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Level 35

Risk & Return of a Portfolio: Portfolio Analysis

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Holding period return
the total return received from holding an asset or portfolio of assets; not for different time frame and different investments.
arithmetic mean return
average of a series of periodic returns
geometric mean return
compound annual rate
money weighted rate of return
Internal Rate of return on a portfolio based on all of its cash inflows and outflows
gross return
total return before deducting fees for management and admin
net return
Difference between return and initial investment.
after tax nominal return
return prior to paying tax
real return
nominal return adjusted for inflation
leveraged return
a return to an investor that is a multiple of the return on the underlying asset
Risk and Return of major asset classes
Small-cap stocks --> Large-cap stocks --> Long-term corporate bonds --> Long-term treasury bonds --> Treasury bills --> Inflation (from the riskiest to the least risky) based on standard deviation and expected returns
risk-averse investor
dislikes risks (prefers Less risk to more risk); choose the one with Less risk (lower standard deviation)
risk-seeking investor
prefers more risk, given equal return will choose the riskier investment
Geometric Mean
[(1+R1) X (1+RT)]^(1/t)-1
-Short term, one year
Arithmetic mean is better for _ term returns
N variance terms = how many covariance terms
Correlation coefficient between A and B =
the Covariance of a and B/ (SD of a* SD of B)
How to calculate variance of a portfolio
-Sum each assets variance * (the respective weight^2), as well as 2 times each assets pair combinations' covariance and the weight of both assets
Risk Averse
You don't like risk
The lower the covariance at a given risk the _______ the return
A portfolio of _______ unrelated common stocks achieves most of the benefits of diversification
Sharpe Ratio
Slope of the capital market line
index funds match the market
Evidence that investor behavior is consistent with portfolio theory
A virtual place (sometimes physical) where there are trades.
Yes because it may be good if market goes down
Would we ever take a risky stock that has a lower return than the risk free rate?
beta and leverage
Basset = cov(UCF, Market)/ SD^2 market
When beta's greater than 1 do well
good years; in bad years They do worse than the market
Expected return on asset J (equation)
Risk free rate + sensitivity of asset to factor(expected return of factor - risk free rate) ..... the term to the side of the plus sign gets repeated for every factor
Fama French Results
Two characteristics describe most of the variation in security returns
Book to market ratio
Book value per share of common stock / stock price
Value Potential
Portfolio Classification is made up of what Two influences?
More exclusivity
What is a Critical Portfolio Type?
Complex Specifications
What is a Bottleneck Portfolio Type?
Many Sources of supply
What is a Routine Portfolio Analysis?
What is Leverage Portfolio type?
Many qualified sources of supply
Blue chip:
highest quality co.'s with proven earnings and dividend records. NYSE listed issues mainly
companies in a period of above avg growth. Low div. payout ratios, sell at higher P-E multiples than mature companies because of exceptional growth.
Emerging growth
brand-new ventures of high risk but also high potential reward.
mature companies with high div. payout ratios (such as utilities)
companies whose fortunes track the business cycle closely (home building is highly cyclical)
operate in reverse of business cycle
company who remains unaffected during business cycle downturns. (drug and public utilities companies)
companies that fly high during business cycle upturns.
Special situation
A company going through a takeover, restructuring, bankruptcy, or manage change.
Balance between equities and debt
The major decision to be made for a client
Interest bearing investments
lower credit risk and no volatility of return. Downside: susceptible to market risk and purchasing power risk.
Equity investments
higher credit risk and much greater volatility of returns. Grow at a faster rate than inflation, building purchasing power risk.
LT horizons
Inflation has proven to be the greatest risk, making equity investments the better choice for LT horizon
ST horizons
Equity can be much more volatile, making interest bearing securities the better vehicle.
Strategic asset allocation
Selecting proportion to be invested in different types of securities. Proportion of assets in each asset clase is termed portfolio balance or normal asset allocation. The target weights depend on investment objective, time horizon, risk tolerance
tactical asset allocation
minimums and maximums are set for each asset class's portfolio proportion. Allows port. Manager to take advantage of market conditions. (time the market w/in allowed percentages)
Active asset management
based on belief that analysis can ID undervalued sec. and produce superior return. Strategy seeks to find inefficiencies in market pricing.
Passive asset management
Based on belief that the market is efficient in pricing securities; and that an index fund can be used for each class, giving desired diversification with min. annual expenses.
asset allocation.
Primary determinant of investment performance over time
Value line index
1,700 stocks of companies listed on the NYSE, AMEX, AND NASDAQ that are followed by Value Line investment survey
Wilshire 7,000 index
It's now about 7,000 stocks
russell 2,000 index
2,000 small-cap issues
Investment policy statement
used to give customer a summary of what can be expected from the strategy chosen
Portfolio rebalancing
Balances may shift dur to relative performance of each asset class. To rebalance a portfolio just reallocate money from the overperforming assets to those that are underperforming.
