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investment chapter 5.2 (vii. beta: popular measure of risk (interpreting…
investment chapter 5.2
vi. international diversification
advantages & disadvantages
Advantages of International Diversification
Broader investment choices
Potentially greater returns than in U.S.
Reduction of overall portfolio risk
Disadvantages of International Diversification
Currency exchange risk
Less convenient to invest than U.S. stocks
More expensive to invest
Riskier than investing in U.S.
vii. components of risk
Diversifiable (Unsystematic) Risk
Results from uncontrollable or random events that are firm-specific
Can be eliminated through diversification
Examples: labor strikes, lawsuits
Nondiversifiable (Systematic) Risk
Attributable to forces that affect all similar investments
Cannot be eliminated through diversification
Examples: war, inflation, political events
total risk
vii. beta: popular measure of risk
interpreting Beta
Higher stock betas should result in higher expected returns due to greater risk
If the market is expected to increase 10%, a stock with a beta of 1.50 is expected to increase 15%
If the market went down 8%, then a stock with a beta of 0.50 should only decrease by about 4%
Beta values for specific stocks can be obtained from Value Line reports or websites such as yahoo.com
A measure of undiversifiable risk
Indicates how the price of a security responds to market forces
Compares historical return of an investment to the market return (the S&P 500 Index)
The beta for the market is 1.0
Stocks may have positive or negative betas. Nearly all are positive.
Stocks with betas greater than 1.0 are more risky than the overall market.
Stocks with betas less than 1.0 are less risky than the overall market.
capital asset pricing model (CAPM)
Model that links the notions of risk and return
Helps investors define the required return on an investment
As beta increases, the required return for a given investment increases
required return on investment formula
ix. Two approaches to constructing portfolios
traditional approach
Emphasizes “balancing” the portfolio using a wide variety of stocks and/or bonds
Tends to focus on well-known companies
Perceived as less risky
Stocks are more liquid and available
Familiarity provides higher “comfort” levels for investors
Uses a broad range of industries to diversify the portfolio
modern approach
Modern Portfolio Theory (MPT)
Emphasizes statistical measures to develop a portfolio plan
Focus is on
Standard deviation of returns
Correlation between returns
Expected returns
Combines securities that have negative (or low-positive) correlations between each other’s rates of return
Key Aspects of MPT: Efficient Frontier
The leftmost boundary of the feasible set of portfolios that include all efficient portfolios: those providing the best attainable tradeoff between risk and return
Portfolios that fall to the right of the efficient frontier are not desirable because their risk return tradeoffs are inferior
Portfolios that fall to the left of the efficient frontier are not available for investments
Key Aspects of MPT: Portfolio Betas
Portfolio Beta
The beta of a portfolio; calculated as the weighted average of the betas of the individual assets the portfolio includes
To earn more return, one must bear more risk
Only nondiversifiable risk (relevant risk) provides a positive risk-return relationship
Portfolio betas are interpreted exactly the same way as individual stock betas.
Portfolio beta of 1.00 will experience a 10% increase when the market increase is 10%
Low-beta portfolios are less responsive and less risky than high-beta portfolios.
A portfolio containing low-beta assets will have a low beta, and vice versa.
x. Reconciling the Traditional Approach and MPT
Recommended portfolio management policy uses aspects of both approaches:
Determine how much risk you are willing to bear
Seek diversification between different types of securities and industry lines
Pay attention to correlation of return between securities
Use beta to keep portfolio at acceptable level of risk
Evaluate alternative portfolios to select highest return for the given level of acceptable risk