Finance Ch. 8

Rebalance

in looking at the expected return of a portfolio, when prices of stock change, the weight of each company owned may change, so you have to do this.

Compensation

required only for risk that cannot be eliminated by diversification. If risk premiums existed on a stock due to diversifiable risk, that stock would be a bargain to well-diversified investors, and they would buy until the price of the stock was bid up.

Coefficient of Variation

How do we choose between two investments if one has the higher expected return but the other has the lower standard deviation? - shows the risk per unit of return and helps us compare two alternatives that are not the same

Risk Premium and Beta

If one stock is twice as risky as another stock as measured by their beta coefficients, risk premium should be twice as high.

Independent Returns

If returns are not related to one another at all, they are said to be this. - p = 0

Lowering Portfolio Risk

If we chose stocks with low correlations with one another and with low stand-alone risk, the portfolio's risk would decline faster than if random stocks were added. The reverse would hold if we added stocks with high correlations and high standalone risk.

Standalone Risk

An asset's risk can be analyzed based on this, where the asset is considered by itself, or on a portfolio basis, where the asset is held as one of a number of assets in a portfolio. - Important to the owners of small businesses - Important to examination of physical assets in the capital budgeting chapters.

Sigma

On a standalone stock, the measure of a weighted average of the variances between your expected return and potential return. - If this = 54%, you read "risk level is 54%" - Standard deviation, quantifies the tightness of the probability distribution and thus the risk of a given investment. - The standard deviation is a measure of how far the actual return is likely to deviate from the expected return. - Higher standard deviation = more risky

Security Market Line

The slope of this reflects the degree of risk aversion in the economy. The greater the average investor's risk aversion, the steeper the slope of the line and the greater the risk premium for all stocks.

Beta Coefficient

The tendency of a stock to move with the market is measured by its this, b. This measures market risk. Slopes of the stock's lines are this. - Because a stock's this reflects its contribution to the riskiness of a portfolio, this is the theoretically correct measure of a stock's riskiness.

Peaked Probability Distribution

This type of probability distribution means the likelihood is higher the actual outcome will be close to the expected outcome.

.35

When portfolios are properly constructed, they reduce risk to this p value.

Riskless Portfolio

When two stocks combine to form this, their returns move countercyclically to each other: when one falls, the other rises, and vice versa.

Total Risk

a combination of diversifiable risk and market risk.

Market Portfolio

consists of all stocks. - Not logical for individual investors due to high administrative costs and commissions. - Index funds usually diversify risk just as well

Coefficient of Variation

the measure of risk per unit of return. For every 1% return I'm getting back, how much risk am I exposed to?

Investment Risk

the probability of actually earning a low or negative return. The greater the chance of a low or negative return, the riskier the investment.

Capital Asset Pricing Model

the risk and return of an individual stock should be analyzed in terms of how the security affects the risk and return of the portfolio in which it is held.

Diversifiable Risk

the risk that is eliminated by adding stocks - makes up for random, unsystematic events like lawsuits, strikes, marketing, R+D, etc.

Market Risk

the risk that remains even if the portfolio held every stock in the market - stems from factors that systematically affect all firms, like war, inflation, recessions, interest rates, etc. Most stocks are affected by these macroeconomic factors.

Relevant Risk

the risk that remains once a stock is in a diversified portfolio is its contribution to the portfolio's market risk. It's measured by the extent to which the stock moves up or down with the market.