Investments Quiz 2 Part 1
Public analysis:
-Independent analysts also provide commentary and computations of fair value on a subscription basis for whoever wishes to subscribe (examples, Morningstar, S&P, etc.)
Dollar weighted return
-The rate of return that would make the present value of future cash flows plus the final market value of an investment or business opportunity equal the current market price of the investment or opportunity; in other words, the rate of return at which the net present value of the project is zero. (similar to Geometric average; IRR in Excel)
Proprietary analysis
-The research and commentary from these analysts are used to guide investment decisions by the institution and is not disclosed to the public
Geometric average
-the interest rate that enables period returns to equal the final value (like PV or FV calculations)
arithmetic average
-the mean result of dividing the sum of independent variables by the number of variables
Holding Period Return
-the return for a holding period -the increase or decrease of investment value during a period -the annualized rate is usually the rate that is used
Sources of return
1.For most common stock, the largest source of investment return comes from market appreciation. 2.The investment return has been higher than other classes of investment over the reasonable investment horizon. 3.Again, stocks don't expire over time. Stock values can vary over time, too. -Stock performance can be cyclical, seasonal, or subject to changes over time -Stocks that are out of favor can rebound later on and vice-versa
Investor or owner?
1.Legally, common stockholders own the corporation? 2.Stockholders vote to elect the Board of Directors. -Typically, the Chairman of the BOD invites the Board Members to run for election to the BOD - Management runs the company but reports to the Board of Directors 3.Are stockholders in public companies, true owners? -Stock investors are merely interested in making money. They do not intend to manage the company -If the company's outlook is not promising, investors will sell their stock and buy another -Legally, management is not an "agent" of shareholders
What is the standard deviation?
A common measure of spread (+ or - from the mean) based on the sampling distribution of the random rates of return -a statistical method that can be used to calculate the likely range of possible rates of return (based on the data provided) relative to the arithmetic average. •a measure that is used to quantify the amount of variation or dispersion of a set of data values. •The 5 year average rate of return is about 13% and there is a SD of about 13%. The likely rate of return of the SP 500 is somewhere between 0% and 26% but the most frequent rate of return is 13% Data with a small standard deviation have a low level of variance from the mean. SD is computed as square root of the variance of outcomes in order to prevent the combination of adding positive and negative variances from reducing overall variance. Standard Deviation is handy because it is quantified the same "units" as the average
Annual percentage rate (APR
APR is the per period rate and does not consider the compounded rate of return. Level debt instruments (equal payments) are often quoted using APR
•The formula for calculating APR is:
Annual percentage rate of return = Per-period rate × periods per year
Example for converting APR to EAR(from the Bodie text)
Assume that you buy a 30 day, $10k Treasury bill for $9900. Treasury bills are discount instruments (no interest payments are paid; the principal value of the instrument accretes by the interest rate). What was your rate of return using APR and EAR? 1.Holding period return (HPR) = price change/initial price or ($100/$9900) which is .0101 or 1.01% 2. APR is Per-period rate × Periods per year or 1.01% x 12 which is 12.12% 3. EAR = (1+APR/n)n or (1.0101)12 or 1.1282 or .1282 or 12.82%
What is common stock?
Common stock indicates ownership of a corporation: All corporations (large and small) must issue stock to their owners Privately-held corporations have common stock but their stock is not traded in the stock market. If corporations have registered their stock for sale in the public stock market, they called publicly-held companies A sale of stock by the company to investors are called public offerings in the primary market oInvestor trading (buys and sells) is conducted in the secondary market
Investments risks/opportunities are hard to foresee 2/2
Continued: 6.Faulty production of airbags and ignition parts cause millions of automobiles to be recalled. Some auto companies have incurred massed losses, lost sales, and the potential for class-action lawsuits 7.The price of entertainment has caused cable television access to skyrocket. In response, customers began to "cut the cable" which resulted in equity market declines of cable TV company equities and entertainment companies. The cut the cable movement caused some entertainment companies to rise (Netflix and Hulu) and others to decline (Disney/ESPN and HBO) 8.Consumer changes regarding food preparation and sales have caused large food chains to disappear and "fresh food" companies to pop up. Cereal and grain companies (Kellogg's and General Mills) suffered as breakfast tastes changed. 9.Volkswagen stock stumbled due to cheating on EPA and mileage tests. Shares of defense contractors and manufacturers sky-rocked when President Trump took office.
