4504c11 - Common Stocks: Analysis and Strategy Chapter 11...

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Common Stocks: Analysis and Strategy Chapter 11 Impact of the Market The single most important risk affecting the price movement of common stocks is the market Particularly true for a diversified portfolio of stocks In diversified portfolio, market risk accounts for 90% of the variability Investors buying foreign stocks face the same issues on market risk of the foreign country i.e. Japanese stock prices drastically fell in the 90’s Overall market (Nikkei) peaked at end of 1989 at 39000 and by mid-1992 had dropped to below 15000 --- 60% drop 1999 still around 13,000 Required Rate of Return Minimum expected rate of return needed to induce investment Given risk, a security must offer some minimum expected return to persuade purchase Required Rate of Return =R f +Risk premium Investors expect the risk free rate as well as a risk premium to compensate for the additional risk assumed Understanding the Required Rate of Return Risk-free rate R f =Real Rate of Return +Inflation premium Real rate of return is basic exchange rate in the economy Nominal R f must contain premium for expected inflation The risk premium Reflects all uncertainty in the asset Level of interest rate changes: SML Shifts due to changes in inflation Slope changes due to risk premium changes Investment Decision Asset allocation Determine Asset classes investing in Percentage of portfolio to allocate to each asset class Security selection
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Passive Stock Strategies Natural outcome of a belief in efficient markets No active strategy should be able to beat the market on a risk-adjusted basis Passive strategies do not seek to outperform the market but to do as well as the market Emphasis is on minimizing transaction costs and time spent in managing the portfolio because any expected benefits from active trading or analysis are less than the costs Passive Strategies: Buy-and-hold strategy Buys stocks and holds them until some time in the future to meet some objective Belief that active management will incur transaction costs and involve inevitable mistakes Odean and Barber Study Of 60,000 investors from 1991-1996—avrg investor earned 15% while active traders averaged 10% return Important initial selection needs to be made Functions to perform over life of the portfolio: reinvesting income adjusting portfolio to maintain asset allocation criteria maintain risk-level of portfolio Index funds Mutual funds designed to duplicate the performance of some market index No attempt made to forecast market movements and act accordingly No attempt to select under- or overvalued securities Low costs to operate, low turnover Reasons why indexing works (Malkiel) Securities market extremely efficient
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4504c11 - Common Stocks: Analysis and Strategy Chapter 11...

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