UNIT 1

CONCEPTS OF INVESTMENT
1. Have a Financial Plan

The first step toward becoming a successful investor should be starting with a financial plan—
one that includes goals and milestones. These goals and milestones would include setting targets
for having specific amounts saved by specific dates.

The goals in question might include, for example, having enough savings to facilitate buying a
home, funding your children's educations, building an emergency fund, having enough to fund
an entrepreneurial venture, or having enough to fund a comfortable retirement.

Moreover, while most people think in terms of saving for retirement, an even more desirable
goal would be to achieve financial independence at as early an age as possible. A movement
devoted to this goal is Financial Independence, Retire Early (FIRE).

While it is possible to create a solid financial plan on your own, if you are new to the process,
you might consider enlisting professional help from someone such as a financial
advisor or financial planner, preferably one who is a Certified Financial Planner (CFP®).
Finally, do not delay. Seek to have a plan in place as early as possible in your lifetime, and keep
it a living document, updated regularly and in light of changed circumstances and goals.

The FIRE Movement

The FIRE (Financial Independence, Retire Early) movement argues for rapid wealth
accumulation far in advance of the traditional retirement age to give you more options in life,
earlier on.

2. Make Saving a Priority

Before you can become an investor, you must have money to invest. For most people, that will
require setting aside a portion of each paycheck for savings. If your employer offers a savings
plan such as a 401(k), this can be an attractive way to make saving automatic, especially if your
employer will match all or part of your own contributions.

In setting up your financial plan, you also might consider other alternatives for making saving
automatic, in addition to utilizing employer-sponsored plans. Building wealth typically has
aggressive saving at its core, followed by astute investing aimed at making those savings grow.

Also, a key to saving aggressively is living frugally and spending with caution. In this vein, a
wise adjunct to your financial plan would be creating a budget, tracking your spending closely,
and regularly reviewing whether your outlays are making sense and delivering sufficient value.
Various budgeting apps and budgeting software packages  are available, or you can choose to
create your own spreadsheets.

3. Understand the Power of Compounding

Saving and investing on a regular, systematic basis and starting this discipline as early as
possible in life will allow you to take full advantage of the power of compounding to increase
your wealth. The current protracted period of historically low interest rates has diminished the
power of compounding to some extent, but it also has made starting early to build savings and
wealth more imperative, since it will take interest-bearing and dividend-paying investments
longer to double in value than before, all else equal.1

4. Understand Risk

Investment risk has many aspects, such as default risk on a bond (the risk that the issuer may
not meet its obligations to pay interest or repay principal) and volatility in stocks (which can
produce sharp, sudden increases or decreases in value). Additionally, there is, in general,
a tradeoff between risk and return, or between risk and reward. That is, the route to achieving
higher returns on your investments often involves assuming more risk, including the risk of
losing all or part of your investment.

As a critical part of your planning process, you should determine your own risk tolerance. How
much you can be prepared to lose should a prospective investment decline in value, and how
much ongoing price volatility in your investments you can accept without inducing undue
worry, will be important considerations in determining what sorts of investments are most
appropriate for you.

Risk
At its most basic level, investment risk includes the possibility of a complete loss. But there are
many other aspects to risk and its measurement.

5. Understand Diversification and Asset Allocation

Diversification and asset allocation are two closely related concepts that play important roles
both in managing investment risk and in optimizing investment returns. Broadly speaking,
diversification involves spreading your investment portfolio among a variety of investments, in
hopes that subpar returns or losses in some may be offset by above average returns or gains in
others. Likewise, asset allocation has similar goals, but with the focus being on distributing your
portfolio across major categories of investments, such as stocks, bonds, and cash.

Once again, your ongoing financial planning process should revisit your decisions on
diversification and asset allocation regularly.

6. Keep Costs Low

You cannot control the future returns on your investments, but you can control the costs.
Moreover, costs (e.g., transaction costs, investment management fees, account fees, etc.) can be
a significant drag on investment performance. Similarly, taking mutual funds as just one
example, high cost is no guarantee of better performance.

The Importance of Costs

Investment costs and fees are often a key determinant of investment results.

7. Understand Classic Investment Strategies

Among the investment strategies that the beginning investor should understand fully
are active versus passive investing, value versus growth investing, and income-
oriented versus gains-oriented investing.

While savvy investment managers can beat the market, very few do it consistently over the long
term. This leads some investment pundits to recommend low-cost passive investing strategies,
mainly those utilizing index funds, that seek to track the market.

In the realm of equity investing, value investors prefer stocks that appear to be relatively
inexpensive compared to the market on measures such as price-earnings ratios (P/E), expecting
that these stocks have upside potential as well as limited downside risk. Growth investors, by
contrast, see greater opportunity for gain among stocks that are recording rapid increases in
revenues and earnings, even if they are relatively expensive.

Income-oriented investors seek a steady stream of dividends and interest, either because they
need the ongoing spendable cash or because they see this as a strategy that limits investment
risk, or both. Among the variations of income-oriented investing is focusing on stocks that
offer dividend growth.

Gains-oriented investors are largely unconcerned about income streams from their investments
and instead look for the investments that seem likely to deliver the most price appreciation in
the long term.

8. Be Disciplined

If you are indeed investing for the long term, according to a well-thought and well-constructed
financial plan, stay disciplined. Try not to get excited or rattled by temporary market
fluctuations and panic-inducing media coverage of the markets that might border on the
sensationalistic. Also, always take the pronouncements of market pundits with a grain of salt
unless they have lengthy independently verified track records of predictive accuracy. Few do.

9. Think Like an Owner or Lender

Stocks are shares of ownership in a business enterprise. Bonds represent loans extended by the

investor to the issuer. If you intend to be an intelligent long-term investor rather than a short-
term speculator, think like a prospective business owner before you buy a stock, or like a
prospective lender before you buy a bond. Do you want to be a part owner of that business, or a
creditor of that issuer?

10. If You Don’t Understand It, Don’t Invest in It

Given the proliferation of complex and novel investment products, as well as of companies with
complex and novel business models, beginning investors today are faced with a vast array of
investment choice that they may not fully understand. A simple and wise rule of thumb is never
to make an investment that you do not fully understand, particularly when it comes to its risks.
A corollary is to be very careful about avoiding investing fads, many of which may not stand
the test of time.

What Are Basic Investment Objectives?

Safety

It is said that there is no such thing as a completely safe and secure investment. But you can get
close.

Investing in government-issued securities in stable economic systems is one. U.S.-issued bonds

remain the gold standard. You must envision the collapse of the U.S. government to worry
about losing your investment in them.1

Next in safety are AAA-rated corporate bonds issued by large, stable companies. Such
securities are arguably the best means of preserving your principal while receiving a pre-set rate
of interest.2

The risks are like those of government bonds. You'd have to imagine IBM or Costco going
bankrupt in order to worry about losing money investing in their bonds.

Extremely safe investments also are found in the money market. In order of increasing risk,
these securities include Treasury bills (T-bills), certificates of deposit (CDs), commercial paper,
or bankers' acceptance slips.

Safety comes at a price. The returns are very modest compared to the potential returns of riskier
investments. This is called "opportunity risk." Those who choose the safest investments may be
giving up big gains.

There also is, to some extent, interest rate risk. That is, you could tie your money up in a bond
that pays a 1% return, and then watch as inflation rises to 2%. You have just lost money in
terms of real spending power.
That is why the very safest investments are short-term instruments such as 3-month and 6-
month CDs. And those safest investments pay the least of all in interest.3

Income

Investors who focus on income may buy some of the same fixed-income assets that are
described above. But their priorities shift towards income. They're looking for assets that
guarantee a steady income supplement. And to get there they may accept a bit more risk.

This is often the priority of retirees who want to generate a stable source of monthly income
while keeping up with inflation.

Government and corporate bonds may be in the mix, and an income investor may go beyond the
safest AAA-rated choices and will go longer than short-term CDs.45

The ratings are assigned by a rating agency that evaluates the financial stability of the company
or government issuing the bond. Bonds rated at A or AA are only slightly riskier than AAA
bonds but offer a higher rate of return. BBB-rated bonds carry a medium risk but more income.6

Below that, you're in junk bond territory and the word safety does not apply.

Income investors may also buy preferred stock shares or common stocks that historically pay
good dividends.

Capital Growth

Capital growth is achieved only by selling an asset. Stocks are capital assets. Barring dividend
payments, their owners must cash them in to realize gains.

There are many other types of capital growth assets, from diamonds to real estate. What they all
share is some degree of risk to the investor. Selling at lower than the price paid is referred to as
a capital loss.

The stock markets offer some of the most speculative investments available since their returns
are unpredictable. But there is risky and riskier.

