Investment Models Securities and Investments

Why Use Investment Models? All investors expect to earn money on their investments. All investors wish they could predict the future so they would know which investments will earn the greatest returns. Investors could close their eyes and pick investments randomly, but that could be very risky. All investors want to eliminate as much risk as possible. Investment models provide tools for selecting investments. Copyright © Texas Education Agency, All rights reserved. 2

Measures of Risk  Beta - a measure of volatility of a company’s stock compared to the entire industry  Variance – the calculation of the measurement of risk involved, can be reduced through diversification Copyright © Texas Education Agency, All rights reserved. 3

Capital Asset Pricing Model (CAPM) Used for pricing risky securities Formula includes a return for a risk-free security in addition to a premium which accounts for the additional risk Example: If an expected rate of return for a lower-risk security is 2% with a beta of 2 (industry average) and the projected return for the particular market is 8%, the selected stock should generate a 14% return (2% + 2(8%-2%)) Copyright © Texas Education Agency, All rights reserved. 4

Capital Asset Pricing Model (CAPM) – cont.  Uses beta as an indicator-compares a stock’s performance to the market as a whole o >1 can mean the particular stock is more volatile than the market as a whole o <1 can indicate slower movement than the market  Contains risk that cannot be eliminated through diversification  Also contains risk that can be reduced through diversifying Copyright © Texas Education Agency, All rights reserved. 5

Arbitrage Pricing Theory Stephen Ross created this theory in 1976 Assumes that the asset in question may not be priced accurately Studies the investment itself as opposed to the entire market Copyright © Texas Education Agency, All rights reserved. 6

Modern Portfolio Theory Investors construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward. Copyright © Texas Education Agency, All rights reserved. 7

Modern Portfolio Theory Assumes inherent market risk but attempts to reduce risk through diversification The diversification can raise returns due to the balancing of risky and less-risky investments The risk of one stock or investment is higher than a combination of different types of investments or stock in different companies. Copyright © Texas Education Agency, All rights reserved. 8

Modern Portfolio Theory According to the theory, it's possible to construct an "efficient frontier" of optimal portfolios offering the maximum possible expected return for a given level of risk. This theory was pioneered by Harry Markowitz in his paper "Portfolio Selection," published in 1952 by the Journal of Finance. Copyright © Texas Education Agency, All rights reserved. 9

Four basic steps: -Security valuation -Asset allocation -Portfolio optimization -Performance measurement 10

Measurements Used: Alpha Beta Standard Deviation R-Squared Sharpe Ratio Copyright © Texas Education Agency, All rights reserved. 11

Alpha A measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund's alpha. Copyright © Texas Education Agency, All rights reserved. 12

Beta A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Copyright © Texas Education Agency, All rights reserved. 13

Standard Deviation Standard deviation is a statistical measurement that sheds light on historical volatility. For example, a volatile stock will have a high standard deviation while the deviation of a stable blue chip stock will be lower. A large dispersion tells us how much the return on the fund is deviating from the expected normal returns. Copyright © Texas Education Agency, All rights reserved. 14

R-Squared R-squared values range from 0 to 100. An R- squared of 100 means that all movements of a security are completely explained by movements in the index. A high R-squared (between 85 and 100) indicates the fund's performance patterns have been in line with the index. A fund with a low R-squared (70 or less) doesn't act much like the index. Copyright © Texas Education Agency, All rights reserved. 15

Sharpe Ratio The Sharpe ratio is often used to compare the change in a portfolio's overall risk-return characteristics when a new asset or asset class is added to it. Copyright © Texas Education Agency, All rights reserved. 16

Venture Capital  Venture capital is money invested in a business, usually a new or small business with a high potential for growth.  Businesses financed with venture capital are usually extremely risky.  The investors are considered part owners.  These owners can create their own ‘fund’ Copyright © Texas Education Agency, All rights reserved. 17

Venture Capital (continued)  These funds are more risky than mutual funds because the companies being funded are risky themselves, being new and growth-oriented.  The performance measurement for the fund is basically the internal rate of return of the money invested in the fund Copyright © Texas Education Agency, All rights reserved. 18

Angels v. Sharks Angels (private money) invest in 55,000 startups each year versus 1,500 companies by VC (venture capital) funding. Last year, angel investments surpassed VC’s by $3 billion (15%). Angels invest in one out of every forty deals they review (2.5%) versus the one out of 400 by VC’s (0.25%). There are 225,000 angels who made investments over the last two years and only 15,000 of them belong to angel groups. Furthermore, according to the IRS, about 3.9 million people qualify as accredited investors. Copyright © Texas Education Agency, All rights reserved. 19