Series 66: Session 12 - Method of Quantitative Analysis

Alpha

- a positive Alpha means the investment performance is better than anticipated, given the risk taken -can be positive, negative or zero *(total portfolio return - risk-free rate) - (portfolio beta x [market return - RF]) see p.436 for examples

NPV and IRR

-IRR is the method of computing long-term returns that takes into consideration time value of money -the yield to maturity of a bond reflects its IRR -the investment is a good one if it has a positive NPV; stay away if the NPV is negative -NPV is generally considered more important than IRR

geometric mean

-harder to compute -rarely used -is obtained by multiplying all of them together, and then taking the nth root of them *arithmetic mean will always be higher than geometric mean*

median

-is a midpoint of a distribution find the median of 11,7,4,13,and 8: 4,7,8,11,13. median is 8 -if even numbers, take the average of the middle two -this measure is more appropriate than the mean in skewed distributions or in situations with variables that fall far outside the normal range

Correlation

-means that securities move in the same direction

mode

-measures the most common value in a distribution of numbers. ex. 2,2,2,6,7,7,9 mode is 2

mean or arithmetic mean "outliers"

-most commonly used to measure central tendency -simply take an average

measure of central tendency

-the center or middle of a distribution -mean or arithmetic mean -median -mode -geometric mean -range

Rule of 72

The number of years it takes for a certain amount to double in value *72 / annual rate of interest*

Example of PE ratio

a company's stock trades for $30 per share and has earnings of $1.50 per share. It has a PE of 20. If the avg. PE of the company's industry is 11, this stock is high priced. If the average PE is 35, this company is low priced.

income in perpetuity

a method for providing an annual income "forever" for a relative or a charity *desired annual income/avg. expected rate of return = lump sum required*

standard deviation

is a measure of the volatility of an investment's project returns, computed by using historical performance data. -the larger the dispersion, the higher the standard deviation, the larger the security's returns are expected to deviate from its average return, hence greater the risk. -includes both systematic and unsystematic risk or total risk of the security

correlation coefficient

is a number that ranges from -1 to +1 -a perfectly correlated securities has a correlation coefficient of +1. -unrelated securities has a correlation of zero. -if prices move in perfectly opposite directions, they are negatively correlated or have a correlation coefficient of -1. -including negatively correlated assets in a portfolio is the best way to diversify it.

Net Present Value (NPV)

is the difference between an investment's present value and its cost *PV - cost basis* -corporation use this to determine whether to invest in a capital project -If NPV is positive, the project adds value -If NPV is negative, the project will drain value from the company -can be used to evaluate an investment vehicle

range

is the difference between the highest and lowest returns -reorder the data set from smallest to largest and the subtract the first element from the last element

time value of money

is the difference between the value of money today and its value sometime in the future

Internal Rate of Return (IRR)

is the discount rate (r) that makes the future value of an investment equal to its present value -is difficult to calculate directly; done by iteration -is not practical for common stock due to uneven cash flow and no maturity date and price -can be used to determine whether an investment meets the investor's required rate of return

present value

is the value today of the future cash flows of an investment discounted at a specified interest rate to determine the present worth of those future cash flows

Index funds' goal

is to achieve perfect correlation (+1) with the index they are mirroring or to come as close as possible to matching the performance of the underlying index. It's not the goal to exceed the performance.

Beta/Beta cofficient

is used to measure the variability between a particular stock's (or portfolio) movement and that of the market in general -beta of -1.2, a 10% up move in the market's return will cause the stock return to decline by 12% -Beta below 1.0 = conservative -Beta above 1.0 = aggressive -measuring only systematic risk

price to earnings ratio (P/E)

provides investors with a rough idea of the relationship between the prices of different common stocks compared with the earnings that accured to one share of stock. *CMV of common share/EPS* -growth companies have higher PE ratios than do cyclical companies or defensive companies -speculative stocks often sell at one extreme or the other

price-to-book ratio

reflects the market price of the common stock relative to its book value per share -growth investors look for a high price-to-book ration -value investors look for companies with a low price-to-book ratio

future value; FV

what an amount invested today at a given rate will be worth at some time in the future *=PV x (1 + r)^n* r = rate of return n = number of years over which it is invested