Blue-chip stocks are generally considered the best of the bunch as many of them offer
reasonable safety, modest income from dividends, and potential for capital growth over the long
term.

Growth stocks are for those who can tolerate some ups and downs. These are the fast-growing
young companies that may grow up to be Amazons. Or they might crash spectacularly.

The dividend stars are established companies that may not grow in leaps and bounds but pay
steady dividends year after year.7
 
Profits on stocks offer the advantage of a lower tax rate if they are held for a year or more.8

Many individual investors avoid stock-picking and go with one or more exchange-traded

funds or mutual funds, which can get them stakes in a broad selection of stocks.

One built-in bonus of stocks is a favorable tax rate. Profits from stock sales, if the stocks are
owned for at least a year, are taxed at the capital gains rate, which is lower than the income tax
rates paid by most.

Secondary Objectives

Safety, income, and capital gains are the big three objectives of investing. But there are others
that should be kept in mind when they choose investments.

Tax Minimization: Some investors pursue tax minimization as a factor in their choices. A

highly paid executive, for example, may seek investments with favorable tax treatment to lessen
the overall income tax burden.

Contributing to an individual retirement account or any other tax-advantaged retirement plan is

a highly effective tax minimization strategy for all of us.

Liquidity: Investments such as bonds or bond funds are relatively liquid, meaning they can in
many cases be converted into cash quickly and with little risk of loss. Stocks are less liquid
since they can be sold easily but selling at the wrong time can cause a serious loss.

Many other investments are illiquid. Real estate or art can be excellent investments unless you
are forced to sell them at the wrong time.

The safest investments are found in the money market. They include T-bills, CDs, commercial
paper, or bankers' acceptance slips. Other safe investments include highly rated government
and corporate bonds.

What is Investing Process?

When we speak of investment, I am sure most of you would think of investing in some fixed
deposit or investing in a property or some of you would even buy gold. But there is much more
to investing. An investment is the purchase of an asset with an expectation to receive return or
some other income on that asset in future. The process of investment involves careful study and
analysis of the various classes of assets and the risk-return ratio attached to it.

An investment process is a set of guidelines that govern the behavior of investors in a way which
allows them to remain faithful to the tenets of their investment strategy, that is the key
principles which they hope to facilitate out-performance.
There are 5 investing process steps that help you in selecting and investing in the best asset class
according to your needs and preferences. Read here is details every note on process of investing.

Step 1- Understanding the Client

The first and the foremost step of investing process is to understand the client or the investor
his/her needs, his risk-taking capacity and his tax status. After getting an insight of the goals and
restraints of the client, it is important to set a benchmark for the client’s portfolio management
process which will help in evaluating the performance and check whether the client’s objectives
are achieved.

Step 2- Asset Allocation Decision

This step involves decision on how to allocate the investment across different asset classes, i.e.
fixed income securities, equity, real estate etc. It also involves decision of whether to invest in
domestic assets or in foreign assets. The investor will make this decision after considering the
macroeconomic conditions and overall market status.

Step 3- Portfolio Strategy Selection

Third step in the investment process is to select the proper strategy of portfolio creation.
Choosing the right strategy for portfolio creation is very important as it forms the basis of
selecting the assets that will be added in the portfolio management process. The strategy that
conforms to the investment policies and investment objectives should be selected.

There are two types of portfolio strategy.

1. Active Management Process

2. Passive Management Process

Active portfolio management process refers to a strategy where the objective of investing is to

outperform the market return compared to a specific benchmark by either buying securities that
are undervalued or by short selling securities that are overvalued.  In this strategy, risk and return
both are high. This strategy is a proactive strategy it requires close attention by the investor or
the fund manager.

Passive portfolio management process refers to the strategy where the purpose is to generate
returns equal to that of the market. It is a reactive strategy as the fund manager, or the investor
reacts after the market has responded.

Step 4- Asset Selection Decision

The investor needs to select the assets to be placed in the portfolio management process in the
fourth step. Within each asset class, there are different sub asset-classes. For example, in equity,
which stocks should be chosen? Within the fixed income securities class, which bonds should be
chosen?
Also, the investment objectives should conform to the investment policies because otherwise the
main purpose of investment management process would become meaningless.

Step 5- Evaluating Portfolio Performance

This is the final step in the investment process which evaluates the portfolio management
performance. This is an important investing process step as it measures the performance of the
investment with respect to a benchmark, in both absolute and relative terms. The investor would
determine whether his objectives are being achieved or not.

What Is a Contrarian?
Contrarian investing is an investment style in which investors purposefully go against
prevailing market trends by selling when others are buying and buying when most investors are
selling. Berkshire Hathaway Chair and Chief Executive Officer (CEO) Warren Buffett is a
famous contrarian investor.

Contrarian investors believe that people who say the market is going up do so only when they
are fully invested and have no further purchasing power. At this point, the market is at a peak.
So, when people predict a downturn, they have already sold out, and the market can only go up
at this point.

KEY TAKEAWAYS

 Contrarian investing is an investment strategy that involves bucking against existing

market trends to generate profits.
 The idea is that markets are subject to herding behavior augmented by fear and greed,
making markets periodically over- and underpriced.
 The contrarian sees buying opportunities in stocks that are currently selling for below
their intrinsic value.
 Being a contrarian can be rewarding, but it is often a risky strategy that may take a long
period of time to pay off.
 Another drawback associated with being a contrarian investor is the need to spend a
good deal of time researching stocks to find undervalued opportunities.

Understanding Contrarian Strategy

Contrarian investing is, as the name implies, a strategy that involves going against the grain
of investor sentiment at a given time. The principles behind contrarian investing can be applied
to individual stocks, an industry, or even entire markets.

A contrarian investor enters the market when others are feeling negative about it. The contrarian
believes the value of the market or stock is below its intrinsic value and thus represents an
opportunity. In essence, an abundance of pessimism among other investors has pushed the price
of the stock below what it should be, and the contrarian investor will buy that before the broader
sentiment returns and the share prices rebound.

According to David Dreman, contrarian investor and author of Contrarian Investment

Strategies: The Next Generation, investors overreact to news developments and overprice "hot"
stocks and underestimate the earnings of distressed stocks. This overreaction results in limited
upward price movement and steep falls for stocks that are "hot" and leaves room for the
contrarian investor to choose underpriced stocks .

What is Momentum Investing?

Momentum investing is an investment strategy aimed at purchasing securities that have been
showing an upward price trend or short-selling securities that have been showing a downward
trend. The main rationale behind momentum investing is that once a trend is well-established, it
likely to continue.

There is no consensus among economists and finance professionals regarding the validity of a

momentum investing strategy. Economists try to explain the effects of momentum investing
using the efficient-market theory.

One hypothesis state that investors bear a significant risk when implementing a momentum
investing strategy. Potentially high returns are the reward that counterbalances that risk. Another
hypothesis suggests that momentum investors are leveraging the behavioral weaknesses of other
investors, such as the tendency to “follow the herd”, also known as the “herd mentality bias”.

How Momentum Investing Works

Traders employing a momentum investing strategy look to profit from either buying or selling
short securities when they are strongly trending – i.e., when price action momentum is high.
High momentum is evidenced by price advancing or declining over a wide range in a relatively
short period of time. Markets with high levels of momentum typically show increased volatility
as well.

Momentum investing is typically short-term investing, as traders are merely looking to capture
part of the price movement in a trend. A momentum investing trade unfolds as follows:

1. A trader uses technical indicators such as trend lines, moving averages, and specific
momentum indicators such as the ADX to identify the existence of a trend.
2. As the trend gains momentum – strengthens – the trader takes a market position in the
direction of the trend (buying an uptrend, selling a downtrend).
3. When the momentum of the trend shows signs of weakening, such as a divergence
between price action and the movement of momentum indicators such as the MACD or
RSI, the trader looks to exit their position (hopefully at a profit), prior to any actual trend
reversal.
1. High-yield savings accounts

Overview: A high-yield online savings account pays you interest on your cash balance. And just
like a savings account earning pennies at your brick-and-mortar bank, high-yield online savings
accounts are accessible vehicles for your cash.

Who are they good for? A savings account is a good vehicle for those who need to access cash
in the near future. A high-yield savings account also works well for risk-averse investors, and
want to avoid the risk that they won’t get their money back.

Risks: The banks that offer these accounts are FDIC-insured, so you don’t have to worry about
losing your deposit.

While high-yield savings accounts are considered safe investments, like CDs, you do run the risk
of losing purchasing power over time due to inflation, if rates are too low.

Rewards: With fewer overhead costs, you can typically earn much higher interest rates at online
banks.

Plus, you can typically access the money by quickly transferring it to your primary bank or
maybe even via an ATM.

