1. Chapter 11 Charles P. Jones, Investments: Analysis and Management, Eleventh Edition, John Wiley & Sons 11 -1

2.  Pervasive and dominant  The single most important risk affecting the price movement of common stocks ◦ Particularly true for a diversified portfolio of stocks  Accounts for 90% of the variability in a diversified portfolio’s return  Investors buying foreign stocks face the same situation 11 -2

3.  Minimum expected rate of return needed to induce investment ◦ Given risk, a security must offer some minimum expected return to persuade purchase ◦ Required RoR = RF + Risk premium ◦ Investors expect the risk free rate as well as a risk premium to compensate for the additional risk assumed 11 -3

4.  Beta = 1.0 implies as risky as market  Securities A and B are more risky than the market ◦ Beta >1.0  Security C is less risky than the market ◦ Beta <1.0 11-4 A B C kMkM k RF 01.02.00.51.5 SML Beta M E(R)

5.  Risk-free rate  RF =Real RoR +Inflation premium ◦ Real rate of return is basic exchange rate in the economy ◦ Nominal RF must contain premium for expected inflation  The risk premium ◦ Reflects all uncertainty in the asset 11 -5

6.  Natural outcome of a belief in efficient markets ◦ No active strategy should be able to beat the market on a risk adjusted basis  Emphasis is on minimizing transaction costs and time spent in managing the portfolio ◦ Expected benefits from active trading or analysis less than the costs 11 -6

7.  Buy-and-hold strategy ◦ Belief that active management will incur transaction costs and involve inevitable mistakes ◦ Important initial selection needs to be made ◦ Functions to perform: reinvesting income and adjusting to changes in risk tolerance 11 -7

8.  Index funds ◦ Mutual funds designed to duplicate the performance of some market index ◦ No attempt made to forecast market movements and act accordingly ◦ No attempt to select under- or overvalued securities ◦ Low costs to operate, low turnover 11 -8

9.  Assumes the investor possesses some advantage relative to other market participants ◦ Most investors favor this approach despite evidence about efficient markets  Identification of individual stocks as offering superior return-risk tradeoff ◦ Selections part of a diversified portfolio 11 -9

10.  Majority of investment advice geared to selection of stocks ◦ Value Line Investment Survey  Security analyst’s job is to forecast stock returns ◦ Estimates provided by analysts  expected change in earnings per share, expected return on equity, and industry outlook ◦ Recommendations: Buy, Hold, or Sell 11 - 10

11.  Similar to stock selection, involves shifting sector weights in the portfolio ◦ Benefit from sectors expected to perform relatively well and de-emphasize sectors expected to perform poorly  Four broad sectors: ◦ Interest-sensitive stocks, consumer durable stocks, capital goods stocks, and defensive stocks 11 - 11

12.  Market timers attempt to earn excess returns by varying the percentage of portfolio assets in equity securities ◦ Increase portfolio beta when the market is expected to rise  Success depends on the amount of brokerage commissions and taxes paid ◦ Can investors regularly time the market to provide positive risk-adjusted returns? 11 - 12

13.  If EMH true: ◦ Active strategies are unlikely to be successful over time after all costs ◦ If markets efficient, prices reflect fair economic value  EMH Proponents argue that little time should be devoted to security analysis ◦ Time spent on reducing taxes, costs and maintaining chosen portfolio risk 11 - 13

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