Questions and Answers
The formula for calculating holding period return is (Sum of dividends or interest paid - Gains in principal invested)/Original cost.
False
Liquidity risk is the risk of receiving a lower than market price upon sale of your holding.
True
The risk of unfavorable business conditions caused by weakness in the overall economy is known as company risk.
False
Standard deviation measures fluctuations that result in gains and losses, whereas semi-variance only measures fluctuations resulting in losses.
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The most common measurement of price fluctuations is correlation.
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Semi-variance includes fluctuations that result in both gains and losses while standard deviation only measures fluctuations resulting in losses.
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Unsystematic risk is the risk related to an individual company.
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The expected rate of return is equal to the risk free rate minus the risk premium.
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The extra return that compensates you for the additional amount of risk you are taking with a particular security over a completely safe one is known as the risk premium.
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If the risk free rate is 5% and the risk premium is 4%, the expected rate of return is 1%.
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The risk premium is calculated by the risk free rate divided by the risk premium.
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Government bonds are the furthest to the left of the security market line.
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The efficient market hypothesis states that stock prices fully reflect all available information.
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The efficient market hypothesis suggests that a security's current market price reflects all known information about it.
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According to the semi-strong form efficient market hypothesis, looking at past stock price patterns is useful.
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Technical analysis is considered ineffective according to the weak form efficient market hypothesis.
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Mean reversion implies that returns for securities tend to move toward average performance over longer time frames.
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Bonds are considered safer than most other securities because they offer flexible annual income payments.
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A defensive stock is characterized by a company that grows more rapidly in sales and earnings than the overall economy.
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Bondholders have priority in receiving liquidation proceeds should bankruptcy occur.
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Overhead costs are considered a weakness associated with mutual funds.
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According to the strong form efficient market hypothesis, all information, public and private, is reflected in stock prices.
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ETFs are traditionally considered actively managed investments.
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Smaller capitalization companies are associated with greater potential returns and greater risk.
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An index fund attempts to duplicate market performance by using computerized programs to purchase holdings.
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Total Portfolio Management considers all household assets and their correlations in investment decisions.
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Consideration of personal factors is a step in the planning system for asset allocation.
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A time frame of 2-4 years is associated with a long-term horizon.
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Risk tolerance can be influenced by personality and upbringing.
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Intermediate-term investment policies include short-term bond funds.
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Study Notes
Holding Period Return Calculation
- Holding period return formula: (Sum of dividends or interest paid + Gains in principal invested) / Original cost.
- Given values for calculation:
- Sum of dividends = $45,000
- Gains in principal invested = $2,500
- Original cost = $365,500
- Resultantly, this calculates to approximately 13%.
Liquidity Risk
- Defined as the risk of receiving a lower than market price upon sale of an asset.
- Involves challenges in selling securities without significantly impacting their price.
Economic Weakness Risk
- Represents the risk of unfavorable business conditions due to overall economic weakness.
- Referred to as market risk in financial contexts.
Measurement of Price Fluctuations
- Standard deviation is the most common measure for price fluctuations.
- It accounts for both upward and downward variations in asset prices.
Standard Deviation vs. Semi-Variance
- Standard deviation encompasses fluctuations indicating both gains and losses.
- Semi-variance only measures fluctuations resulting in losses.
Unsystematic Risk
- Associated with risks specifically related to an individual company rather than overall market factors.
Risk Premium Definition
- Refers to the additional return expected from a risky investment compared to a risk-free investment.
- It compensates for the acceptance of additional risk.
Expected Rate of Return
- Calculation: Risk-free rate + Risk premium.
- For a risk-free rate of 5% and a risk premium of 4%, expected return is 9%.
Security Market Line
- The furthest to the left indicates the risk-free rate, often represented by government bonds.
Efficient Market Hypothesis (EMH)
- States that all available information is reflected in stock prices.
- New information is quickly integrated into share prices, implying a market in equilibrium.
Semi-Strong Form EMH
- Implicates that all publicly available information impacts stock prices.
- Suggests that technical analysis based on past price movements is ineffective.
Mean Reversion Concept
- Suggests that asset returns tend to move toward average levels over longer time frames.