Passive portfolio rebalancing
Funds are continually reallocated from overperforming asset classes to underperforming asset classes to maintain optimal "target" mix
Active portfolio rebalancing
Funds are reallocated from underfperforming or "market" performing asset classes to those that the manager believes will outperform the market over the coming time period. This is essentially tactical portfolio rebalancing
This gives built-in diversification by simply buying index fund shares that match the asset classes selected.
Growth investing
Selection of equity investments based solely on earnings growth or stock price growth over time.
Value investing
selection of equity investments based on finding securities that are fundamentally undervalued in the makerplace. These tend to be solid companies that are currently out of favor. Look at price/earnings ratio and price/book value ratio.
For personal clients (individual/joint accounts)
current financial status, family composition, tax situation, employment information
Tax situation
If client is in low tax bracket, then taxable investments may be appropriate.
Investment strategy:
To meet goals, a certain amount of money must be available at a future date.
Diversification among mutiple asset classes
Reduces market risk of portfolio and standard deviation of portfolio returns
Market risk
Reduce market risk through constructing a portfolio that uses multiple asset classes. Defensive stocks also reduce market risk.
Factors considered when creating the financial profile of a customer
investment experience, financial knowledge, financial goals (NOT investment timing, it is relevant once the investment vehicles have been selected).
Capital risk
The risk of losing money. By increasing number of stocks in portfolio, risk is reduced through diversification.
Liquidity risk
Risk that a security can only be sold by incurring large transaction costs. Easiest to sell are large cap issues traded on NYSE. Small cap stocks are inactively traded and have a high level of liquidity risk.
If interest rates rise, which suffer the most?
Longest maturity, lowest coupon. 0 coupon bond is most susceptible to interest rate risk.
During periods of inflation, best instruments are?
Tangible assets (tend to keep pace with inflation). Any security that gives a fixed return is a bad bet (fixed annuities or COD)
Margin Trading
Finance an account with money borrowed from the broker.
The proportion of your own money.
Margin Arrangements
Differ for stocks and futures
Maintenance Margin
Minimum equity margin level
Margin Call
Requirement for more equity funds
Margin =
Equity / Stock Value
minimum variance portfolio
smallest variance among all portfolios with identical expected return
minimum variance frontier
graph of the expected return/ variance combination for all minimum variance portfolios
global minimum variance portfolio
portfolio with smallest variance among all possible portfolios
efficient frontier
developed by Prof Harry Markowitz 1952
correlations btw assets
factors that affect diversification
when correlation btw assets = -1
when does a portfolio with std dev. 0 exist?
equally weighted portfolio risk
variance = (1/n)average variance all assets + ((n-1)/n) average covariance
it changes from a curve to a line
what happens to the shape of efficient frontier when we add a risk free asset?
capital allocation line (CAL)
risk return line that lies tangent to the efficient frontier
what will happen if risk free borrowing is not available?
investors desiring a higher return need to select portfolios along the original efficient frontier and not on CAL
CAL equation
intercept: RFR
Capital market line (CML)
the line with an intercept point equal to the risk-free rate that is tangent to the efficient frontier of risky assets; represents the efficient frontier when a risk-free asset is available for investment
CAPM assumptions
investors only need to know expected returns, variances and covariances
implications of CAPM
same risky tangency portfolio: market portfolio
less than 1
value of beta of defensive stock
greater than 1
value of beta of cyclical stock
the SML, but not CML
if markets are in equilibrium, risk and return combinations for individual securities will lie along....
problems when using all assets
too many parameters 2n + n(n-1)/2
Market model
a regression equation that specifies a linear relationship between the return on a security (or portfolio) and the return on a broad market index
beta instability problem
the beta derived from market model is good estimate of historical relationships not necessarily good predictor of future
adjust beta
assume AR(1) with alpha = 1 or more often assume it tends to 1 over time
statistical inputs are unkown
problems for min variance frontier instability
constrain portfolio weights
how to address instability?
not regression slopes
standardized sensitivities (fundamental factor models)
which model uses more factors: fundamental or macro?
asset pricing theory (APT)
diff btw APT and multifactor models
APT is cross sectional equilibrium pricing models explains variation during a single time period <> multifactor times series regression explain variation over time
active return
Rp - Rb
std. dev of active return
active risk, tracking error or tracking risk
active risk squared
active factor risk + active specific risk
information ratio
(Rp - Rb) / s(Rp-Rb)
pure factor portfolio
portfolio that has sensitivity equal to one to only one risk factor and zero to the remaining factors
tracking portfolio
has a designed set of factor exposures
Treynor-Black model
portfolio optimization framework that combines market inefficiency & modern portfolio theory
Can test scores be reliable but not valid?
ex ante information ratio
alpha A / unsystematic std. dv. A
return objectives
2 inv. objectives
IPS elements
description of client's situation