Where to get them: You can browse Bankrate’s list of best high-yield savings accounts for a
top rate. Otherwise, banks and credit unions offer a savings account, though you may not get the
best rate.

2. Short-term certificates of deposit

Overview: Certificates of deposit, or CDs, are issued by banks and generally offer a higher
interest rate than savings accounts. And short-term CDs may be better options when you expect
rates to rise, allowing you to re-invest at higher rates when the CD matures.

Who are they good for? Because of their safety and higher payouts, CDs can be a good choice
for retirees who don’t need immediate income and are able to lock up their money for a little bit.
A CD works well for risk-averse investors, especially those who need money at a specific time
and can tie up their cash in exchange for a bit more yield than they’d find on a savings account.

Risks: CDs are considered safe investments. But they do carry reinvestment risk — the risk that
when interest rates fall, investors will earn less when they reinvest principal and interest in new
CDs with lower rates, as we saw in 2020 and 2021.

The opposite risk is that rates will rise and investors won’t be able to take advantage because
they’ve already locked their money into a CD. And with rates expected to rise even further in
2022, it may make sense to stick to short-term CDs, so that you can reinvest at higher rates in the
near future.
It’s important to note that inflation and taxes could significantly erode the purchasing power of
your investment.

Rewards: With a CD, the financial institution pays you interest at regular intervals. Once it
matures, you get your original principal back plus any accrued interest.

It pays to shop around online for the best rates.

Where to get them: Bankrate’s list of best CD rates will help you find the best rate across the
nation, instead of having to rely on what’s available only in your local area.

Alternatively, banks and credit unions typically offer CDs, though you’re not likely to find the
best rate locally.

3. Short-term government bond funds

Overview: Government bond funds are mutual funds or ETFs that invest in debt securities
issued by the U.S. government and its agencies. Like short-term CDs, short-term government
bond funds don’t expose you to much risk when interest rates rise, as they did in 2022.

Who are they good for? The funds invest in U.S. government debt and mortgage-backed
securities issued by government-sponsored enterprises. These government bond funds are well-
suited for the low-risk investor. These funds can also be a good choice for beginning investors
and those looking for cash flow. Government bond funds may work well for risk-averse
investors, though some types of funds (like long-term bond funds) may fluctuate a lot more than
short-term funds due to changes in the interest rate.

Risks: Funds that invest in government debt instruments are considered to be among the safest
investments because the bonds are backed by the full faith and credit of the U.S. government.

If interest rates rise, the prices of existing bonds drop; and if interest rates decline, the prices of
existing bonds rise. Interest rate risk is greater for long-term bonds than it is for short-term
bonds, however. Short-term bond funds will have minimal impact from rising rates, and the
funds will gradually increase their interest rate as prevailing rates rise.

However, if inflation stays high, the interest rate may not keep up and you’ll lose purchasing
power.

Rewards: Bond funds pay out on a monthly basis, and with rates surging higher in 2022, these
funds pay quite a bit more than they have in the recent past.

Where to get them: You can buy bond funds at many online brokers, namely those that allow
you to trade ETFs or mutual funds. Most brokers that offer ETFs allow you to buy and sell them
at no commission, while mutual funds may require you to pay a commission or make a minimum
purchase, though not always.
4. Series I bonds

Overview: The U.S. Treasury issues savings bonds for individual investors, and an increasingly
popular option in 2022 is the Series I bond. This bond helps build in protection against inflation.
It pays a base interest rate and then adds on a component based on the inflation rate. The result:
If inflation rises, so does the payout. But the reverse is true: If inflation falls, so will the interest
rate. The inflation adjustment resets every six months.

Who are they good for? Like other government-issued debt, Series I bonds are attractive for
risk-averse investors who do not want to run any risk of default. These bonds are also a good
option for investors who want to protect their investment against inflation. However, investors
are limited to buying $10,000 in any single calendar year, though you can apply up to an
additional $5,000 in your annual tax refund to the purchase of Series I bonds, too. (And there’s a
little-known secret to get around that annual limit, too.)

Risks: The Series I bond protects your investment against inflation, which is a key downside to
investing in most bonds. And like other government-issued debt, these bonds are considered
among the safest in the world against the risk of default.

Rewards: Series I bond earn interest for 30 years if they are not redeemed for cash, but the rate
will fluctuate with the prevailing rate of inflation.

Where to get them: You can buy Series I bonds directly from the U.S. Treasury
at treasurydirect.gov. The government will not charge you a commission for doing so.

5. Short-term corporate bond funds

Overview: Corporations sometimes raise money by issuing bonds to investors, and these can be
packaged into bond funds that own bonds issued by potentially hundreds of corporations.

Short-term bonds have an average maturity of one to five years, which makes them less
susceptible to interest rate fluctuations than intermediate- or long-term bonds.

Who are they good for? Corporate bond funds can be an excellent choice for investors looking
for cash flow, such as retirees, or those who want to reduce their overall portfolio risk but still
earn a return. Short-term corporate bond funds can be good for risk-averse investors who want a
bit more yield than government bond funds.

Risks: As is the case with other bond funds, short-term corporate bond funds are not FDIC-
insured.

There is always the chance that companies will have their credit rating downgraded or run into
financial trouble and default on the bonds. To reduce that risk, make sure your fund is made up
of high-quality corporate bonds.
Rewards: Investment-grade short-term bond funds often reward investors with higher returns
than government and municipal bond funds. But the greater rewards come with added risk.

Where to get them: You can buy and sell corporate bond funds with any broker that allows you
to trade ETFs or mutual funds.

Most brokers allow you to trade ETFs for no commission, whereas many brokers may require a
commission or a minimum purchase to buy a mutual fund.

6. S&P 500 index funds

Overview: The fund is based on about five hundred of the largest American companies, meaning
it comprises many of the most successful companies in the world. For
example, Amazon and Berkshire Hathaway are two of the most prominent member companies in
the index.

Who are they good for? If you want to achieve higher returns than more traditional banking
products or bonds, a good alternative is an S&P 500 index fund, though it does come with more
volatility. An S&P 500 index fund is an excellent choice for beginning investors, because it
provides broad, diversified exposure to the stock market. An S&P 500 index fund is a good
choice for any stock investor looking for a diversified investment and who can stay invested for
at least three to five years.

Risks: An S&P 500 fund is one of the less-risky ways to invest in stocks, because it’s made up
of the market’s top companies and is highly diversified. Of course, it still includes stocks, so it’s
going to be more volatile than bonds or any bank products.

It’s also not insured by the government, so you can lose money based upon fluctuations in value.
However, the index has done quite well over time.

The index rallied furiously after its pandemic-driven plunge in March 2020, but has performed
poorly in 2022, so investors may want to proceed with caution and stick to their long-term
investment plan.

Rewards: Like nearly any fund, an S&P 500 index fund offers immediate diversification,
allowing you to own a piece of all of those companies. The fund includes companies from every
industry, making it more resilient than many investments.

Over time, the index has returned about 10 percent annually. These funds can be purchased
with very low expense ratios (how much the management company charges to run the fund) and
they’re some of the best index funds.

Where to get them: You can purchase an S&P 500 index fund at any broker that allows you to
trade ETFs or mutual funds. ETFs are typically commission-free, so you won’t pay any extra
charge, whereas mutual funds may change a commission and require you to make a minimum
purchase.
7. Dividend stock funds

Overview: Dividends are portions of a company’s profit that can be paid out to shareholders,
usually on a quarterly basis.

Who are they good for? Buying individual stocks, whether they pay dividends or not, is better
suited for intermediate and advanced investors. But you can buy a group of them in a stock fund
and reduce your risk. Dividend stock funds are a good selection for almost any kind of stock
investor but can be better for those who are looking for income. Those who need income and can
stay invested for longer periods of time may find these attractive.

Risks: As with any stock investments, dividend stocks come with risk. They’re considered safer
than growth stocks or other non-dividend stocks, but you should choose your portfolio carefully.

Make sure you invest in companies with a solid history of dividend increases rather than
selecting those with the highest current yield. That could be a sign of upcoming trouble.
However, even well-regarded companies can be hit by a crisis, so a good reputation is finally not
a protection against the company slashing its dividend or eliminating it entirely.

However, you eliminate many of these risks by buying a dividend stock fund with a diversified
collection of assets, reducing your reliance on any single company.

Rewards: Even your stock market investments can become a little safer with stocks that pay
dividends.

With a dividend stock, not only can you gain on your investment through long-term market
appreciation, you’ll also earn cash in the short term.

Where to get them: Dividend stock funds are available as either ETFs or mutual funds at any
broker that deals in them. ETFs may be more advantageous, because they often have no
minimum purchase amount and are typically commission-free.

