Week 10 & 11: Portfolio Flashcards
What does portfolio management focus on?
Risk and return.
What will investors prefer in regards to an investment and level of risk?
They prefer an investment that generates greatest return for a given level of risk
“Reducing risk should reduce returns”
What type of assets are safe to invest in? What about riskier assets?
Safe
- GICs, Canada Savings Bonds
Riskier
- Riskier stocks: Tesla, Amazon, Google
List types of investments from less risk/less return to greater risk/greater return
(Less risk / lesss returns)
- Treasury bills
- Bonds
- Debts
- Preferrred Shares
- Common Shareas
- Derivatives
(Greater risk / greater returns)
What is the formula for total return?
= sum of interest or dividends receive when you own it (cash flow yield)
- capital gain (price change)
What is the formula for % return?
= (Cash flow + [Ending value - beginning vlaue]) / Beginning value
OR
= ((div. + interest) + (end value - beg. value)) / beg. value
What is the formula for “Cash flow”
= interest / dividends received
What is the formula for capital gain?
= (Ending value - beginning value)
What is the real rate of return? What’s the formula for it?
The real rate of return is how much an investment has increased in real terms, after adjusting for inflation
Real rate of return (approx) = nominal rate - inflation rate
What is nominal rate?
Actual rate of return.
Example: Assume inflation rate has been 1.5% for the past year. What is the real rate of return for an investment that provided a 6.5% nominal return?
Real rate of return 6.5% - 1.5% = 5.0%
What are types of risk (4)?
- Inflation risk - Inflation erodes future value of seucrity’s cash flow.
- Business risk - risk to that particular business or industry
- Political risk - risk of doing business in particular country
- Liquidity risk - can I monetize my investment quickly and easily
- Interest rate risk - how sensitive is a security’s return to an increase in interest rate
- Foreign exchange risk - how the strength/weakness of the C$ will affect investment returns if investing in foreign securities
- Default risk - risk that company goes bankrupt or defaults on its debt obligations. Not a good thing, esp. for equity holders
- Systematic risk (market) - risk related to overall market
- Non-systematic (non-market) risk - risk relating to specific firm.
What risk cannot be diversified away? What can?
Systematic (market) risk cannot be diversified away because we will always be exposed to general movements in the overall market or economy
Non-systematic (non-market) risk can be diversified away by not putting all of your eggs in one basket. Differentiate stocks (for example).
How do we measure risk?
- Variance
- Standard deviation (square root of variance)
- Beta (measures security risk relative to overall market, higher beta, greater risk)
What does correlation measure?
How the returns of 2 securities are related
- +1.0 = perfect positive correlation
- -1.0 = perfect negative correlation
- 0.0 = no correlation
Perfect correlation means that 2 securities’ returns move perfectly together 100% of the time.
What correlation does an ideal portfolio consist of?
As much NEGATIVE CORRELATION as possible
Portfolios are based on investor objectives. What are some primary iand secondary investment objectives?
Primary
- Safety (can we lose some or all of our money)
- Income (typically from interest or dividends)
- Capital growth (increases in the price of a security)
Secondary
- Marketability / liquidity (need money, and need it fast)
- Tax minimization
What are trade-offs regarding objectives?
We cannot minimize safety and maximize income and capital growth