Effective annual rate (EAR)
EAR return considers the compounded rate of investment return. •is used to calculate the rate of return on discount instruments (such as T-bills) • WARNING: While this may make perfect sense, many sellers will quote APR (not APY) when they are using EAR
Sector and individual equity risks/opportunities are hard to foresee 1/2
Examples include: 1.An chemical explosion in India caused two huge chemical companies to seek bankruptcy protection 2.Research conclusions about the danger of smoking caused tobacco companies to plummet 3.Concern about sugar, peanut allergies, antibiotics in animal feed, excessive salt, cause food and beverage companies to suffer setbacks 4.The price of gasoline in the late 20th century caused SUV sales to plummet and hybrid sales to climb. Declines in gas prices in 2015-2016 caused SUV's to become popular and hybrid sales to decline 5.An abundance of coal makes fossil fuel the primary source of fuel for electric companies. Fear of global warming and political activism resulted in the near bankruptcy of all coal companies, economic chaos in coal producing states, and power utility concern about becoming forced to close some power plans and building newer plants with new (perhaps untested) technology
Calculation of Holding-Period Return (HPR)
HPR= [PS − PB + CF] / PB PS = Sale price PB = Buy price CF = Additional cash flow during holding period Assume that Jack buys 100 shares of Verizon at $42/share. The stock is now worth $45/share. During the year, her received $1.05 in dividend payments. What is his HPR? HPR= ($45-42+1.05)/42=9.64%
How do investors earn money by investing in common stock?
Investors can make money in three ways: 1.Dividend distributions 2.Appreciation or depreciation in market value. 3.Corporation action: -Repurchase shares -Stock split -Merger
Market risk and security risk can occur together (Essentials of Investments, Bodie et al.)
Market risk can sharply effect most (or all) potential investments in an asset class . Some market or economic risks can affect multiple asset classes at the same time. Nevertheless, some investments in the class can rise separately rise or fall Example. A supply glut of oil caused all energy stocks to plummet in 2015/2016
Preferred Stock
Preferred stock is typically non-voting stock that provides a fixed dividend: -Still it an "ownership" security but it performs like fixed income -Preferred shareholders can vote if dividends are not paid -Preferred shares usually must be paid before common shareholders received dividends (cumulative) -Liquidation priority over common stock The price of preferred stock does not typically fluctuate as company earnings change The price of preferred stock is calculated by determining the price that will enable the dividend adjusted return to equal long-term interest rates (see next slide)
Risk-free rate
Rate of return that can be earned with certainty (I use the 90-day T-bill, but other analysts use the 10-year T-Note)
Historic info on RTN market prices
Stock Price Target for RTN (2/4/2016) High $150.00 Median $139.00 Low $119.00 Average $137.53 Current Price $126.65
•Consider conditions that have recently caused the markets to change:
Tariff negotiations that are likely to result in more jobs but will also cause inflation due to higher prices for imported goods Bond investors are concerned that interest rates will kill the current economic boom Large tech companies have fluctuated in value due to 1) technology that provide services and access to products 2) concerns about privacy problems and monopolistic tendencies
Risk premium
The expected return in excess of the rate of return of risk-free securities Example: the difference between the arithmetic average of return for large cap stock of 12.2% less a T-bill return of 3.3% is a risk premium of 8.9%
Risk-free rates and risk premium
These terms are typically used to assess the additional rate of return given for accepting risk
Risk of one investment
While the overall stock market can rise (or fall), individual stocks are more volatile than the overall market. Some of the stocks may rise or fall due to the investment sector that they are in (example, Walmart, Kohls, and Macys are all big box retail stores) or a company may do something wonderful or awful that can cause their stock value to change. If we only invest in one asset, the value of our investment could sharply change for a number of reasons (example, Walmart stock has dropped due to Amazon's success or Exxon has declined due to gas prices). The volatility (risk) of an investment portfolio tends to decline as we increase the number of investment assets that we hold. The standard deviation of return declines rapidly when additional investments are added. However, the rate of SD decline slows as more assets are added.