In contrast, mutual funds may require a minimum purchase and your broker may charge a
commission for them, depending on the broker.

8. Value stock funds

Overview: These funds invest in value stocks, those that are more bargain-priced than others in
the market.

Who are they good for? When stocks run up in valuation as they do from time to time, many
investors wonder where they can put their investment dollars. Value stock funds may be a good
option. Value stock funds are good for investors who are comfortable with the volatility
associated with investing in stocks. Investors in stock funds need to have a longer-term investing
horizon, too, at least three to five years to ride out any bumps in the market.
Risks: Value stock funds will tend to be safer than other kinds of stock funds because of their
bargain price, but they’re still composed of stocks, so they will fluctuate a lot more than safer
investments such as short-term bonds.

Value stock funds are not insured by the government, either.

Rewards: Value stocks tend to do better as interest rates rise and growth stocks become less
attractive on a relative basis.

Many value stock funds also pay a dividend, so that’s an additional attraction for many investors.

Where to get them: Value stock funds can come in two major types: ETFs or mutual funds.
ETFs are usually available commission-free and without a minimum purchase requirement at
most major online brokers.

However, mutual funds may require a minimum purchase and online brokers may charge a
commission to trade them.

9. Nasdaq-100 index funds

Overview: An index fund based on the Nasdaq-100 is a great choice for investors who want to
have exposure to some of the biggest and best tech companies without having to pick the
winners and losers or having to analyze specific companies.

The fund is based on the Nasdaq’s 100 largest companies, meaning they’re among the most
successful and stable. Such companies include Apple and Alphabet, each of which comprises a
large portion of the total index. Microsoft is another prominent member company.

Who are they good for? A Nasdaq-100 index fund is a good selection for stock investors
looking for growth and willing to deal with significant volatility. Investors should be able to
commit to holding it for at least three to five years. Using dollar-cost averaging to buy into an
index fund trading at all-time highs can help reduce your risk, compared to buying in with a
lump sum.

Risks: Like any publicly traded stock, this collection of stocks can move down, too. While the
Nasdaq-100 has some of the strongest tech companies, these companies also are usually some of
the most highly valued.

That high valuation means that they’re likely prone to falling quickly in a downturn, though they
may rise quickly during an economic recovery.

Rewards: A Nasdaq-100 index fund offers you immediate diversification, so that your portfolio
is not exposed to the failure of any single company.

The best Nasdaq index funds charge a very low expense ratio, and they’re a cheap way to own
all the companies in the index.
Where to get them: Nasdaq-100 index funds are available as both ETFs and mutual funds. Most
brokers allow you to trade ETFs without a commission, while mutual funds may charge a
commission and have a minimum purchase amount.

10. Rental housing

Overview: Rental housing can be a great investment if you have the willingness to manage your
own properties. To pursue this route, you’ll have to select the right property, finance it or buy it
outright, maintain it and deal with tenants. You can do very well if you make smart purchases.

Who are they good for? Rental housing is a good investment for long-term investors who want
to manage their own properties and generate regular cash flow.

Risks: You won’t enjoy the ease of buying and selling your assets in the stock market with a
click or a tap on your internet-enabled device.

Worse, you might have to endure the occasional 3 a.m. call about a burst pipe.

Rewards: Despite mortgage rates climbing higher, it still may be a good time to finance the
purchase of a new property, though the unstable economy may make it harder to actually run it.

If you hold your assets over time, gradually pay down debt and grow your rents, you’ll likely
have a powerful cash flow when it comes time to retire.

Where to get them: You’ll likely need to work with a real estate broker to find rental housing,
or you can work on building out a network that may be able to source you better deals before
they hit the market.

11. Cryptocurrency

Overview: Cryptocurrency is a kind of digital electronic-only currency that is intended to act as

a medium of exchange. It has become a hot property in the last few years in particular, as dollars
flew into the asset, pushing up prices and drawing even more traders to the action.

Bitcoin is the most widely available cryptocurrency, and its price fluctuates a lot, attracting many
traders. For example, from a price below $10,000 a coin at the start of 2020, Bitcoin soared to
around $30,000 at the start of 2021. Then it doubled above the $60,000 mark, before falling back
significantly in 2022.

Who are they good for? Cryptocurrency is good for risk-seeking investors who wouldn’t mind
if their investment goes to zero in exchange for the potential of much higher returns. It’s not a
good choice for risk-averse investors or those who need any kind of safe investment.

Risks: Cryptocurrency has very significant risks, including ones that could turn any individual
currency into a complete zero, such as being outlawed or heavily regulated. Digital currencies
are highly volatile and may fall (or rise) precipitously even over very short time frames, and the
price depends entirely on what traders will pay.

Traders also run some risk of being hacked, given some high-profile thefts in the past. And if
you’re investing in cryptocurrencies, you’ll have to pick the winners that manage to stick around,
when many could well disappear entirely.

Unlike other assets listed here, it’s not backed by the FDIC or the money-generating power of
either a government or company. It’s worth is determined solely by what traders will pay for it.

Rewards: This year has been particularly rough for cryptocurrency, with most of the top cryptos
declining sharply.

However, many cryptos such as Bitcoin are coming off all-time highs, so those who bought years
ago and held (or HODL) may still be sitting on some pretty nice gains, despite the recent plunge.

Where to get them: Cryptocurrency is available at many brokers, including Interactive

Brokers, Webull and TradeStation, but often these sources have a selection that is limited to the
most popular coins.

In contrast, a crypto exchange such as Binance or Coinbase may have hundreds of available

cryptos, from the most popular to the relatively obscure.

Types of Security
Debt, equities, derivatives, hybrid securities

What are the Types of Security?

There are four main types of security: debt securities, equity securities, derivative securities, and
hybrid securities, which are a combination of debt and equity.

Summary

 Security is a financial instrument that can be traded between parties in the open market.
 The four types of security are debt, equity, derivative, and hybrid securities.
 Holders of equity securities (e.g., shares) can benefit from capital gains by selling stocks.

Debt Securities

Debt securities, or fixed-income securities, represent money that is borrowed and must be repaid
with terms outlining the amount of the borrowed funds, interest rate, and maturity date. In other
words, debt securities are debt instruments, such as bonds (e.g., a government or municipal
bond) or a certificate of deposit (CD) that can be traded between parties.
Debt securities, such as bonds and certificates of deposit, as a rule, require the holder to make the
regular interest payments, as well as repayment of the principal amount alongside any other
stipulated contractual rights. Such securities are usually issued for a fixed term, and, in the end,
the issuer redeems them.

A debt security’s interest rate on a debt security is determined based on a borrower’s credit

history, track record, and solvency – the ability to repay the loan in the future. The higher the
risk of the borrower’s default on the loan, the higher the interest rate a lender would require
compensating for risk taken.

It is important to mention that the dollar value of the daily trading volume of debt securities is
significantly larger than stocks. The reason is that debt securities are largely held by institutional
investors, alongside governments and not-for-profit organizations.

Equity Securities

Equity securities represent ownership interest held by shareholders in a company. In other words,
it is an investment in an organization’s equity stock to become a shareholder of the organization.

The difference between holders of equity securities and holders of debt securities is that the
former is not entitled to a regular payment, but they can profit from capital gains by selling the
stocks. Another difference is that equity securities provide ownership rights to the holder so that
he becomes one of the owners of the company, owning a stake proportionate to the number of
acquired shares.

In the event a business faces bankruptcy, the equity holders can only share the residual interest
that remains after all obligations have been paid out to debt security holders. Companies
regularly distribute dividends to shareholders sharing the earned profits coming from the core
business operations, whereas it is not the case for the debtholders.

Derivative Securities

Derivative securities are financial instruments whose value depends on basic variables. The
variables can be assets, such as stocks, bonds, currencies, interest rates, market indices, and
goods. The main purpose of using derivatives is to consider and minimize risk. It is achieved by
insuring against price movements, creating favorable conditions for speculations and getting
access to hard-to-reach assets or markets.

Formerly, derivatives were used to ensure balanced exchange rates for goods traded
internationally. International traders needed an accounting system to lock their different national
currencies at a specific exchange rate.
There are four main types of derivative securities:

1. Futures

Futures, also called futures contracts, are an agreement between two parties for the purchase and
delivery of an asset at an agreed-upon price at a future date. Futures are traded on an exchange,
with the contracts already standardized. In a futures transaction, the parties involved must buy or
sell the underlying asset.

2. Forwards

Forwards, or forward contracts, are similar to futures, but do not trade on an exchange, only
retailing. When creating a forward contract, the buyer and seller must determine the terms, size,
and settlement process for the derivative.

Another difference from futures is the risk for both sellers and buyers. The risks arise when one
party becomes bankrupt, and the other party may not able to protect its rights and, as a result,
loses the value of its position.