- Short-term price movements may diverge, but long-term trends revert to the mean.
Bond Safety Characteristics
- Bonds are typically perceived as safe because:
- Principal (loan amount) is expected to be repaid.
- Bondholders have priority in bankruptcy scenarios.
Defensive Stocks
- Characterized by companies less impacted by economic cycles.
- Tend to exhibit stable earnings and growth even during downturns.
Mutual Fund Weaknesses
- Include aspects like overhead costs and tax inefficiencies.
- While they provide diversification, they can also introduce fees that reduce returns.
Exchange-Traded Funds (ETFs)
- Typically feature lower costs than mutual funds.
- Trade like stocks throughout the day, providing liquidity and flexibility for investors.
Characteristics of Small-Cap Companies
- Smaller companies often present greater potential returns alongside increased risks.
- May be more volatile due to their size and market position.
Total Portfolio Management
- Considers all household assets and their correlations for informed investment decisions.
- Focused on maximizing returns by managing overall risk.
Performance Evaluation Queries
- Performance reviews typically assess how well investments did, reasons for variances, and strategies for improvement.
Record Keeping by Fund Management
- Maintained records provide a strong audit trail and insights into fund performance.
- It can help investors monitor the effectiveness of fund managers.
Asset Allocation and Investment Planning
- Asset allocation involves personal factors, investment alternatives, and portfolio management principles.
- Investments serve as a delivery mechanism by transforming current savings into future spending and helping create assets to meet goals.
Personal Considerations in Asset Allocation
- Key personal factors influencing asset allocation include current resources, projected cash flows, taxes, and risk neutrality.
Time Horizons
- Long-term investment horizons typically span 10-20 years or 15-35 years.
- Short-term investment policies may include short-term bond funds, money market accounts, U.S. government bonds, and certificates of deposit.
Risk Tolerance Influencers
- Factors influencing risk tolerance consist of personality, upbringing, and types of future cash flows.
Financial Metrics
- Holding period return and the distinction between semi-variance and standard deviation in financial metrics.
- Unsystematic risk pertains to individual companies, while systematic risk relates to overall market factors.
Risk Premium
- The risk premium compensates for taking on additional risk with a particular security versus a risk-free investment.
- Expected rate of return calculation: risk-free rate (5%) + risk premium (4%) leads to an expected return of 9%.
Security Market Line
- The security market line represents the relationship between expected return and risk.
- Government bonds are considered the least risky and would be positioned furthest to the left on this line.
Efficient Market Hypothesis
- Efficient market hypothesis asserts that market prices reflect all known information, making it challenging to predict market movements.
- Semi-strong form implies all publicly available information is incorporated into stock prices.
Technical Analysis
- Considered ineffective under weak-form and semi-strong form efficient market hypotheses.
Mean Reversion
- Mean reversion suggests that returns tend to move toward average performance when evaluated over longer time frames.
Safety of Bonds
- Bonds are generally considered safer due to the likelihood of full repayment of principal, priority in liquidation, and predictable income flows.
Defensive Stocks
- Defensive stocks exhibit less sensitivity to economic cycles, often growing at or below average rates.
Mutual Funds and ETFs
- Mutual funds incur overhead costs and taxes, which can be viewed as weaknesses.
- ETFs offer lower cost structures and trade similar to stocks but are typically not actively managed.
Capitalization and Investment Potential
- Smaller capitalization companies usually offer greater potential returns but come with higher risks.
Total Portfolio Management
- This strategy takes into account all household assets, focusing on their interactions, correlations, and individual asset risks.
Performance Evaluation
- Key questions in performance evaluation address individual performance, reasons for outcomes, and potential improvements.
Risks Associated with Financial Assets
- Market, liquidity, economic, inflation, political, regulatory, currency, technological, preference, industry, and company risks highlight the uncertainties in financial investments.
Strengths of Mutual Funds
- Mutual funds provide diversification, professional management, accessibility, liquidity, lower investment costs, and the ability to invest in a wide range of assets, among other benefits.
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Description
Test your knowledge on the calculation of investment returns with this quiz. It covers concepts like dividends, interest paid, and gains in principal. Use these formulas to evaluate the performance of investments effectively.