•The formula for calculating covariance is
X1 = each independent variable x = mean of independent variable y1 =each dependent variable Y=mean of dependent variables N=number of variables
Investment concentration
a term to describe a heightened investment risk that arises from owning too much of one investment, investments in one industry, or one type of investment asset The SEC sets standards for various types of mutual fund investment diversification (often a 5% max in each security) but hedge funds, investment partnerships, or private placements are not mutual funds and may not diversify their investrments
Inadvertent investment concentration
can arise when an investor invests in various pooled funds (mutual funds, wraps, ETF's) have large holdings of the same funds OR when an investor has a 401k and pooled funds and individual holdings that hold large concentrations of the same funds.
Non-systematic risk
refers to a problem that influences a company or an industry. When oil companies pump too much oil, a glut of oil reduces the value of oil. This causes the market value of almost all oil companies
Sell-side analysts
typically work for broker-dealers and/or investment banks. These analysts make recommendations on the securities they cover. -Many of the more popular sell-side analysts work for prominent brokerage firms that also provide investment banking services for corporate clients—including companies whose securities the analysts cover.
Buy-side analysts
typically work for institutional money managers—such as mutual funds, hedge funds, or investment advisers—that purchase securities for their own accounts. -They counsel their employers on which securities to buy, hold, or sell and stand to make money when they make good calls.
Normal distribution
•A symmetric, bell-shaped frequency distribution of investment return that can be described with only an average and a standard deviation.
Investment analysis terms(from SEC.gov)
•Analysts often use a variety of terms to reflect their views, such as: -Buy -Strong buy, -Hold -Sell The meanings of these terms can differ from firm to firm. •While there are analysts that we may favor (example, Standard & Poor's), I prefer to the look at the consensus of several analysts -I also like to look at the recent and highs and lows for the stock price. (Yes, this is foolish if we are making long-term acquisitions)
Diversification in a bond portfolio
•Bonds may not respond to market change in the that is similar to stocks...and can be respond differently than other bonds. For example, in a recession, stocks are likely to decline but investors may begin to buy US Treasury bonds to prevent the value of their investments from declining. Individual stocks can go up or down based on the potential for the issuer to earn more profits. Companies with declining earnings may still have a very strong credit rating and vice versa. All bond prices change when interest rates change Interest rates changes will impact some bonds more than others. This depends upon the maturity date, coupon, etc. In a recession, bonds with strong credit ratings can decline less dramatically than bonds with weak credit ratings.
Consider the environment before buying
•Companies may be doing well, but the stock market may not be moving up. -Example, Apple profits increased to the highest return in the 4th quarter of 2020. Instead, of the stock going up, it went down. •The economy could be going up or it may be declining. This can affect the affluence of investors •The sector that the stock is in (pharmaceutical, autos, clothing) may be increase or it may decline (oil has been a sector that has moved up and down)
Common stock
•Each share of stock represents fractional ownership of a corporation. As we know, stock provides the highest rate of return amongst the basic type of investments Stock price typically increase when corporate earnings are expected to rise. Since there are many types of companies that issue stock, investments in common stock can vary in both return and volatility Stockholders are represented by the Board of Directors. The BOD is responsible for hiring the CEO and they are responsible for overseeing the operation of the corporation
Calculating effective annual rate (EAR) when annual percentage rate (APR) is quoted
•In order to calculate EAR from APR, the formula is (1+APR/n)n n = the number of holding periods The key difference between APR and EAR is that APR is based on simple interest, while EAR takes compound interest into account. The more frequently a transaction is compounded, the higher the EAR becomes
Overview of equity fair value
•In order to decide whether an investment in stock is attractive, investors must determine the fair value of the stock. -The market value of securities often fluctuates each market day. The nature of volatility makes it difficult to know when to buy and when to sell. •Fair value is an investor's estimate of the value of stock value in the open market -Simplistically, fair value provides investors with a measure that is used to determine when: 1. when stock prices are too expensive (overvalued). Over-valued stocks should not be purchased and, perhaps, should be sold. 2. An unvalued stock can be purchased at a prices that is lower than fair value. Undervalued stocks should be purchased
Assessing fair value
•In theory, the fair value of a stock is the fair price that an investor will pay for the expected stream of future income that the stock will generate. •Analysts assess fair value by forecasting and valuing the likely streams of distributable profits that a company is likely to generate in the future. •There is no "correct" method to calculate the fair value for an equity, but calculations typically take into account future growth rates, profit margins, capital needs or earnings retention, economic conditions, societal values, and other risk factors, etc. -The method of determining fair value can vary from sophisticated calculations of corporate profits to very simple historic relationships.
