PART 5: RISK AND RETURN

Risk. The variability of returns from those that are expected.

Return. The income received on an investment plus any change in market price, usually expressed as a
percentage of the beginning market price of the investment.

Risk-Return Tradeoff
 The trading principle that links high risk with high reward.
 Appropriate Risk-Return Tradeoff depends on a variety of factors including an investor’s risk
tolerance, the investor’s years to retirement and the potential to replace lost funds

Rate of Return (RoR). The net gain or loss of an investment over a specified time period, expressed as a
percentage of the investment’s initial cost.
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 The required rate of return is the nominal rate of return that an investor needs in order to make
an investment worthwhile.
 This return varies over time and is comprised of the following:
o Real risk-free rate. The minimum return an investor requires. This rate does not take
into account expected inflation and the capital market environment.
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o Inflation premium
o Risk premium. The excess return above the investor’s required rate of return.
 The fundamental sources of risk that contributes to the need of risk premium:
 Business Risk. The risk that a business’ cash flow will not meet its needs
due to uncertainty in the company’s business lines.
 Financial Risk. The risk to equity holders as a company increases its debt
load. As debt load increases, interest expense also increases, leading to
less income to be paid out to investors.
 Liquidity Risk. The uncertainty around the ability to sell an investment.
The more liquid an investment is the easier it is to sell.
 Exchange Rate Risk. The risk a company faces wen it has businesses in
other countries.
 Political Risk. The risk of changes in the political environment of a
country in which company transacts its businesses.

Portfolio Management
 The art and science of selecting and overseeing a group of investments that meet the long-term
financial objectives and risk tolerance of a client, a company, or an institution.
 The process an investor takes to aid him in meeting his investment goals.
 Key Elements of Portfolio Management:
o Asset Allocation
o Diversification
o Rebalancing
 Types of Portfolio Management
o Active Portfolio Management. Portfolio managers are actively involved.
o Passive Portfolio Management. Portfolio managers deals with fixed portfolio designed to
match the current market scenario.
 o Discretionary Portfolio Management Services. An individual authorizes a portfolio
manager to take care of all his investment needs.
o Non-Discretionary Portfolio Management Services. Portfolio manager can merely advise
clients what is good and bad in an investment.
 Portfolio Management Procedure:
o Create a Policy Statement. A policy statement is the statement that contains the
investor’s goals and constraints as it relates to his investment.
o Develop an Investment Strategy. This entails creating a strategy that combines the
investor’s goals and objects with current financial market and economic conditions.
o Implement the Plan Created. This entails putting the investment strategy to work,
investing in a portfolio that meets the client’s goals and constraint requirements.
o Monitor and Update the Plan. Both markets and investors’ need change as time
changes. As such, it is important to monitor for these changes as they occur and to
update the plan to adjust for the changes that have occurred.
 Policy Statement. Contains the investor’s goals and constraints as it relates to his investments.
This could be considered as the most important of all the steps in the portfolio management
process. The statement requires the investor to consider his true financial needs, both in the
short run and the long run. It helps to guide the investment portfolio manager in meeting the
investor’s needs.
 Expressing investment objectives in terms of risk and return. Return objectives are important.
They help to focus an investor on meeting his financial goals and objectives. However, risk must
be considered as well. An investor may require a high rate of return. A high rate of return is
typically accompanied by a higher risk.
 Factors Affecting Risk Tolerance:
o Age. An investor may have lower risk tolerance as they get older and financial
constraints are more prevalent.
o Family Situation. An investor may have higher income needs if they are supporting a
child in college or an elderly relative.
o Wealth and Income. An investor may have a greater ability to invest in a portfolio if he
or she has existing wealth or high income.
o Psychological. An investor may simply have a lower tolerance for risk based on his
personality.

Return Objectives
 Capital Preservation. The need to maintain capital. To accomplish this objective, the return
objective should, at a minimum, be equal to the inflation rate.
 Capital Appreciation. The need to grow, rather than simply preserve capital. To accomplish this
objective, the return objective should be equal to a return that exceeds the expected inflation.
 Current income. The need to create income from the investor’s capital base. With this objective,
an investor needs to generate income from his investments.
 Total Return. The need to grow the capital base through both capital appreciation and
reinvestment of that appreciation.

