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Unformatted text preview: Chapter 8 Copyright© 2011 Money Education, LLC Chapter 8 Introduction
2 Investing is the process whereby capital resources are
allocated and committed by investors with the expectation
of earning a future positive economic return. The overall return investors expect is primarily a function
of the riskiness of the investment. Returns can be in the form of current income (interest or
dividends) and/or capital appreciation. To achieve the investment goals, the client is expected to
invest at a risk level consistent with an assessment of his
risk tolerance. Copyright© 2011 Money Education, LLC Chapter 8 Risk Tolerance (Ability)
3 One’s ability to take on investment risk is a function of
objective measures such as:
• Investment goals
• Time horizon for each goal
• Need for liquidity
• Client’s tax situation
• Unique circumstances Chapter 8 Copyright© 2011 Money Education, LLC Risk Tolerance Questionnaire (Willingness)
4 The risk tolerance questionnaire evaluates a client’s
willingness to take on risk by inquiring about risk issues. The questionnaire can help the planner determine
whether the client is physiologically risk averse or risk
tolerant. A risk averse investor requires significantly more return in
order to consider investing in a higher risk investment. A risk tolerant investor is more willing to accept risk, for a
small increase in return. Copyright© 2011 Money Education, LLC Chapter 8 Risk Tolerance Questionnaire (1 of 2)
5 Copyright© 2011 Money Education, LLC Chapter 8 Risk Tolerance Questionnaire (2 of 2)
6 Chapter 8 Copyright© 2011 Money Education, LLC Risk Tolerance Questionnaire (Willingness)
7 If the client’s ability to take on investment risk is higher than the client’s
Low √ Medium
√ If the client’s ability to take on investment risk is lower than the client’s
Low √ Medium √ High √ Only when the client’s willingness and ability are equal does the financial
planner proceed to develop an investment strategy.
Copyright© 2011 Money Education, LLC Chapter 8 Expected Return
8 Expected return is the compound annual rate of return
expected for an asset or investment portfolio. It is
primarily a function of the riskiness of the investment(s). Historical Risk and Return Relationship Between Equities, Bonds, and
Treasury Bills 1900 – 2008
Return (Standard Deviation) Range of Expected
Annual Returns Equities 11.2% 20.2% -29.2 to 51.6 Government Bonds 5.5% 8.3% -11.1 to 22.1 Government Bills 4.0% 2.8% -1.6 to 9.6 Risk* Inflation
-6.7 to 12.9
*Expected return in a normal market in a year range by 2 standard deviations + / -. Chapter 8 Copyright© 2011 Money Education, LLC The Investment Planning Process
9 The investment planning process is a series of steps the
financial planner and client follow to build an investment
portfolio designed to achieve the client’ s investment goals.
• The client and the planner create a written investment
• The planner examines the external environment.
• The planner and the client select an investment
• Periodic monitoring, updating, and evaluating of
investment performance by the planner is required. Chapter 8 Copyright© 2011 Money Education, LLC Investment Policy Statement
10 An investment policy statement is a document, agreed upon by
the client and the advisor, which specifically identifies the
investment goals of the client and the strategies and
parameters, such as risk tolerance, time horizon, asset
allocation and acceptable investment vehicles, that will be
employed to reach such goals.. The statement guides the financial planner and the client
regarding appropriate investment choices and serves as a
benchmark to measure performance. Copyright© 2011 Money Education, LLC Chapter 8 Investment Policy Statement (1 of 2)
11 Copyright© 2011 Money Education, LLC Chapter 8 Investment Policy Statement (2 of 2)
12 Chapter 8 Copyright© 2011 Money Education, LLC Measuring Investment Returns
13 There are six ways to measure actual investment returns. The Holding Period Return (HPR) The Arithmetic (Average) Return (AR) The Geometric Return (GR)* The Weighted Average (Expected) Return (WAR)* The Internal Rate of Return (IRR) Dollar Weighted and Time Weighted Returns
*covered now, the others will be covered in the
Copyright© 2011 Money Education, LLC Chapter 8 The Geometric Return (GR)