The impact of diversification on systematic and nonsystematic risk
•Investors can reduce the impact of losses that can arise from non-systematic risk arises by diversifying their investment portfolio. For example, assume that you own 2 stocks worth $50 each and one of the stocks declined by 50%. The decline in the value of your portfolio would be 25%. On the other hand, assume you had 20 investments (worth $5.00 each) and one stock had 50% decline. In that case, the decline in your portfolio would be $2.50 or 2.5% of your portfolio ($5 x 50%) Diversification to avoid non-systematic risk can work well if the portfolio is well-diversified. Diversification is less effective with systematic risk because systematic risk, typically, impacts many securities. Asset allocation among asset classes can help investors increase or decrease investment risk. For example, if you invest 50% in stocks and 50% in bonds, and interest rates risk dramatically, the impact on bonds could be greater than the impact on stock.
Investors should examine stocks before buying
•Keep in mind that value of a stock is dependent upon the advantages or risks of owning the business (almost as if you own the business) -Examples of business advantages or risks can include technology changes, capital adequacy, good products, competitive advantage, good management, etc.) -In other words, the risks and advantages of a public corporation influences the company's profits. If profits go up, the value of the stock goes up and vice versa However, stockholders do not participate in most company business decisions. Therefore, investors must carefully research potential investments in stock to identify the companies are well-managed
Mean variance analysis
•Mean-variance analysis is the process of weighing risk by calculating the expected return of securities divided by the standard deviation of the assets. •Investors use mean-variance analysis to make decisions about which financial instruments to invest in, based on how much risk they are willing to take on in exchange for different levels of reward. Mean-variance analysis allows investors to find the biggest reward at a given level of risk or the least risk at a given level of return.
Why Does a Risk Premium Exist?
•Modern investment theory centers on this question but there is no correct answer for all situations. - Sometimes, the premium purely depends upon the market demand •However, we can examine part of this question by looking at the dispersion, or spread, of historical returns. • •We use two statistical concepts to study this dispersion, or variability: variance and standard deviation. •As we have said, the greater the potential reward, the greater the risk.
Price of preferred stock
•My preferred stock pays $5.00 per share. •Current long-term interest rates are 6% •In order for my preferred stock to provide a similar return to long term interest rates, what stock price is needed for $5.00 to provide an 8% return •How do I calculate this? $5.00 =X*.08 X= $5.00/.08 X= $62.50
Is the average the amount we should expect?
•No, arithmetic averages may not be accurate indicators for the future . • However, if we combine the average return and a range of likely possible outcomes (such as the standard deviation) we can get a better sense of the future. •Keep in mind that the accuracy of this forecast will still be dependent upon the range of outcomes based on past. •Past performance is better than guessing, but it is STILL not necessarily indicative of the future results (the past must repeat itself for this forecast to be accurate)
Mean and standard deviation in a normal distribution curve
•Normal distribution curves are typically drawn with 3 standard deviations from the mean (the Greek letter sigma is used to represent a standard deviation). •The most frequent past outcomes are those that are closest to the mean. •The Standard Deviation is a measure of how to spread out the range of outcomes. •Outcomes that are more than one sigma from the mean are generally considered to be unlikely In other words, an outcome that falls within the 2 sigma range (95 % likelihood that outcome falls within 2 SD) is less likely that one the falls within the 1 sigma range (68.26% likelihood
Long term investment allocation
•Some investors argue that it is a fallacy to regard stock as a long-term investment. •They argue that investment returns are independent variables which make historic relationships unreliable. •While I agree that investment returns on independent variables, I disagree with them for different reasons: If we look at the long term rates of return for various assets classes, we see that common stock has the highest rate of return but it also has the highest standard deviation. While short-term equity returns can fluctuate sharply, the Ibbotson chart of returns over 70 years shows consistent, sharp upward growth. Perhaps my view is simplistic, but, based on Ibbotson, stock is the best investment for the long-term but not when investors are nearing their investment horizon.
