interest on fixed deposit account.
• CAPITAL GAINS ONLY (benefit from appreciation in the value or price of an asset) –for example, the return on treasury bills

or both

Question 16

what is the return on shareholder investment/ total holding period return?

Answer 16

(p1-p0+dividends)*100/p0

capital gains component - (p1-p0)/p0
income comp - Dividends/p0(as a percentage)

Question 17

why the greater the risk the greater the return

Answer 17

investors require compensation for bearing that risk

Question 18

what is risk

Answer 18

refers to the degree of uncertainty or variability in year to year returns on investments

Question 19

how is the risk on an investment measured

Answer 19

sd and var - sd preferred

Question 20

the greater the variance the…

Answer 20

greater the risk

Question 21

variance and mean of historical data

Answer 21

normal calculator way

mean - add and divide

Question 22

mean of forecast data

Answer 22

expected value
Σpi*Ri
probability of that amount * that amount

Question 23

variance of forecast data

Answer 23

Σpi(Ri-E(R))^2 [E(R)] ==> expected value

Question 24

what is the coefficient of variation

Answer 24

e.g. if Z has lower risk and return than y

measure the amount of risk per unit of expected return

cv = σ/(E(R))

higher CV = high risk

Question 25

what is a portfolio of assets?

Answer 25

a collection or group of assets that are held by an investor
ensures that not all your assets are put in the same basket

Question 26

what is covariance

Answer 26

measure of how returns on two assets move together or co-vary - correlation coeff is used

Question 27

what does the correlation coeff measure

Answer 27

the strength of the relationship between the return on two shares in a portfolio

value between -1 and +1

Question 28

what does a positive correl coeff mean

Answer 28

if asset A increases then asset B will also increase

Question 29

what does a negative correl coeff mean

Answer 29

if asset A increases then asset B deacreses

Question 30

what does a zero correl coeff mean

Answer 30

the assets are independent

Question 31

so what does the riskiness of a portfolio depend on

Answer 31

the riskiness of each of the assets in the portfolio and the relationship between their returns

Question 32

what is diversification

Answer 32

By investing in two or more assets whose returns are not perfectly positively correlated, an investor can reduce the risk (or the standard deviation) of the portfolio.

Diversification tells us that spreading an investment across assets of different classes or from different sectors reduces total risk by eliminating unsystematic risk.

Question 33

what is the purpose of diversification

Answer 33

The purpose of diversification is to reduce portfolio risk or portfolio standard deviation.

(not recommended to do over too many assets)

Question 34

what makes up total risk

Answer 34

systematic and unsystematic risk

sd of returns is a measure of the total risk

Question 35

what is systematic risk?

Answer 35

cannot be eliminated through diversification and it effects assets in the entire market
- market risk, non-diversifiable risk
- examples of things that could cause this type of risk
announcements of: a decrease in the GDP, increase in interest rates or inflation rate

Question 36

what does the total risk of a diversified portfolio consist of

Answer 36

• The total risk of a diversified portfolio comprise only systematic risk

Question 37

what is unsystematic risk?

Answer 37

This is the risk that can be eliminated through diversification and it affects either specific assets or a limited number of assets. Hence:–It is also known as diversifiable risk, unique risk, or asset-specific risk.–For a well diversified portfolio, unsystematic risk is zero.

Question 38

examples of events that can give rise to unsystematic risk

Answer 38

–The CEO of a company is fired.
–The directors of Bid Widget die in a plane crush
.–Five construction firms are fined for price collusion by the Competition Tribunal.

Question 39

what are the factors that limit portfolio diversification

Answer 39

• systematic risk cannot be eliminated through diversification
• cost to diversify - transaction costs, taxes etc.
• The benefits of diversification become incrementally smaller as you add more assets to your portfolio.–The first asset added to your portfolio provides the biggest decrease in risk and the addition of more assets will result in increasingly smaller reductions in portfolio risk.