For the final exam: need to understand MPT.
Basic determination of the price of an financial asset: p = r / (i+t)
r is the discounted sum of the net future returns (interest, dividends, rent, profit, earnings)
portfolio: a collection of financial assets
Risk versus uncertainty: risk can be measured and predicted.
Risk: the known probability of a loss.
Market risk involves volatility.
alpha: the return on a mutual fund relative to the general market portfolio of the same risk.
beta: a measure of the volatility of a stock or mutual fund compared to a relevant market average.
Add a risk premium to returns.
Uncertainty: the possibility of a loss whose probability is not known and cannot be known.
Markets are both risky and uncertain.
When you invest, you need to beware of scares, greed, panic, gullibility.
We can reduce risks either by choosing a less volatile investment or by diversifying.
Two ways to get rich: try to outperform the market, or go with the flow of the market.
investment versus speculation
Investment is based on the yield of a productive asset. Earnings of companies.
Speculation is the expectation that changes in supply or demand will change the price favorably.
Shakespeare, Julius Caesar:
There is a tide in the affairs of men when, taken at the flood, lead to fortune.
Catch a tide and ride it to the crest. Like the technology boom of the 1990s.
But much easier said than done. Tides such as technology can crash.
The key question in finances:
Are markets efficient?
Unless you have special knowledge about the tide, and have the time to keep in contact with markets, for most ordinary investors, it makes more sense to go with the flow.
Yes, but not perfectly. Markets rather efficiently process known information and expectations into the prices of assets. But expectations change unexpectedly.
Use economics and common sense: no magic or free lunch.
Brokers who tell you a stock is sure to go up are lying.
The method that applies the theory of efficient markets is
MPT is a sophisticated investment approach developed by University of Chicago economist
Harry Markowitz, who won a Nobel Prize for that in 1990.
MPT allows investors to estimate the expected risks and returns on portfolios.
Markowitz described how to combine assets into efficiently diversified portfolios.
He discovered that a portfolio's risk could be reduced or the expected rate of return could be improved if investments having dissimilar price movements were combined.
Some companies' stock tends to follow in step with overall economic trends. These are referred to as cyclical stocks. Other companies tend to do well when the economy does poorly, and these are known as counter-cyclicals. Holding securities that tend to move in concert with each other does not lower your risk.
Diversification reduces risk only when assets are combined whose prices move inversely, or at different times, in relation to each other.
In other words, Markowitz explained how to best assemble a diversified portfolio, and proved that such a portfolio would likely do well.
Shakespeare on Diversification
The Merchant of Venice
by William Shakespeare
ACT I, SCENE I. Venice. A street
Enter ANTONIO, SALARINO, and SALANIO
ANTONIO:
Believe me, no: I thank my fortune for it,
My ventures are not in one bottom trusted,
Nor to one place; nor is my whole estate
Upon the fortune of this present year:
Therefore my merchandise makes me not sad.
First priority: insurance, to prevent large losses.
Annuity: insurance against dying with money or running out of money before you die.
Then,
Go with the flow market.
Three key variables: annual amount invested a, net return or interest on assets (i), and number of years that one will invest (y).
In MPT, the key to getting rich is compound interest.
The longer it goes, the greater the return from compounding.
Method:
1. Choose a level of risk (such as low, medium, or high)
2. Determine from past prices, using statistical methods, several uncorrelated categories and percentages of assets that maximize returns for that level of risk.
Examples: large company, small company, growth stocks, value stocks (paying dividends), international stocks, corporate bonds, municipal bonds, real estate stocks, technology stocks, natural resource stocks.
3. Select index funds or broad-based mutual funds for the categories.
4. About once a year, rebalance the assets to restore the original percentages.
Some details of personal finance:
margin: borrowing (first buy with own funds, then marginal extras with borrowed funds)
MPT does not usually buy with borrowed funds except house and maybe car.
Mortgages have favorable tax treatment.
Taxes:
not taxed until withdrawn: IRA, etc., pension plans, annuities.
Inheritance is taxed. Double taxation for IRA.
Trusts: revocable and irrevocable.
Social Security: low return
Savings account, at bank. Pays low interest. Insured.
CD, certificates of deposit. Time deposit. higher interest. Less liquid. Insured.
Treasury bill. From FED. safe. exempt from state sales tax.
Money market fund. Can be treasury only. Principal usually safe.
Bonds.
Zero-coupon bonds. Buy at discount. Am Cent Benham Target funds. Guaranteed at maturity.
Municipal bonds. Low interest. No federal tax.
State bonds, no state tax. Can be risky.
Corporate bonds. Pay higher, have risk.
Junk bonds, high-yield bonds. Risky companies. High interest.
Stocks. Shares of ownership.
Common and preferred stock.
Large cap, small cap < $1 billion
sectors: industrial, tech, real estate, energy, retail, mining
Voting rights.
Stock split: not very relevent except psychologically.
Through broker: high commission. Via web site or by phone dialing: low commission.
Several approaches to stock buying.
Long term: buy good companies, stick with them.
Medium term: buy growing companies at the right time, with a stop loss. Say ten percent.
Cut losses short. Stock chart analysis.
Short term: speculation, day trading.
load and no-load.
closed and and open end.
Check on expenses.
Index funds typically low. Vanguard low. But expense can be justified. Best check long run performance: 3+ years. One year or less, return not significant. bear funds.
Index funds, e.g. QQQ. Vanguard total stock market index fund, Wilshire 5000 index.
Options: calls and puts.
LEAP: long-term equity AnticiPations. longer than nine months
Futures markets.
Real estate. REITs. real-estate mutual funds.
Partnerships. Housing tax credits. Tax advantages with partnerships.
Oil and gas. Stocks, funds, partnerships.
Gold and silver.
Stamps and coins. Common versus rare. Common stamps don't become valuable.
Gems, diamonds. Need knowledge, or reputable dealer.
Financial managers versus do-it-yourself. Manager good for discipline.