Measuring risk vs reward
•The Sharpe (Reward-to-Volatility) Ratio •Mean-Variance Analysis •Capital Allocation Line
Arithmetic vs geometric mean
•The arithmetic mean is relevant any time several quantities add together to produce a total. - The arithmetic mean answers the question, "What is the number that is most likely to occur" • In the same way, the geometric mean is relevant any time several quantities multiply together to produce a product. -The geometric mean answers the question, "if all the quantities had the same value, what would that value have to be in order to achieve the same product?"
Objective of calculating the CAL
•The capital allocation line aids investors in choosing how much to invest in a risk-free asset and one or more risky assets. Asset allocation is the allotment of funds across different types of assets with varying expected risk and return levels, whereas capital allocation is the allotment of funds between risk-free assets, such as certain Treasury securities, and risky assets, such as equities.
Calculation of Covariance
•The covariance formula is similar to standard deviation. We take the sum of the differences between each independent variable and the mean for the independent variables multiplied by the differences between each dependent variable and the mean for the dependent variables
What is the geometric return?(aka time weighted return)
•The geometric return is equal to a single rate of return that would provide the same cumulative performance as the sequence of the several interim returns over time. -The geometric mean return formula is used to calculate the average rate per period on an investment that is compounded over multiple periods. •It calculates the return of return needed to produce the ending amount over the time frame The geometric mean return may also be referred to as the geometric average return. -Time weighted return (geometric return) is the method that must be used by portfolio managers who publish investment data for managed investment funds since it smooths out the return caused by compounding •To calculate the geometric mean return, you only need to know the initial investment, the final balance and the number of years until the payoff. RG=(Final balance less initial balance)1/# of periods -1
Inflation impact on real and nominal rates of return
•The nominal rate of return includes 2 factors: 1.The inflation rate (i.e, the purchasing power of $) 2.The real rate of return: the rate of return received by investors for accepting risk. •We must keep in mind that the rate of return on investments is not necessarily based on the rate of return as measured by the Consumer price index (CPI) which is based on change in prices of a hypothetical basket of consumer goods •As such, a portfolio that earns 8% when inflation is 5% means that the investor is receiving only 3% for accepting the investment risk.
The news and analyst views can move the market
•The prices of a common stock is likely to move when analysts change their estimates of a company's future profits (typically, earnings per share) -Sometimes, business factors in the news can influence the price of a common stock or all common stocks in an industry. As examples: •Chipotle restaurants struggled with infected lettuce •The coal industry was identified as a pollutant •When the actual news is released or analysts release their new forecasts is released, the market will move.
Market factors are difficult to forecast
•The securities markets are difficult to forecast: Sometimes industry conditions change. As examples: The prospect of rising interest rates caused equity prices and bond prices to decline on several occasions in 2015. At other times, announcements of potential interest rate increases by the FRB caused the equity market to rally because investors believed that the FRB's economic view had become clear. Rising oil prices typically cause investment markets to decline as rising gasoline prices act in similar fashion to a tax increase In 2015, markets began to plummet as the supply of oil was estimated to be much higher than originally calculated. As such, the price of oil companies declined and the sales of trucks and luxury cars rose.. Sometimes market or products change over time. As examples: New research about use of genes and stem cells in 2015 led to speculation that new gene-based cures for cancer were becoming effaceable. Almost all pharmaceutical stocks rallied. The rally faded away with time. Manufacturing and financial market stocks rallied when Pres. Trump took office and promised to establish import taxes, cutting regulatory rules, and lowering both corporate and individual income taxes.
Calculating standard deviation and confidence levels (FYI only)
•The standard deviation of a random variable, statistical population, data set, or probability distribution is the square root of its variance -SD is expressed in the same units as the data •To calculate the variance 1.Calculate the arithmetic average (the mean) 2.Then subtract the Mean from each number in the sample (rates of return in our situation): and square the result (squared difference) 3.Then calculate the average of those squared differences oFor a population, use the number of items in the population oFor a sample, subtract 1 from the number of data items in the sample which is a "simple correction" for the sample (NO, I don't know why) 4.As you might expect, the Standard Deviation is bigger when the differences are more spread out •In statistics, the 68-95-99.7 rule is a shorthand used to remember the percentage of values that lie within a band around the mean in a normal distribution with a width of one, two and three standard deviations, respectively; more accurately, 68.27%, 95.45% and 99.73% of the values lie within one, two and three standard deviations of the mean,
Average return
•The total of the individual returns in the measurement period divided by the number of individual returns
Why do corporations issue common stock?