3. Options

Options, or options contracts, are similar to a futures contract, as it involves the purchase or sale
of an asset between two parties at a predetermined date in the future for a specific price. The key
difference between the two types of contracts is that, with an option, the buyer is not required to
complete the action of buying or selling.

4. Swaps

Swaps involve the exchange of one kind of cash flow with another. For example, an interest rate
swap enables a trader to switch to a variable interest rate loan from a fixed interest rate loan, or
vice versa.

What Is a Real Asset?

Real assets are physical assets that have an intrinsic worth due to their substance and properties.
Real assets include precious metals, commodities, real estate, land, equipment, and natural
resources. They are appropriate for inclusion in most diversified portfolios because of their
relatively low correlation with financial assets, such as stocks and bonds.

KEY TAKEAWAYS

 A real asset is a tangible investment that has an intrinsic value due to its substance and
physical properties.
 Commodities, real estate, equipment, and natural resources are all types of real assets.
  Real assets provide portfolio diversification, as they often move in opposite directions to
financial assets like stocks or bonds.
 Real assets tend to be more stable but less liquid than financial assets.

Hybrid Securities

Hybrid security, as the name suggests, is a type of security that combines characteristics of both
debt and equity securities. Many banks and organizations turn to hybrid securities to borrow
money from investors.

Like bonds, they typically promise to pay a higher interest at a fixed or floating rate until a
certain time in the future. Unlike a bond, the number and timing of interest payments are not
guaranteed. They can even be converted into shares, or an investment can be terminated at any
time.

Examples of hybrid securities are preferred stocks that enable the holder to receive dividends
prior to the holders of common stock, convertible bonds that can be converted into a known
amount of equity stocks during the life of the bond or at maturity date, depending on the terms of
the contract, etc.

Hybrid securities are complex products. Even experienced investors may struggle to understand
and evaluate the risks involved in trading them. Institutional investors sometimes fail at
understanding the terms of the deal they enter while buying hybrid security.
Advantages and Disadvantages of Real Assets
Real assets tend to be more stable than financial assets. Inflation shifts in currency values, and
other macroeconomic factors affect real assets less than financial assets. Real assets are
particularly well-suited investments during inflationary times because of their tendency to
outperform financial assets during such periods. 

In a 2017 report, asset management firm Brookfield cited a global value of real asset equities
totaling $5.6 trillion. Of this total, 57% consisted of natural resources, 23% was real estate, and
20% was in infrastructure. In the firm's 2017 report on real assets as
a diversification mechanism, Brookfield noted that long-lived real assets tend to increase in
value as replacement costs and operational efficiency rise over time. Further, the found that
cash-flow from real assets like real estate, energy servicing, and infrastructure projects can
provide predictable and steady income streams for investors.

Real assets, however, have lower liquidity than financial assets, as they take longer to sell and
have higher transaction fees in general. Also, real assets have higher carried and storage costs
than financial assets. For example, physical gold bullion often must be stored in third-party
facilities, which charge monthly rental fees and insurance.

Pros
 Portfolio diversification
 Inflation hedge
 Income stream

Cons
 Illiquidity
 Storage fees, transport costs

What Is a Mutual Fund?

A mutual fund is a financial vehicle that pools assets from shareholders to invest in securities
like stocks, bonds, money market instruments, and other assets. Mutual funds are operated by
professional money managers, who allocate the fund's assets and attempt to produce capital
gains or income for the fund's investors. A mutual fund's portfolio is structured and maintained
to match the investment objectives stated in its prospectus.

Mutual funds give small or individual investors access to professionally managed portfolios of
equities, bonds, and other securities. Each shareholder, therefore, participates proportionally in
the gains or losses of the fund. Mutual funds invest in a vast number of securities, and
performance is usually tracked as the change in the total market cap of the fund—derived by the
aggregating performance of the underlying investments.1
Most mutual funds are part of larger investment companies such as Fidelity Investments,
Vanguard, T. Rowe Price, and Oppenheimer. A mutual fund has a fund manager, sometimes
called its investment adviser, who is legally obligated to work in the best interest of mutual fund
shareholders.

KEY TAKEAWAYS

 A mutual fund is a type of investment vehicle consisting of a portfolio of stocks, bonds,

or other securities. 
 Mutual funds give small or individual investors access to diversified, professionally
managed portfolios.
 Mutual funds are divided into several kinds of categories, representing the kinds of
securities they invest in, their investment objectives, and the type of returns they seek.
 Mutual funds charge annual fees, expense ratios, or commissions, which may affect their
overall returns.
 Employer-sponsored retirement plans commonly invest in mutual funds.

What Is Risk Analysis?

The term risk analysis refers to the assessment process that identifies the potential for
any adverse events that may negatively affect organizations and the environment. Risk analysis
is commonly performed by corporations (banks, construction groups, health care, etc.),
governments, and nonprofits. Conducting a risk analysis can help organizations determine
whether they should undertake a project or approve a financial application, and what actions
they may need to take to protect their interests. This type of analysis facilitates a balance
between risks and risk reduction. Risk analysts often work in with forecasting professionals to
minimize future negative unforeseen effects.

KEY TAKEAWAYS

 Risk analysis seeks to identify, measure, and mitigate various risk exposures or hazards
facing a business, investment, or project.
 Quantitative risk analysis uses mathematical models and simulations to assign numerical
values to risk.
 Qualitative risk analysis relies on a person's subjective judgment to build a theoretical
model of risk for a given scenario.
 Risk analysis is often both an art and a science.

Understanding Risk Analysis

Risk assessment enables corporations, governments, and investors to assess the probability that
an adverse event might negatively impact a business, economy, project, or investment.
Assessing risk is essential for determining how worthwhile a specific project or investment is
and the best process(es) to mitigate those risks. Risk analysis provides different approaches that
can be used to assess the risk and reward tradeoff  of a potential investment opportunity.

A risk analyst starts by identifying what could potentially go wrong. These negatives must be
weighed against a probability metric that measures the likelihood of the event occurring.

Finally, risk analysis attempts to estimate the extent of the impact that will be made if the event
happens. Many risks that are identified, such as market risk, credit risk, currency risk, and so
on, can be reduced through hedging or by purchasing insurance.

Almost all sorts of large businesses require a minimum sort of risk analysis. For example,
commercial banks need to properly hedge foreign exchange exposure of overseas loans, while
large department stores must factor in the possibility of reduced revenues due to a
global recession. It is important to know that risk analysis allows professionals to identify and
mitigate risks, but not avoid them completely.

What is Risk-Return Tradeoff?

The risk-return tradeoff states that the potential return rises with an increase in risk. Using this
principle, individuals associate low levels of uncertainty with low potential returns, and high
levels of uncertainty or risk with high potential returns. According to the risk-return tradeoff,
invested money can render higher profits only if the investor will accept a higher possibility of
losses.

Understanding Risk-Return Tradeoff

The risk-return tradeoff is the trading principle that links high risk with high reward. The
appropriate risk-return tradeoff depends on a variety of factors including an investor’s risk
tolerance, the investor’s years to retirement and the potential to replace lost funds. Time also
plays an essential role in determining a portfolio with the appropriate levels of risk and reward.
For example, if an investor has the ability to invest in equities over the long term, that provides
the investor with the potential to recover from the risks of bear markets and participate in bull
markets, while if an investor can only invest in a short time frame, the same equities have a
higher risk proposition.

Investors use the risk-return tradeoff as one of the essential components of each investment
decision, as well as to assess their portfolios. At the portfolio level, the risk-return tradeoff can
include assessments of the concentration or the diversity of holdings and whether the mix
presents too much risk or a lower-than-desired potential for returns.

KEY TAKEAWAYS

 The risk-return tradeoff is an investment principle that indicates that the higher the risk,
the higher the potential reward.
 To calculate an appropriate risk-return tradeoff, investors must consider many factors,
including overall risk tolerance, the potential to replace lost funds and more.
  Investors consider the risk-return tradeoff on individual investments and across
portfolios when making investment decisions.

What Is Systematic Risk?

Systematic risk refers to the risk inherent to the entire market or market segment. Systematic
risk, also known as “undiversifiable risk,” “volatility” or “market risk,” affects the overall
market, not just a particular stock or industry.

KEY TAKEAWAYS

 Systematic risk is inherent to the market, reflecting the impact of economic, geopolitical,
and financial factors.
 This type of risk is distinguished from unsystematic risk, which impacts a specific
industry or security.
 Systematic risk is largely unpredictable and generally viewed as being difficult to avoid.
 Investors can somewhat mitigate the impact of systematic risk by building a diversified
portfolio.

