15.5 Summary

Overview

In this chapter, we discussed the following key aspects of the portfolio approach to investment:

Risk and Return

• Generally, to achieve higher returns, investors must be willing to accept a higher degree of risk. In statistics, risk is defined as the likelihood that the actual return will be different from the expected return.

• Systematic risk is non-diversifiable risk; it is always present and affects all assets within a certain class. Non-systematic risk is the risk that the price of a specific security or group of securities will change to a different degree or in a different direction from the market as a whole. Non-systematic risk can be reduced through diversification. Two common measures of risk are standard deviation and beta.

Asset Allocation

• Asset allocation involves determining the optimal division of an investor’s portfolio among the different asset classes of cash, fixed income, and equities to maximize portfolio return and reduce overall risk.

• The return is calculated as the weighted average return on the securities held in the portfolio.

Correlation

• Correlation refers to the way securities relate to each other when they are added to a portfolio and how the resulting combination affects the portfolio’s total risk and return.

• Beta is a measure of a portfolio’s volatility in comparison to that of the market. A higher beta means greater risk.

• Alpha measures the degree to which an equity portfolio performs better than would be expected from beta.

Portfolio Management Strategies

• Active managers attempt to outperform the market by actively seeking stocks that will do better than the market.

• Passive managers tend to replicate the performance of a specific market index without trying to beat it.

• Fixed-income managers make choices based on term to maturity, credit quality, and their expectations of changes in interest rates.

• Equity growth managers use the bottom-up style of growth investing by focusing on current and future earnings of individual companies.

• Equity value managers focus on buying undervalued stock.

• Equity sector rotators apply a top-down investing approach. They analyze the overall economy and invest in promising industry sectors.

Key Takeaways

1. Risk: Understand the difference between systematic and non-systematic risk and how they can be managed.
2. Asset Allocation: Learn the importance of diversifying investments across asset classes to achieve an optimal balance of risk and return.
3. Correlation and Beta: Grasp the concepts of correlation and beta to better evaluate portfolio risk and performance.
4. Management Strategies: Differentiate between active and passive management, as well as various equity and fixed-income management approaches.

Glossary

• Systematic Risk: Risk inherent to the entire market or an entire market segment.
• Non-systematic Risk: Risk unique to a specific company or industry.
• Standard Deviation: A measure of the dispersion of a set of values relative to their mean.
• Beta: A measure of a security’s volatility in relation to the market.
• Alpha: A measure of performance on a risk-adjusted basis.

Mathematical Formulas

Expected Return

• \( E(R) \): Expected return of the portfolio
• \( w_i \): Weight of each asset in the portfolio
• \( R_i \): Return of each asset in the portfolio

Beta Calculation

• \( \beta_i \): Beta of the asset
• \( \text{Cov}(R_i, R_{m}) \): Covariance of the asset’s returns with the market returns
• \( \sigma^2_m \): Variance of the market returns

Frequently Asked Questions (FAQs)

What is the difference between systematic and non-systematic risk?

Systematic risk impacts the entire market and cannot be diversified away, whereas non-systematic risk is specific to a particular company or industry and can be reduced through diversification.

How is the expected return of a portfolio calculated?

The expected return is calculated as the weighted average return on the securities held in the portfolio.

What does a high beta signify?

A high beta signifies that the security or portfolio is more volatile compared to the market, indicating higher risk.

How do active portfolio managers seek to outperform the market?

Active managers attempt to outperform the market by selecting stocks that they believe will perform better than market averages.

Diagram: Asset Allocation and Risk

    graph TD
	    A[Asset Allocation] --> B[Cash]
	    A --> C[Fixed Income]
	    A --> D[Equities]
	
	    B --> E[Low Risk]
	    C --> F[Medium Risk]
	    D --> G[High Risk]

Conclusion

Now that you have completed this chapter, you should be ready to address the Chapter 15 Review Questions. For any further clarification, you can refer to the frequently asked questions (FAQs).