14 The geometric return is a time-weighted compounded rate of return.
The formula for the geometric return is: Randal has owned a stock for three years, with the following returns:
Year 1: 12%
Year 2: 5%
Year 3: <2%> Answer: 4.8442%
Copyright© 2011 Money Education, LLC Chapter 8 The Weighted Average (Expected) Return (WAR)
15 The weighted average return is based on the dollar amount or percentage of a
portfolio invested in each asset. Keith owns the following portfolio. What is the weighted average expected
return of the portfolio? Chapter 8 Copyright© 2011 Money Education, LLC Risk
16 Risk is the uncertainty associated with investment returns.
Risk is the possibility that actual returns will be different
from what is expected. There is a direct relationship between risk and an investor’s
expected return. The risk premium is the amount of return above the riskfree rate of return that an investor will require to invest in a
risky asset. Copyright© 2011 Money Education, LLC Chapter 8 Systematic Risk
17 Systematic risk represents the risk that is inherent in the
“system” and cannot be eliminated through
diversification. Examples of systematic risk include: Purchasing Power Risk Reinvestment Rate Risk Interest Rate Risk Market Risk Exchange Rate Risk Copyright© 2011 Money Education, LLC Chapter 8 Unsystematic Risk
18 Unsystematic risk represents the risk that can be
diversified away, by combining multiple stocks from
multiple industries into one portfolio. Unsystematic risks are unique to one firm, industry, or
country. Examples of unsystematic risk include: Chapter 8 Business Risk
Copyright© 2011 Money Education, LLC Total Risk
19 Copyright© 2011 Money Education, LLC Chapter 8 Measuring Investment Risks
20 Investment risk is broadly defined as the uncertainty
surrounding returns. Risk can be measured using both Beta (β) and Standard
Deviation (σ). Copyright© 2011 Money Education, LLC Chapter 8 Beta
21 Beta is derived from regression analysis when plotting the
returns for a particular security or portfolio to market
Beta is a measure of systematic risk.
The market is predefined as having a beta of 1.0.
Portfolios that have a beta greater than 1.0 are more
volatile than the market.
Portfolios with a beta less than 1.0 are less volatile than
the market. Chapter 8 Copyright© 2011 Money Education, LLC Standard Deviation (1 of 2)
22 Standard deviation measures the total risk of an
The larger the standard deviation, the more risky the asset.
Standard deviation measures the amount of variation
around a historical average or mean return.
A low standard deviation indicates that the annual returns
are close to the average return.
A large standard deviation would indicate a large variation
around the average return.
Calculating standard deviation will be covered in the
Copyright© 2011 Money Education, LLC Chapter 8 Standard Deviation (2 of 2)
23 Investment returns are generally thought to be normally
distributed around the mean return. Based on that
assumption, standard deviation can be used to estimate
probabilities of outcomes: Copyright© 2011 Money Education, LLC Chapter 8 Modern Portfolio Theory
24 Modern portfolio theory was developed by Harry
Markowitz. He concluded investors will seek to maximize their
expected returns, for any given level of risk. It is an approach to plan and construct a portfolio. Harry Markowitz developed the Efficient Frontier, which
compares various portfolios based on their risk-return
relationship. Chapter 8 Copyright© 2011 Money Education, LLC Efficient Frontier
25 Portfolios A and B lie on the efficient frontier, therefore portfolios A, B, and all portfolios
that lie on the efficient frontier represent the most return achievable for any given level of
risk. Any portfolio that lies below the efficient frontier are inefficient because there is
another portfolio that provides a higher level of return. Since, in theory, the efficient
frontier represents the most efficient portfolios in terms of the risk-return relationship,
no portfolios can lie above the efficient frontier. The efficient frontier represents
portfolios of 100 percent of risky assets. Copyright© 2011 Money Education, LLC Chapter 8 Capital Asset Pricing Model (CAPM)
26 The Capital Asset Pricing Model (CAPM) calculates the
relationship of risk and return for an individual security
using Beta (β) as its measure of risk. CAPM is derived by combining a risk-free asset, with
risky assets from the original efficient frontier. The result is a new efficient frontier. Copyright© 2011 Money Education, LLC Chapter 8 Capital Asset Pricing Model (CAPM)
27 r = rf + β(rm - rf)
r = Required or expected rate of return.
rf = Risk-free rate of return.