Understanding Systematic Risk

Systematic risk is both unpredictable and impossible to completely avoid. It cannot be mitigated
through diversification, only through hedging or by using the correct asset allocation strategy.

Systematic risk underlies other investment risks, such as industry risk. If an investor has placed
too much emphasis on cybersecurity stocks, for example, it is possible to diversify by investing
in a range of stocks in other sectors, such as healthcare and infrastructure. Systematic risk,
however, incorporates interest rate changes, inflation, recessions, and wars, among other major
changes. Shifts in these domains can affect the entire market and cannot be mitigated by
changing positions within a portfolio of public equities.

To help manage systematic risk, investors should ensure that their portfolios include a variety of
asset classes, such as fixed income, cash, and real estate, each of which will react differently in
the event of a major systemic change. An increase in interest rates, for example, will make some
new-issue bonds more valuable, while causing some company stocks to decrease in price as
investors perceive executive teams to be cutting back on spending. In the event of an interest
rate rise, ensuring that a portfolio incorporates ample income-generating securities will mitigate
the loss of value in some equities.
What Is Unsystematic Risk?
Unsystematic risk is the risk that is unique to a specific company or industry. It's also known as
nonsystematic risk, specific risk, diversifiable risk, or residual risk. In the context of an
investment portfolio, unsystematic risk can be reduced through diversification—
while systematic risk is the risk that's inherent in the market.

KEY TAKEAWAYS

 Unsystematic risk, or company-specific risk, is a risk associated with a particular

investment.
 Unsystematic risk can be mitigated through diversification, and so is also known as
diversifiable risk.
 Once diversified, investors are still subject to market-wide systematic risk.
 Total risk is unsystematic risk plus systematic risk.
 Systematic risk is attributed to broad market factors and is the investment portfolio risk
that is not based on individual investments. 

Understanding Unsystematic Risk

Unsystematic risk can be described as the uncertainty inherent in a company or industry

investment. Examples of unsystematic risk include a new competitor in the marketplace with
the potential to take significant market share from the company invested in, a regulatory
change (which could drive down company sales), a shift in management, or a product recall.

While investors may be able to anticipate some sources of unsystematic risk, it is nearly
impossible to be aware of all risks. For instance, an investor in healthcare stocks may be aware
that a major shift in health policy is on the horizon but may not fully know the particulars of the
new laws and how companies and consumers will respond.

Other examples of unsystematic risks may include strikes, outcomes of legal proceedings, or
natural disasters. This risk is also known as a diversifiable risk since it can be eliminated by
sufficiently diversifying a portfolio. There isn't a formula for calculating unsystematic risk;
instead, it must be extrapolated by subtracting the systematic risk from the total risk.

Unsystematic Risk vs. Systematic Risk

Total risk for investments is unsystematic risk plus systematic risk. Unsystematic risk is a risk
specific to a company or industry, while systematic risk is the risk tied to the broader market.
Systematic risk is attributed to broad market factors and is the investment portfolio risk that is
not based on individual investments. 

Types of systematic risks can include interest rate changes, recessions, or inflation. Systematic
risk is often calculated with beta, which measures the volatility  of a stock or portfolio relative to
the entire market. Meanwhile, company risk is a bit more difficult to measure or calculate.
 
Systematic and unsystematic risks can be mitigated, in part, with risk management. Systematic
risk can be reduced with asset allocation, while unsystematic risk can be limited with
diversification. 

Risk Management
Risk management is a crucial process used to make investment decisions. Risk
management involves identifying and analyzing risk in an investment and deciding whether or
not to accept that risk given the expected returns for the investment. Some common
measurements of risk include standard deviation, Sharpe ratio, beta, value at risk (VaR),
conditional value at risk (CVaR), and R-squared.

KEY TAKEAWAYS

 Risk management is the analysis of an investment's returns compared to its risk with the
expectation that a greater degree of risk is supposed to be compensated by a higher
expected return.
 Risk—or the probability of a loss—can be measured using statistical methods that are
historical predictors of investment risk and volatility.
 Commonly used risk management techniques include standard deviation, Sharpe ratio,
and beta.
 Value at Risk and other variations not only quantify a potential dollar impact but assess
a confidence interval of the likelihood of an outcome.
 Risk management also oversees systematic risk and unsystematic risk, the two broad
types of risk impacting all investments.

Standard Deviation
Standard deviation measures the dispersion of data from its expected value. The standard
deviation is commonly used to measure the historical volatility associated with an investment
relative to its annual rate of return. It indicates how much of the current return is deviating from
its expected historical normal returns. For example, a stock that has high standard deviation
experiences higher volatility and is therefore considered riskier.

Standard deviation is most useful in conjunction with an investment's average return to evaluate
the dispersion from historical results.

 
Standard deviation is calculated by dividing the square root of the sum of squared differences
from an investment's mean by the number of items contained in the data set.

An alternative to the standard deviation is the semi-deviation, a measurement tool that only

assesses part of an investment’s risk profile. The semi-deviation is calculated similarly to the
standard deviation but can be used to specifically look at only the downside or risk of loss
potential of an investment as only half the distribution curve is determined.

Sharpe Ratio
The Sharpe ratio measures investment performance by considering associated risks. To
calculate the Sharpe ratio, the risk-free rate of return is removed from the overall expected
return of an investment. The remaining return is then divided by the associated investment’s
standard deviation. The result is a ratio that compares the return specific to an investment with
the associated level of volatility an investor is required to assume for holding the investment.
The Sharpe ratio serves as an indicator of whether an investment's return is worth the associated
risk.

One variation of the Sharpe ratio is the Sortino ratio which removes the effects of upward price
movements on standard deviation to focus on the distribution of returns that are below the target
or required return. The Sortino ratio also removes the risk-free rate of return in the numerator of
the formula.

The Sharpe ratio is most useful when evaluating differing options. This measurement allows
investors to easily understand which companies or industries generate higher returns for any
given level of risk.

 
The Sharpe ratio is calculated by subtracting the risk-free rate of return from an investment's
total return. Then, divide this result by the standard deviation of the investment's excess return.

Another variation of the Sharpe ratio is the Treynor Ratio which integrates a portfolio’s beta
with the rest of the market. Beta is a measure of an investment's volatility compared to the
general market. The goal of the Treynor ratio is to determine whether an investor is being
compensated fairly for taking additional risk above the market. The Treynor ratio formula is
calculated by dividing the investment’s beta from the return of the portfolio less the risk-free
rate.

Beta
Beta measures the amount of systematic risk an individual security or sector has relative to the
entire stock market. The market is always the beta benchmark an investment is compared to,
and the market always has a beta of one.

If a security's beta is equal to one, the security has the same volatility profile as the broad
market. A security with a beta greater than one means it is more volatile than the market. A
security with a beta less than one means it is less volatile than the market.

Beta is most useful when comparing an investment against the broad market.

 
Beta is calculated by dividing the covariance of the excess returns of an investment and the
market by the variance of the excess market returns over the risk-free rate.

Beta can also be used to measure the scale of volatility that a security has compared to the
market. For example, suppose a security's beta is 1.5. The security is considered 50% more
volatile than the market. Beta is helpful when comparing across securities—at a glance, beta
easily identifies that an investment with a beta of 1.5 is more volatile than an investment with a
beta of 1.3.

Value at Risk (VaR)

Value at Risk (VaR) is a statistical measurement used to assess the level of risk associated with
a portfolio or company. The VaR measures the maximum potential loss with a degree of
confidence for a specified period. For example, suppose a portfolio of investments has a one-
year 10% VaR of $5 million. Therefore, the portfolio has a 10% chance of losing $5 million
over a
one-year period.

 
VaR is most useful when wanting to assess a specific outcome and the likelihood of that
outcome occurring.

There are several different methods for calculating Value at Risk, each of which with its own
formula:

 The historical simulation method is the simplest as it takes prior market data over a
defined period and applies those outcomes to the current state of an investment.
 The parametric method or variance-covariance method is more useful when dealing with
larger data sets.
 The Monte Carlo method is best suited for the most complicated simulations and
assumes the probability of risk for each risk factor is known.

Conditional Value at Risk (CVaR)

Conditional Value at Risk (CVaR) is another risk measurement used to assess the tail risk of an
investment. Used as an extension to the VaR, the CVaR assesses the likelihood, with a certain
degree of confidence, that there will be a break in the VaR. It seeks to assess what happens to
investment beyond its maximum loss threshold. This measurement is more sensitive to events
that happen at the tail end of a distribution.

 
CVaR is most useful for investors wanting to know maximum potential losses for outcomes less
statistically likely to occur.

