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Introduction to Portfolio Approach - Coggle Diagram
Introduction to Portfolio Approach
Risk & Return
Types of Risks
systematic / market / non specific = risk of being in the market at all, can't be taken away by diversified, due to inflation, interest rates hikes, recession, affects all secs, eg: stock market crashes - diversified portfolios loose value too
non systematic / specific / non market = risk from one particular sector / company, can be diversified away, affects one or specific secs, eg: one comp has bad annual report earnings - other companies are fine
Typical Risks
inflation risk = infla up, cogs up, less profit, earn 10% but infla 3% so real return is 7%
business risk = if you sell lemonades but kids prefer ice cream this summer, uncertainty in business, causes--mangement decisions, demand,competition
political risk = elections, change of gov, new tax laws affecting regulations,
liquidity risk = risk of being able to sell at price, sell @ discount, eg thinly traded secs
interest rate risk = rates up, price down
foreign exchange risk = currency fluctuations, legal diff, regulation gaps, larger bid ask spreads
default risk = can't pay back the loan, aka credit risk, high in lower rated bonds
Types of Returns
expressed in $ or %
types
nominal=rate before inflation
real=rate after subtracting inflation
ex ante=predictions, forecast, forward looking, expect stock to go 8% higher based on growth + divs
ex post=actual, backward looking, at year end stock actually made a 6% return
risk free rate of return = t bills safest; guaranteed return (backed by gov); lowest return; acts as benchmark; other secs offer higher returns > tbills-this diff in risk is called
risk premium
(tbills pay 3% return, corporate bonds pay 7%, risk premium = 7-3=4%)
Measuring Risk
standard deviation = measures volatility of a stock, higher sd-more risky, stock a-always 10% is safer, stock b-3% 10% -20% is risky (no stable return)
Beta = how much stock dances with the market, market neutral is beta 1, anything above or over is much the stock moves with respect to market, market movement x beta; eg market +10% beta 1.5 = stock moves 15%
portfolio expected return = mixing diff secs, each one contributes acc to weight, per=weight x return; eg cash earning 2%, 30% bonds earning 4%, and 50% equities earning 8%. What is the expected portfolio return = (0.2×2%) + (0.3×4%) + (0.5×8%) = 0.4% + 1.2% + 4% = 5.6%
The Portfolio Manager Styles
Calculating Rate of Return in Portfolio
Combining securities in Portfolio
alpha = how much your manager added or subtracted value from portfolio; alpha=(actual return-expected return); a >0 = outperformng; a< 0=underperforming
portfolio beta = combines beta of all secs in portfolio based on their weightage; Bp >1 = aggressive; Bp =1 = market like, Bp < 1 = defensive; eg 50% stock A (β=1.2), 30% stock B (β=0.8), 20% stock C (β=1.5); βp=(0.5×1.2)+(0.3×0.8)+(0.2×1.5)=0.6+0.24+0.3=1.14; Portfolio is 14% more volatile than the market.
correlation = how two pairs move in comparison to each other; +1=positive corelation, move similar, no use of diversification; 0=uncorrelated, some diversi benefit; -1=negatively correlated, max diversi benefits, both move in opposite directions; naive diversification= many stocks that move in same direction, high positive correlation, looks diversified but is not
diversification = combining various secs in one portfolio; reduces non systemic (specific risk) but not market risk; over diversifying (indexing) - perform same as market never overperform
Relationship between Risk & Return in a Portfolio
Passive Investment Management
no point in trying to outperform market, market is efficient & provides all the info
indexing = invest in indexes, get the same return as an index
buy & hold = buy active reliable stocks, hold them for as long as possible
indices, etfs, match the market
Active Investment Management
outperform market - actively keep changing investments / secs in portfolio
high fee / commissions
top down approach = analyze world eco - choose country - choose industry - choose sector - companies
bottom up approach = see company (fundamentals, earning report) directly, no use analysing world eco
Equity Manager Styles
growth managers
invest in growing companies, pay higher prices, low divs, up market, bottom up approach, seek earnings momentum-if growth justifies, hihg p/e, high p/cashflow, high valuation, capital gains
value managers
invest in cheap but strong stocks (undervalued), down markets, bottom up approach, high divs, req patience, low p/e, low p/casdhflow, takes time for stocks to rise and show profits
sector rotators
top down approach, keep changing sectors/industries, focus on industry booming and invest in high performing stocks (large cap stocks) of that industry/sector, switch between cyclical / defensive sectors
Fixed Income Manager Styles
term to maturity = <5 yr (short term); 5-10 yr (medium term); >10yr (long term)
credit quality = some buy only high quality bonds (credit safe - more chances of repaying), some buy low quality bonds called junk bonds (less chances of repaying, more default chances, high return, high risk, trade cheaper)
interest rate anticipators = bet on interest rate changes, if rates going to fall-buy long term bonds (inverse relation-with falling rates, prices go up)