Five Types of Investment Constraints

1. Liquidity Constraints. Identify an investor’s need for liquidity, or cash.
2. Time Horizon. Develops a timeline of an investor’s various financial needs. The time horizon also
affects an investor’s ability to accept risk. If an investor has a long time horizon, the investor may
 have a greater ability to accept risk because e would have a longer time period to recoup any
losses.
3. Tax Concerns. After-tax returns are the returns investors are focused on when creating an
investment portfolio. If an investor is currently in a high tax bracket as a result of his income, it
may be important to focus on investments that would make the investor’s situation worse, like
investing more heavily in tax-deferred investments.
4. Legal and Regulatory. Can act as an investment constraint and must be considered. An example
of this would occur in a trust. A trust could require that no more than 10% of the trust be
distributed each year. Legal and regulatory constraints such as this one often can’t be changed
and must not be overlooked.
5. Unique Circumstances. Any special needs or constraints not recognized in any of the constraints
listed above would fall in this category.

Asset Allocation
 The process of dividing a portfolio among major asset categories such as bonds, stocks, or cash.
The purpose of asset allocation is to reduce risk by diversifying the portfolio.
 The ideal asset allocation differs based on the risk tolerance of the investor.

Risk Measures. Statistical measures are statistical measures that are historical predictors of investment
risk and volatility, and they are also major components in Modern Portfolio Theory (MPT).
 Five Risk Measures:
1. Alpha.
2. Beta.
3. R-Squared.
4. Standard Deviation.
5. Sharpe Ratio.

Modern Portfolio Theory (MPT). Standard financial and academic methodology for assessing the
performance of a stock or a stock fund as compared to its benchmark index.

Standard Deviation
 A mathematical concept that is employed in various disciplines such as finance, economics,
accounting, and statistics.
 It measures how spread individual data points are from the mean value.
 Computed by deducting the mean from each value, calculating the square root, adding them up,
and finding the average of the differences to obtain the variance.
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Covariance
 A statistical measure of the degree to which two variables (e.g. securities’ returns) move
together.
 The measure of how two assets relate (move) together. If the covariance of the two assets is
positive, the assets move in the same direction.
 Positive Covariance. Indicates that two variables tend to move in the same direction.
 Negative Covariance. Reveals that two variables tend to move in inverse direction.
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Capital Asset Pricing Model (CAPM)

  A mode that describes the relationship between the expected return and risk of investing in a
security.
 Calculates expected return based on expected rate of return on the market, the risk-free rate
and the beta coefficient of the stock.
 The general idea behind CAPM is that investors need to be compensated in two ways: time
value of money and risk. Time value for money is represented by the isk-free (rf) rate in formula.
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Security Market Line (SML). Derived from CAPM, solving for expected return. However, the level of risk
used is Beta, the slope of the SML.
 Beta. Measure of a stock’s sensitivity of returns to changes in the market. It is a
measure of systematic risk.
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Correlation Coefficient. The relative measure of the relationship between two assets. It is between +1
and -1, with a +1 indicating that the two assets move completely together and a -1 indicating that the
two assets move in opposite directions from each other.
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Capital Market Theory. Builds upon the Markowitz portfolio model. The main assumptions of the capital
market theory are:
 All investors are efficient investors. Investors follow Markowitz idea of the efficient frontier and
choose to invest in portfolios along the frontier.
 Investors borrow/lend money at the risk-free rate. This rate remains static for any amount of
money.
 The time horizon is equal for all investors. When choosing investments, investors have equal
time horizons for the chosen investments.
 All assets are infinitely divisible. This indicates that fractional shares can be purchased and the
stocks can be infinitely divisible.
 No taxes and transaction costs. Assumes that investors’ results are not affected by taxes and
transaction costs.
 All investors have the same probability for outcomes. When determining the expected return,
assume that all investors have the same probability for outcomes.
 No inflation exists. Returns are not affected by the inflation rate in a capital market as none
exists in capital market theory.
 There is no mispricing within the capital markets. Assume the markets are efficient and that no
mispricings within the markets exist.

What happens when a risk-free asset is added to a portfolio of risky assets? To begin with, the risk-free
asset has a standard deviation/variance equal to zero for its given level of return, hence he “risk-free”
label.

Expected Return – When the Risk-Free Asset is Added. Given its lower level of return and its lower level
of risk, adding the risk-free asset to a portfolio acts to reduce the overall return of the portfolio.