Happy #FinanceFriday ! We’re now getting to the fun stuff, CALCULATIONS! There are a lot of different calculations CFAs can do to evaluate the potential return and risk of an investment. But don’t you fret! I won’t get into the calculations, we’ll only cover concepts.
Finance professionals evaluate the return on an investment (ROI) based on 2 different cash flows, cash flow while holding the investment (dividends or interest) and cash flow when you sell the investment (capital gain/loss).
There are 5 types of returns:
- Expected Return: What we imagine future cash flows will be and what we expect return will be.
- Realized Return: The return that has be calculated from the actual cash flows.
- Required Return: The return you set with your portfolio manager; a benchmark goal.
- Holding Period Return: Total return for the entire time you own the investment
- Annual Return: Annualizing the holding period return, or putting it on a calendar basis
Many people may view risk as the chance you could lose money on an investment, but in Finance, we view risk as anything that was not expected, good or bad. In order to measure risk, we must know what is expected by calculating the expected return/point of Central Tendency. We measure risk by standard deviation (the variability of returns) and beta (the volatility of returns relative to the market).
The Standard Deviation of a portfolio depends on each asset’s variability or individual standard deviation, each asset’s weight in the portfolio (what percentage of the portfolio is each asset), and covariance between the different assets.
Covariance is the measure of how 2 investments vary in relation to each other; one investment can offset (no Migos) risk in another investment. The correlation of 1 asset to the market is measured by the asset’s beta. The correlation of 1 asset to another asset is known as Correlation Coefficient.
Beta measures how your stock moves in relation to the overall market; a.k.a. a correlation measure. If you look up an stock on Yahoo! Finance, you will see it’s beta, which shows how much it changes as the market changes. In theory, an investment with a beta of 1.0 moves exactly with the market/ has the same volatility as the market. For example, if the market gains 5%, your stock will gain 5% and if the market drops 3%, your stock will drop 3%. Investments with a beta less than 1.0 are seen as defensive, meaning it doesn’t move as much as the market/less volatile than the market and you will not gain or lose as much as the market. An investment with a beta of greater than 1.0 are seen as aggressive and moves more that the market/more volatile that the market, which means if the market increases, your investment will increase more and if the market declines, your investment will decline more than the market. Finance professionals can calculate the weighted average beta for your portfolio to predict how much it will move with the market.
There are 2 main types of risk:
- Systematic Risk: a.k.a. Market Risk. You cannot escape this type of risk. These risks include Market Risk, Interest Rate Risk, Reinvestment Rate Risk, Purchasing Power Risk, Exchange Rate Risk, and Sovereign Risk. Exchange Rate Risk and Sovereign Risk is associated with foreign securities.
- Unsystematic Risk: a.k.a. Firm Specific Risk. You CAN reduce this risk through diversification. These risks include Business Risk (management of company, how products are selling, etc.) and Financial Risk (can company get funds needed to grow business, etc.).
Unsystematic Risk and Total Risk decline as more securities are added to your portfolio. The theory is that having 20 different securities, preferably in different markets, decreases your Diversification Risk; having more than 20 won’t make much of a difference, but having less than 20 puts you at greater Diversification Risk. This makes sense if you think about it. Say you invest in a swimsuit clothing company. Your return on this investment will decrease during the winter, which will decrease the value of your portfolio. However, if you also invest in a winter coat clothing company, you will see portfolio gains in both the summer (from the swimsuit company) and the winter (from the winter coat company). Investing in mutual funds (a large pool of various investments) is an easy way to eliminate Diversification Risk.