This section describes Risk & Portfolio Theory by taking about the time value of money, return, sources of risk, portfolio theory, diversification and beta.
Time Value of Money
The time value of money is one of the most crucial concepts in finance. It is the notion your dollar received in the future is worth less than a dollar in your hand today. Cash flows occurring in different periods must be adjusted to their value at a common point in time to be compared.
Interest and dividends are often added to your holdings and starts to earn interest on the interest, called compounding. Thinking about the value of this process in the present is called calculating the future value.
The reverse process occurs when thinking about the present value of your holding. Discounting is the process of determining present value. The formula involves choosing the appropriate interest factor to account for inflation and opportunity costs.
Investments are made to earn you a return though you must accept a chance of loss. The challenge of portfolio management is to set the mix of risk and return which yields you the highest return for a given level of risk.
The expected return is your desired flow of income and price growth. It is the sum of outcomes times the chances of occurrence. Your required return is the return needed to induce you to bear the risk with a single holding..
Sources of Risk
Risk deals with the chance your return will not equal what you expect. Asset returns tend to move in the same direction. There is a systemic bond between the price of a single asset and the market as a whole.
You also face unsystematic risk tied to a single asset. Sources include business risk in the nature of their business and financial risk which is how the firm funds their assets. Also, unsystematic risk may be reduced through diversification.
The number of assets to achieve a diversified portfolio is few. Several studies have shown as little as ten to fifteen is enough while other experts suggest one hundred. SCM feels thirteen to fifteen is about right. Unfortunately, systemic risk can not be removed.
Measuring risk focuses either on the extent your return varies from the mean return or on the volatility of your return relative to the return on the market. Variability is measured by SD while the volatility is measured by beta.
Stocks with wider ranges are riskier because their prices tend to move farther from the mean price. Plus or minus one SD has been shown to capture sixty-eight percent of all data points. For a given identical expected return for two securities, you would chose the security with the smallest SD.
The spread around a mean return can also apply to holdings return. The inner bounds among your holdings are dealt with in building your account. For a given mean return, you will select the asset set with the lowest co-variance.
Your account might have achieved diversification in the past because the single returns were not highly related. However, this may not be so in the future. It is felt by many, stocks have become more correlated in recent years.
To deal with the variable correlation of stocks in different economic environment, you should chose a broad array of asset classes such as bonds, money market mutual funds, real estate, tangible assets and foreign.
Harry Markowitz built a model on which an risk-averse investor can construct a group of assets which maxes their wants by maxing holding returns for a given risk level.
All groupings which offer the highest return for a given amount of risk are referred to as efficient. Any portfolio which offers a lower return for the same risk is inefficient. in conclusion, an efficient frontier curve is formed where the highest returning groupings are stacked up with varying risk levels.
Capital Asset Pricing Model
The CAPM model gives us a precise outlook of the relation we should observe between the risk of an asset and its expected return. In addition, the concept is applied in both a macro context on a holdings level and micro context pointing to the marriage of risk and the return of a single asset.
A capital market line is drawn by holding a risk-free asset and a asset set holding risk assets. The line says to earn larger returns, you have to take greater risks.
Risk is measured by your account’s SD while the single asset’s risk is measured by beta. In addition, beta is a systematic risk metric and measures the volatility of an asset relative to the volatility of the market.
As long as there is a strong relation between your return on a stock and your return on the market, the beta has meaning. Also, the greater the beta, the more systemic risk is associated with the individual stock.
Betas vary among stocks and industries. Separately, utilities and consumer staple stocks have lower betas than consumer discretionary stocks and materials empirical studies have shown beta for individual securities may be unstable.
Also, visit these topics for further detail or return to the Investment Basics page:
- Basics Intro
- Info Sources
- Investment Firms
- Stock Values
The info on this Risk & Portfolio Theory section and in other Basics sections are adapted from Dave’s lecture notes for the Investments for Pros course taught at UCLA (1998-2005) and three decades on the job. Also, see our Site Credits page for Risk & Portfolio sources.