•To raise CAPITAL (money) to start or expand a business. Stock provides (near) permanent capital for the corporation Corporations can repurchase their stock Stock does not expire or mature By contrast, capital from debt must be repaid to the lender Issuing additional common stock dilutes earnings per share Some corporations may issue stock to raise money for a specific purchase: -Merge or buy another company -Buy land or equipment -To repay debt or buy another corporation
What does the average rate of return tell us?
•We can use average rates of return to compare our portfolio to other investment opportunities: -Are we out-performing similarly constructed investment portfolio's or under-performing them? •How much more could we earn by pursuing other strategies? •However, averages are based on the past.
Investment returns often change
•While the performance of individual stocks can vary from each other each day, some types and sectors of stocks can move in the same direction. On the next slide, we will see a chart created by Morgan Stanley that depicts the performance of difference types & classes of securities (highest performance is on top and the lowest is at the bottom) for 10 years (1993-2003). Note that the performance order of type/class of securities changed almost each year. This suggests to me that setting an effective asset allocation (how much in stocks, bonds, etc.) and have effective diversification within each asset class will help us.
Risky investments usually offer higher returns Does this work for both non-sys and systematic risk?
•Yes, since higher systematic risk increases the risk for most securities, a higher rate of return must be offered to attract buyers. For example, long-term bonds are more volatile in value than short-term bonds. Therefore, long-term bonds tend have higher return yields than shorter bonds. When interest rates rise, all bonds decline in value....long-term bonds decline more than short-term bonds. •Sorry, there is no automatic extra return for accepting greater unsystematic risk. For example, you plan to buy shares of a new tech company that plans to make an exciting new gaming app. Since it's a new business, the chances of the company failing are high. The price per share of gaming app company will be the same (aside from broker fees) whether you purchase 100 shares or 10,000 shares.
Variance
•a common measure of return dispersion. Sometimes, return dispersion is also call variability.
Probability distribution
•a statistical technique that can be used to derive the reward from investment or the "expected return". -distribution (for investment return purposes) produces the range of potential outcomes based on past performance
Sharpe ratio (My favorite)
•assess return vs risk by dividing the risk premium by the standard deviation of portfolio return To calculate a fund's Sharpe ratio, first subtract the return of a riskless asset( usually the 90-day Treasury bill) from the fund's mean return, then divide that figure by the fund's standard deviation: Sharpe ratio = (Porfolio return - riskless rate) (SD of portfolio return) Because it uses standard deviation, the Sharpe ratio can be used to compare risk-adjusted returns across all fund categories.
Internal rate of return (Dollar weighted return)
•can be used for determining the rate of return for portfolio's with varied inflows and outflows •This method uses internal rate of return to calculate annual investment return •The dollar rate of return is used to calculate how much each investment dollar returned on average to the investor. Some investors argue that this is the amount that your received.As such, they believe that DWR a more valuable return than time weighted return.
Capital allocation line (CAL)
•considers the relationship of the real rate of return (for a combination of investments (or mutual funds) divided by the standard deviation (essentially, Sharpe's ratio) of that combination •Investors can graph the relationship of between alternative investments using the Capital allocation line in order to select the investment that offers the best return/risk relationship. Terms that are used to assess risk/reward
Systematic risk
•generally perceived as risk that can affect all or most financial assets . Examples of systematic risk include changes in economic cycles, taxation, Acts of God (flood, drought, etc.), war, political stasis (inability to govern)
diversification
•refers to maintaining a variety of investments within a class of assets In other words, how many different stocks should we hold in our stock portfolio? oDiversification reduces investment portfolio risk
allocation
•refers to the amount of funds that we have in each class of asset. When investing, how much money should be invested in each asset class (stocks, bonds, or cash) ?
Institutional investors
•retain research analysts who (typically) are experts in an industry and economists who can assess future macroeconomic conditions.
Retail investors
•should obtain their research that can be provided by the brokerage firm (usually by full-service brokerages) that they use. -The Wall Street Journal also , Bloomberg, Yahoo Financial, and other websites can provide a significant amount of market news about companies as well as detailed data about companies
Investment risk
•the variance or the deviation of return from the expected return.
