# Portfolio Theory Flashcards

Standard Deviation

Measure of risk and variability of returns

- huger the standard deviation, higher the riskiness of the investment.
- can be used to determine total risk of an UNDIVERSIFIED portfolio

For CFP exam need to be able to:

1.use standard deviation to determine the probability of returns

- Calculate the standard deviation

Standard deviation to calculate probability of returns

Graph illustrates a normal distribution with probabilities between -3,-2,-1 & 1,2,3

Standard deviation - example

Calculating Standard Deviation

CFP exam may ask “which of the following assets is more risky?”

They are really asking you to calculate the standard deviation and select the asset with the highest standard deviation

Calculating total expected return

-calculation is sum of all expected returns returns multiplied by their respective probabilities

Coefficient Of Variation

- useful in determining which investment has more relative risk when investments have different average returns.
- higher coefficient of variation the more risky an investment per unit of return.

CV = standard deviation/average return

Lognormal Distribution

-appropriate if an investor is considering a dollar amount or portfolio value at a point in time.

Kurtosis

-variations of returns

Leoptokurtic - high peak and fat tails (higher chance of extreme events)

Platykurtic - low peak and thin tails (lower chance of extreme events)

Mean Variance Optimization

- process of adding risky securities to a portfolio but keeping the expected return the same.
- balance of combining asset classes that provide lowest variance as measured by standard deviation

Monte Carlo simulation

-spreadsheet simulation that gives probabilistic distribution of events occurring..

Monroe Carlo simulation adjusts assumptions and returns the probability of an event occurring depending on the assumption.

Co-Variance

- is the measure of two securities combined and their interactive risk. How price movements between the two are related two each other.
- measure of relative risk
- formula provided on the sheet.
- need to calculate if you are given the correlation coefficient and need to calculate the standard deviation of a two asset portfolio

Correlation/Correlation Coefficient

-correlation ranges from +1 to -1

+1 denotes two assets are perfectly positively correlated.

0 denotes that assets are completely uncorrelated

1 denotes a perfectly negative correlation.

- diversification benefits (reduction of risk) begin anytime correlation is less than 1, best is -1
- correlation and covariants measure the movement of one security relative to that of another.
- represented by greek letter Rho or r

Beta

- beta coefficient is a measure of an individual securities volatility relative to that of the market.
- best used for a DIVERSIFIED portfolio
- it measures systematic risk dependent on the volatility of the security relative to that of the market.

Beta of the market is 1

- stock with a beta of 1 will mirror the market in terms of direction, return, and fluctuation.
- stock with beta higher than 1, means stock fluctuates more than the market and greater risk
- stock with beta lower than 1, means stock fluctuates less relative to market movements.
- beta may be calculated with formula or dividing security risk premium by market risk premium

CoEfficient of Determination or R-Squared (r2)

- R-squared measures how much of a return is due to the market.
- calculate by squaring the correlation coefficient.
- higher R2, higher percentage of return from the market (systematic risk) and less from unsystematic risk.
- r2 greater than or equal to .70, beta is an appropriate measure of risk.
- r2 is less than .70, beta is not an appropriate measure of risk and standard deviation should be used

Coefficient of determination example