Time Value of Money
The time value of money is one of the most crucial concepts in finance. It is the notion a dollar received in the future is worth less than a dollar in hand today. Cash flows occurring in different periods must be adjusted to their value at a common point in time to be analyzed and compared.
Interest and dividends are periodically added to the portfolio and starts to earn interest on the interest called compounding. Determining the value of this process in the present is called calculating the future value.
The reverse process occurs when considering the present value of an investment. Discounting is the process of determining present value. The formula involves choosing the appropriate interest factor to account for inflation and opportunity costs.
Return
Investments are made to earn a return while you must accept a possibility of loss. The challenge of portfolio management is to determine the combination of risk and return which allows the investor the highest return for a given level of risk.
The expected return is the anticipated flow of income and price appreciation. It is the sum of possible outcomes multiplied by the probability of occurrence. An investor’s required return is the return necessary to induce the investor to bear the risk associated with a particular investment.
Sources of Risk
Risk is concerned with the uncertainty the realized return will not equal the expected return. Asset returns tend to move together. There is a systemic relationship between the price of a specific asset and the market as a whole.
An investor also faces unsystematic risk attributable to a specific asset. Sources include business risk involving the nature of their business and financial risk referring to how the firm finances their assets. Unsystematic risk may be significantly reduced through diversification.
The number of securities to achieve a diversified portfolio is surprisingly few. Several studies have shown as little as ten to fifteen is enough while other experts suggest one hundred. Unfortunately, systemic risk can not be diversified away.
Risk Measurements
The measurement of risk places emphasis either on the extent to which your return varies from the average return or on the volatility of your return relative to the return on the market. Variability is measured by standard deviation while the volatility is measured by beta.
Stocks with wider ranges are riskier because their prices tend to deviate farther from the average price. Plus or minus one standard deviation has been shown to encompass sixty-eight percent of all observations. For a given identical expected return for two securities, you would chose the security with the smallest standard deviation.
The dispersion around a mean return can also apply to a portfolio. The inner relationships among the holdings are considered in construction of the portfolio. For a specified average expected return, the you will select the portfolio with the lowest co-variance.
Diversification and Risk Management
Your portfolio might have achieved diversification in the past because the individual returns were not highly correlated but this may not be so in the future. It is felt stocks have become more correlated in recent years.
To deal with the variable correlation of stocks in different economic environment, investors should chose a broad array of asset classes such as bonds, money market mutual funds, real estate, tangible assets and foreign securities.
Portfolio Theory
Harry Markowitz developed a model on which an risk-averse investor can construct a diversified portfolio which maximizes their satisfaction by maximizing portfolio returns for a given risk level.
All portfolios 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. An efficient frontier curve is formed where the highest returning portfolio are stacked up with varying risk levels.
Capital Asset Pricing Model
The CAPM model gives us a precise prediction of the relationship we should observe between the risk of an asset and its expected return. The concept is applied in both a macro context on a portfolio level and micro context specifying the relationship of risk and the return of a specific asset.
A capital market line is developed by combining a risk-free security and a portfolio compassing risk securities. The line indicates to earn larger returns, you are required to take greater risks.
Beta
Risk is measured by the portfolio’s standard deviation while the individual asset’s risk is measured by a beta coefficient. 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 relationship between the return on a stock and the return on the market, the beta has meaning. The greater the beta, the more systemic risk is associated with the individual stock.
Betas vary among stocks and industries. 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.
Visit these topics for further detail or return to the Investment Basics page:
- Basics Introduction
- Security Markets
- Information Sources
- Risk and Portfolio Theory
- Investment Companies
- Stock Valuation
- Macroeconomic Environment
- Statement Analysis
- Bond Market
- Foreign Securities
The material presented on this page and Investment Basics pages were adapted from Dave’s lecture notes for the Investments for Professionals course taught at UCLA 1998-2005 and three decades of practical experience. See our Site Credits page for reference sources.