For example, suppose a risk manager believes the average loss on an investment is $10 million
for the worst one percent of possible outcomes for a portfolio. Therefore, the CVaR or
expected shortfall is $10 million for this one percent portion of the investment’s distribution
curve. The VaR loss for this investment will likely be lower than $10 million as the CVaR loss
often exceeds the distribution boundary of the VaR simulation.

R-squared
R-squared is a statistical measure that represents the percentage of a fund portfolio or a
security's movements that can be explained by movements in a benchmark index. For fixed-
income securities  and bond funds, the benchmark is the U.S. Treasury Bill. The S&P 500
Index is the benchmark for equities and equity funds.

R-squared values range from zero to one and are commonly stated as a percentage (0% to
100%). An R-squared value of 0.9 means 90% of the analysis accounts for 90% of the variation
within the data. Risk models with higher R-squared values indicate that the independent
variables being used within the model are explaining more of the variation of the dependent
variable.

R-Squared is most useful when attempting to determine why the price of an investment
changes. It's a byproduct of a financial model that clarifies what variables determine the
outcome of other variables.

 
The formula to find R-Squared is to divide the unexplained variance (the sum of the squares of
residuals) by the total variance (the total sum of squares). Then, subtract this quotient from 1.

Mutual fund investors are often recommended to avoid actively managed funds with high R-
squared ratios which are generally criticized by analysts as being "closet" index funds. In these
cases, with each basket of investments acting very similar to each other, it makes little sense to
pay higher fees for professional management when you can get the same or close results from
an index fund.

Five Ways to Minimize Risk Exposure 

Risk management is something to be taken very seriously. Few things are more harmful to a
company's reputation and bottom line, than a breach of client information. 
 
However, many companies are busy managing their solution over managing risk or using
complicated and expensive resources, practices and solutions to identify risks. To more
efficiently manage risk, let's go back to basics and look at five simple (and often overlooked)
ways to minimize risk exposure:
 

1. Stop looking for a silver bullet

Remember that a “control” is not the same thing as a “security product.” Despite what the
salesman may say, a shiny new technology solution is not a “silver bullet” to reducing
every conceivable risk. Changes to an existing process or the implementation of a simple
 procedure are often all that is required to reduce risk to an acceptable level.  
 
2. Don’t forget risk acceptance
Many times further risk mitigation simply does not make financial sense. When the
potential loss resulting from a risk is less than the cost of implementing a risk mitigating
control, get senior management to accept the risk and move on to more unacceptable
risks. That said, don’t forget to monetize the potential cost of reputational damage or loss
of public or regulatory goodwill in your calculations.
 
3. Use risk to enable business development
You don’t need to eliminate all risk. Sometimes enterprise, IT and vendor risk
management professionals forget that businesses must take some risks to succeed.
Launching innovative new products can be risky. Just be sure your organization
understands the risks and keeps them at an acceptable level. As long as risk is at or below
the organization’s tolerance level, stop, or you'll mitigate your way to a decrease in
revenue!
 
4. Consider risk transference
Shifting risk elsewhere is a relatively painless, but often forgotten method. Risk can be
transferred to a third party through a legal agreement or an insurance policy. Today most
commercial property and casualty policies come with a built-in cyber insurance policy or
rider. Be sure you are aware of any such coverage and factor that into your risk
assessment. Instead of adding new controls, it may be more cost-effective to allow a
contract or insurance policy to cover losses.
 
5. Improve existing controls before deploying new ones
Enterprise, IT and vendor risk management professionals often start down the road of
proposing the implementation of new controls without examining the effectiveness of
existing ones. Sometimes existing controls can be upgraded or shored up enough to
reduce risk to an acceptable level without undertaking a costly new deployment. 

Speculation
Speculation involves calculating risk and conducting research before entering a financial
transaction. A speculator buys or sells assets in hopes of having a bigger potential gain than the
amount he risks. A speculator takes risks and knows that the more risk they assume, in theory,
the higher their potential gain. However, they also know they may lose more than their potential
gain.

For example, an investor may speculate that a market index will increase due to strong
economic numbers by buying one contract in one market futures contract. If their analysis is
correct, they may be able to sell the futures contract for more than they paid, within a short- to
medium-term period. However, if they are wrong, the investor can lose more than their
expected risk.
Gambling
Converse to speculation, gambling involves a game of chance. Generally, the odds are stacked
against gamblers. When gambling, the probability of losing an investment is usually higher than
the probability of winning more than the investment. In comparison to speculation, gambling
has a higher risk of losing the investment.

For example, a gambler opts to play a game of American roulette instead of speculating in the
stock market. The gambler only places their bets on single numbers. However, the payout is
only 35 to 1, while the odds against them winning are 37 to 1. So if a gambler bets $2 on a
single number, their potential gambling income is $70 (35*$2) but the odds of them winning is
approximately 1/37.

Key Differences of speculation and gambling

Although there may be some superficial similarities between the two concepts, a strict definition
of both speculation and gambling reveals the principal differences between them. A standard
dictionary defines speculation as a risky type of investment, where investing means to put
money to use, by purchase or expenditure, in something offering profitable returns, especially
interest or income. The same dictionary defines gambling as follows: To play at any game of
chance for stakes. To stake or risk money, or anything of value, on the outcome of something
involving chance; bet; wager.

Speculation refers to the act of conducting a financial transaction that has a substantial risk of
losing value but also holds the expectation of a significant gain or other major value. With
speculation, the risk of loss is more than offset by the possibility of a substantial gain or other
recompense. Some market pros view speculators as gamblers , but a vigorous market is made up
of not only hedgers and arbitrageurs, but also speculators. A hedger is a risk-averse investor
who purchases positions contrary to others already owned. If a hedger owned 500 shares of
Marathon Oil but was afraid that the price of oil may soon drop significantly in value, they may
short sell the stock, purchase a put option, or use one of the many other hedging strategies.

While speculation is risky, it does often have a positive expected return, even though that return
may never manifest. Gambling, on the other hand, always involves a negative expected return—
the house always has the advantage. Gambling tendencies run far deeper than most people
initially perceive and well beyond the standard definitions. Gambling can take the form of
needing to socially prove oneself or acting in a way to be socially accepted, which results in
taking action in a field one knows little about.

Gambling in the markets is often evident in people who do it mostly for the emotional high they
receive from the excitement and action of the markets. Finally, relying on emotion or a must-
win attitude to create profits rather than trading in a methodical and tested system, indicates the
person is gambling in the markets and is unlikely to succeed over the course of many trades.
 UNIT 2

What Is the Modern Portfolio Theory (MPT)?

The modern portfolio theory (MPT) is a practical method for selecting investments in order to
maximize their overall returns within an acceptable level of risk. This mathematical framework
is used to build a portfolio of investments that maximize the amount of expected return for the
collective given level of risk.

American economist Harry Markowitz pioneered this theory in his paper "Portfolio Selection,"

which was published in the Journal of Finance in 1952.1 He was later awarded a Nobel Prize for
his work on modern portfolio theory.2

A key component of the MPT theory is diversification. Most investments are either high risk and
high return or low risk and low return. Markowitz argued that investors could achieve their best
results by choosing an optimal mix of the two based on an assessment of their individual
tolerance to risk.

KEY TAKEAWAYS

 The modern portfolio theory (MPT) is a method that can be used by risk-averse investors
to construct diversified portfolios that maximize their returns without unacceptable levels
of risk.
 The modern portfolio theory can be useful to investors trying to construct efficient and
diversified portfolios using ETFs.
 Investors who are more concerned with downside risk might prefer the post-modern
portfolio theory (PMPT) to MPT.
 

Understanding the Modern Portfolio Theory (MPT)

The modern portfolio theory argues that any given investment's risk and return characteristics
should not be viewed alone but should be evaluated by how it affects the overall portfolio's risk
and return. That is, an investor can construct a portfolio of multiple assets that will result in
greater returns without a higher level of risk.

As an alternative, starting with a desired level of expected return, the investor can construct a
portfolio with the lowest possible risk that can produce that return.

Based on statistical measures such as variance and correlation, a single investment's

performance is less important than how it impacts the entire portfolio.
Benefits of the MPT
The MPT is a useful tool for investors who are trying to build diversified portfolios. In fact, the
growth of exchange-traded funds (ETFs) made the MPT more relevant by giving investors
easier access to a broader range of asset classes.

For example, stock investors can reduce risk by putting a portion of their portfolios
in government bond ETFs. The variance of the portfolio will be significantly lower because
government bonds have a negative correlation with stocks. Adding a small investment in
Treasuries to a stock portfolio will not have a large impact on expected returns because of this
loss-reducing effect.

Optimal Portfolio

An optimal portfolio is one that occupies the ‘efficient’ parts of the risk-return premium spectrum.

It satisfies the requirement that no other collection exists with a higher expected return at the same

standard deviation of the return (risk measure).