β = Beta, which is a measure of the systematic risk
associated with a particular portfolio.
rm = Return of the market.
rm - rf = Risk premium.
Chapter 8 Copyright© 2011 Money Education, LLC Security Market Line (SML)
28 If mutual fund XYZ has a beta of 1.5, and the total return of the
market is 10% and the risk-free rate of return is 3%, what is the
expected return for mutual fund XYZ?
r = rf + β(rm - rf )
r = 0.03 + 1.5(0.10 - 0.03)
r = 0.03 + 1.5(0.07)
r = 0.135 or 13.5% Copyright© 2011 Money Education, LLC Chapter 8 Portfolio Statistics
29 As previously discussed, diversification is achieved by
combining stocks from multiple industries and securities
from various asset classes. Portfolio statistics that determine the amount of
diversification achieved is discussed. To develop a
diversified portfolio, the financial planner must understand
the relationship between assets and how the returns for
securities change relative to each other. Copyright© 2011 Money Education, LLC Chapter 8 Correlation Coefficient
30 Correlation coefficient measures the movement of one
security relative to that of another security.
Correlation ranges from +1 to -1.
Correlation provides the investor with insight as to the
strength and direction two assets move relative to each
other. A correlation of +1 suggests that two assets are
perfectly positively correlated.
A correlation of 0 suggests that assets are completely
Diversification benefits (risk is reduced) begin anytime
correlation is less than 1. Chapter 8 Copyright© 2011 Money Education, LLC Coefficient of Determination (r-squared or r2) (2 of 2)
31 The coefficient of determination is a measure of how much
return is a result of the correlation to the market or what
percentage of a security’s return is a result of the market.
R-squared ranges from 0 to 100.
To calculate r-squared, simply square the correlation
R-squared can also be used to determine which index is the
appropriate benchmark with which to measure
The higher the r-squared, the more of the security’s return
is explained by changes in the market.
Copyright© 2011 Money Education, LLC Chapter 8 Coefficient of Determination (r-squared or r2) (2 of 2)
32 Which index should Bill use as a benchmark when
evaluating the performance of SCG mutual fund?
Index 1 Index 2 0.60 0.95 Beta
Standard Deviation 8% 12% 0.60 R-Squared 0.89 Copyright© 2011 Money Education, LLC Chapter 8 Stock Valuation
33 The intrinsic value is the underlying value of a security,
when considering future cash flows and the riskiness of the
security. Stock valuation is unique to each investor, as each
investor’s required rate of return will differ from others. There are two basic stock valuation tools: Dividend valuation models Earnings based valuation model
• P/E Ratio
• Stock Price = P/E x EPS Chapter 8 Copyright© 2011 Money Education, LLC Debt
34 Debt represents the lending of funds in return for periodic interest
payments and the repayment of the principal debt obligation. Bonds
are a debt issuance where the bond issuer makes a promise to make
periodic coupon payments (interest) and repayment of the par value
(principal) at maturity.
If an investor is income oriented, bonds are appropriate as they
provide periodic income. If the investor’s goal is capital appreciation,
bonds can provide capital gains depending on changes in interest
The disadvantages of bonds are: Bonds generally provide lower rates of return than equities.
