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Beta - A measure of the volatility of a security (or portfolio) in comparison to the market as a
whole.
Capital Asset Pricing Model (CAPM) - A method of valuing assets & calculating the cost of
capital.
Correlation - A statistic that measures the degree to which two securities move in relation to
each other.
Modern Portfolio Theory (MPT) - Uses several basic statistical measures to develop a portfolio
plan.
What is a Portfolio?
Efficient Portfolio
- A portfolio that provides the highest return for a given level of risk.
- Requires search for investment alternatives to get the best combinations of risk &
return.
The return on a portfolio is simply the weighted average of the individual assets’ returns
in the portfolio.
The standard deviation of a portfolio’s returns is more complicated & is a function of the
portfolio’s individual assets’ weights, standard deviations & correlations with all other
assets.
Return on Portfolio
Correlation Coefficients
Assets that are less than perfectly positively correlated tend to offset each other’s
movements, thus reducing the overall risk in a portfolio.
The lower the correlation the more the overall risk in a portfolio is reduced.
Foreign markets may not be as efficient as US markets, allowing true gains from superior
research.
International Diversification
- Yankee Bonds
Compares historical return of an investment to the market return - S&P 500 Index.
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.
Components 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 finance.yahoo.com.
Uses beta, the risk-free rate & the expected return on the overall market to define the
required return on an investment.
Find the SML by calculating the required return for a number of betas, then plotting them
on a graph.
Traditional Approach
Less quantitative.
Emphasizes “balancing” the portfolio using a wide variety of stocks and/or bonds.
Focus is on:
- Expected returns
- Standard deviation of returns
Combines securities that have negative (or low-positive) correlations between each
other’s rates of return.
Efficient Frontier
- The leftmost boundary of the feasible set of portfolios that include all efficient
portfolios, those providing the best attainable tradeoff between risk & 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.
Portfolio Beta
- The beta of a portfolio; calculated as the weighted average of the betas of the
individual assets the portfolio includes.
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%.
- Portfolio beta of 0.75 will experience a 7.5% increase when the market increase is
10%.
- Portfolio beta of 1.25 will experience a 12.5% increase when the market increase is
10%.
Low-beta portfolios are less responsive & less risky than high-beta portfolios.
A portfolio containing low-beta assets will have a low beta, & vice versa.
- Evaluate alternative portfolios to select highest return for the given level of
acceptable risk.
The Dutch East India Company (founded in 1602) was the first to
issue shares of stock to the general public. The company funded
international trade, exploratory voyages (such as Henry Hudson),
shipbuilding, etc. They remained in business for nearly 200 years
paying an 18% annual dividend for almost the entire time.