Bond prices are inversely related to changes in interest rates. As interest
rates increase, bond prices decrease. Copyright© 2011 Money Education, LLC Chapter 8 Types of Bonds
35 U.S. Government Excluded from state income taxes Municipal Bonds Excluded from federal income taxes May be excluded from state income taxes Corporate Bonds Taxable Primary Advantage of Bonds Income Diversification (correlation with equities) Copyright© 2011 Money Education, LLC Chapter 8 Zero Coupon Bonds
36 Zero coupon bonds are sold at a deep discount to par
They do not pay periodic interest payments.
Theses bonds increase in value each year, so that at
maturity the bonds are worth their par value.
Zero coupon bonds create a “phantom income” issue.
They may be either Treasury, municipal, or corporate
bonds. Chapter 8 Copyright© 2011 Money Education, LLC Derivatives
37 Derivatives are securities that derive their value from some underlying asset. Examples of derivatives include: options,
warrants, and futures. Options include both calls and puts. Calls give the holder the right to buy the underlying security at a
certain price by a certain date. Puts give the holder the right to
sell the underlying security at a certain price by a certain date. A warrant is a long-term option that gives the holder the right to
buy a certain number of shares of stocks in a particular company
by a certain date. A futures contract is a commitment to deliver an amount of a
certain item at a specified date at an agreed upon price.
Copyright© 2011 Money Education, LLC Chapter 8 Investment Companies
38 Investment companies are financial services companies that sell shares of stock to the public and use the proceeds
to buy portfolios of securities. Investment companies are nontaxable entities (flow
through of income). They are regulated by the Securities and Exchange
Commission and directly by the Investment Company Act
of 1940. The following are some of the types of investment
• Open-End Investment Companies
• Closed-End Investment Companies
Copyright© 2011 Money Education, LLC Chapter 8 Types of Mutual Funds (1 of 3)
39 Equity Funds Equity mutual funds typically invest in equity securities, but
may have different overall objectives. Fixed Income Funds
• Fixed income or bond funds typically invest in bonds of
various maturities. Growth Funds
• Growth mutual funds typically invest in large and mid cap
stocks, where price appreciation is the primary objective. Aggressive Growth Funds
• Aggressive growth funds typically invest in small cap stocks,
where price appreciation is the primary objective.
• Chapter 8 Copyright© 2011 Money Education, LLC Types of Mutual Funds (2 of 3)
40 Value Funds
• Value funds typically invest in securities that are deemed to be out of
favor or extremely undervalued. Balanced Funds
• Balanced funds typically invest in both fixed income securities and
equity securities. Income Funds
• Income funds typically invest in corporate and government bonds. Growth and Income Funds
• Similar to a balanced fund, growth and income funds invest in both
equities and fixed income securities. However, a much larger
percentage of the fund is allocated to equities in a growth and income
Copyright© 2011 Money Education, LLC Chapter 8 Types of Mutual Funds (3 of 3)
41 Sector Funds
• A sector fund restricts investments to a particular segment of the
market. Specialty Funds
• Specialty funds that restrict their investments to firms that are good
corporate citizens and do not operate in industries such as alcohol,
gambling, or tobacco. Money Market Mutual Funds
• Money market mutual funds provide investors with access to shortterm, high quality, large denomination investments. Index Funds
• An index fund purchases a basket of stocks to match or replicate the
performance of a particular index.
Copyright© 2011 Money Education, LLC Chapter 8 Risk Adjusted Return Measures
42 When evaluating the return performance for a security,
only evaluating the actual total return is insufficient. The actual return does not take into consideration the
riskiness of the investment. The financial advisor and client should ask, “Did I receive
an appropriate return, given the riskiness of the
investment?” The risk adjusted performance measures are Sharpe,
Treynor and Jensen’s Alpha, which can be used to
measure the risk adjusted performance of any type of
investment. Chapter 8 Copyright© 2011 Money Education, LLC Formulas for Risk
43 Sharpe Treynor Alpha Chapter 8 Copyright© 2011 Money Education, LLC ...
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This note was uploaded on 02/27/2012 for the course FIN 132 taught by Professor Afda during the Spring '12 term at Centenary College New Jersey.
- Spring '12