Different combinations of assets produce different levels of return. The optimal portfolio concept

represents the best of these combinations, those that provide the maximum possible expected

return for a given level of acceptable risk.

The relationship between assets is an essential part of the optimal portfolio theory. Some prices

move in the same direction under similar circumstances, while others go in opposite directions.

The more out of sync these price developments are, the lower the covariance between two assets

is, which translates into lower overall risk.

The optimal portfolio does not focus on investments with either high expected returns or low risk.

It aims to balance stocks carrying the best potential returns with acceptable risk. When we plot

these, we get the Efficient Frontier.

The Efficient Frontier

The Efficient Frontier concept has its roots in the 1950s, and it’s a pillar of Modern Portfolio

Theory.

The Efficient Frontier is a set of optimal portfolios that give the highest possible expected return

for a given risk level or the lowest risk for a desired expected return. Portfolios below the efficient

frontier are sub-optimal, as they don’t provide enough returns for their risk levels.

Returns depend on the investments combined in the portfolio. Those on the right of the efficient

frontier have higher risk levels for the defined rate of return. Risk seeking investors would look at

these portfolios, while risk-averse investors would look on those on the left side.

For this model, we consider the standard deviation of the return on the asset as its risk measure.

Lower covariance between portfolio securities results in smaller portfolio standard deviation.

Therefore, optimal portfolios that comprise the efficient frontier tend to have a higher degree of

diversification. The compounded annual growth rate is a common choice for the return

component, while the annualized standard deviation represents the related risk.
It’s a graphical way to illustrate the portfolios that maximize the return for the assumed risk.

Profitability depends on the combination of held investments. Ideally, we would want to create a

collection of assets with a high yield and aggregated standard deviation (risk level), which is

lower than the individual assets’ standard deviation.

Lower synchronization rates between the investments (lower covariance) mean lower standard

deviation and risk. If such optimization of return versus risk is successful, the portfolio will lie on

the efficient frontier curve. Optimal portfolios on the efficient frontier tend to be more diversified.

The curve is essential in showing how diversification improves the risk/reward profile for the

investor. It shows that the relation between risk and return is non-linear. There is a diminishing

marginal return to risk; adding more risk does not gain an equal return. Instead, each additional

unit of risk adds a smaller and smaller amount of return to the portfolio.

Assumptions and Limitations

The theory behind the Efficient Frontier relies heavily on some assumptions, not all of which

represent reality. The underlying assumptions for the optimal portfolio are focused primarily on

the investors:

 We expect investors to be rational and all have access to the same information.
 They are all risk-averse and share the goal to maximize returns.
 No single investor can influence the market.
 All market players have access to unlimited funds at a risk-free rate.
 We assume that asset returns follow a normal distribution.
 Investors base all decisions on the market on expected returns and standard deviation
as a measure of risk.
What Is the Capital Asset Pricing Model?
The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk, or
the general perils of investing, and expected return for assets, particularly stocks.1 It is a
finance model that establishes a linear relationship between the required return on an investment
and risk. The model is based on the relationship between an asset's beta, the risk-free
rate (typically the Treasury bill rate), and the equity risk premium, or the expected return on the
market minus the risk-free rate.

CAPM evolved to measure this systematic risk. It is widely used throughout finance for pricing
risky securities and generating expected returns for assets, given the risk of those assets and cost
of capital.

KEY TAKEAWAYS

 The capital asset pricing model - or CAPM - is a financial model that calculates the
expected rate of return for an asset or investment.
 CAPM does this by using the expected return on both the market and a risk-free asset,
and the asset's correlation or sensitivity to the market (beta).
 There are some limitations to the CAPM, such as making unrealistic assumptions and
relying on a linear interpretation of risk vs. return.
 Despite its issues, the CAPM formula is still widely used because it is simple and allows
for easy comparisons of investment alternatives.
 For instance, it is used in conjunction with modern portfolio theory (MPT) to understand
portfolio risk and expected return.

Understanding the Capital Asset Pricing Model (CAPM)

The formula for calculating the expected return of an asset, given its risk, is as follows:

where:

ERi=expected return of investment

Rf=risk-free rate

βi=beta of the investment

(ERm−Rf) =market risk premium

Investors expect to be compensated for risk and the time value of money. The risk-free rate in
the CAPM formula accounts for the time value of money. The other components of the CAPM
formula account for the investor taking on additional risk.
The goal of the CAPM formula is to evaluate whether a stock is valued when its risk and the
time value of money are compared with its expected return. In other words, by knowing the
individual parts of the CAPM, it is possible to gauge whether the current price of a stock is
consistent with its likely return.

What is a Market Portfolio?

A market portfolio is a theoretical bundle of investments that includes every type of asset
available in the investment universe, with each asset weighted in proportion to its total presence
in the market. The expected return of a market portfolio is identical to the expected return of the
market.

KEY TAKEAWAYS

 A market portfolio is a theoretical, diversified group of every type of investment in the

world, with each asset weighted in proportion to its total presence in the market.
 Market portfolios are a key part of the capital asset pricing model, a commonly used
foundation for choosing which investments to add to a diversified portfolio.
 Roll's Critique is an economic theory that suggests that it is impossible to create a truly
diversified market portfolio—and that the concept is a purely theoretical one.

What Is the Capital Market Line (CML)?

The capital market line (CML) represents portfolios that optimally combine risk and return. It is
a theoretical concept that represents all the portfolios that optimally combine the risk-free rate of
return and the market portfolio of risky assets. Under the capital asset pricing model (CAPM), all
investors will choose a position on the capital market line, in equilibrium, by borrowing or
lending at the risk-free rate, since this maximizes return for a given level of risk.

KEY TAKEAWAYS

 The capital market line (CML) represents portfolios that optimally combine risk and
return.
 CML is a special case of the capital allocation line (CAL) where the risk portfolio is the
market portfolio. Thus, the slope of the CML is the Sharpe ratio of the market portfolio.
 The intercept point of CML and efficient frontier would result in the most efficient
portfolio called the tangency portfolio.
 As a generalization, buy assets if Sharpe ratio is above CML and sell if Sharpe ratio is
below CML.
What the CML Can Tell You
Portfolios that fall on the capital market line (CML), in theory, optimize the risk/return
relationship, thereby maximizing performance. The capital allocation line (CAL) makes up the
allotment of risk-free assets and risky portfolios for an investor.

CML is a special case of the CAL where the risk portfolio is the market portfolio. Thus, the
slope of the CML is the Sharpe ratio of the market portfolio. As a generalization, buy assets if
the Sharpe ratio is above the CML and sell if the Sharpe ratio is below the CML.

 
CML differs from the more popular efficient frontier in that it includes risk-free investments.
The intercept point of CML and efficient frontier would result in the most efficient portfolio,
called the tangency portfolio.

Mean-variance analysis was pioneered by Harry Markowitz and James Tobin. The efficient
frontier of optimal portfolios was identified by Markowitz in 1952, and James Tobin included
the risk-free rate to modern portfolio theory in 1958. William Sharpe then developed the CAPM
in the 1960s, and won a Nobel prize for his work in 1990, along with Markowitz and Merton
Miller.1

The CAPM is the line that connects the risk-free rate of return with the tangency point on the
efficient frontier of optimal portfolios that offer the highest expected return for a defined level
of risk, or the lowest risk for a given level of expected return.

The portfolios with the best trade-off between expected returns and variance (risk) lie on this
line. The tangency point is the optimal portfolio of risky assets, known as the market portfolio.
Under the assumptions of mean-variance analysis—that investors seek to maximize their
expected return for a given amount of variance risk, and that there is a risk-free rate of return—
all investors will select portfolios that lie on the CML.

According to Tobin's separation theorem, finding the market portfolio and the best combination
of that market portfolio and the risk-free asset are separate problems. Individual investors will
either hold just the risk-free asset or some combination of the risk-free asset and the market
portfolio, depending on their risk-aversion.

As an investor moves up the CML, the overall portfolio risk and returns increase. Risk-averse
investors will select portfolios close to the risk-free asset, preferring low variance to higher
returns. Less risk-averse investors will prefer portfolios higher up on the CML, with a higher
expected return, but more variance. By borrowing funds at a risk-free rate, they can also invest
more than 100% of their investable funds in the risky market portfolio, increasing both the
expected return and the risk beyond that offered by the market portfolio.

What Is the Security Market Line?

The security market line (SML) is a line drawn on a chart that serves as a graphical
representation of the capital asset pricing model (CAPM)—which shows different levels of
systematic, or market risk, of various marketable securities, plotted against the expected return of
the entire market at any given time.1

Also known as the "characteristic line," the SML is a visualization of the CAPM, where the x-
axis of the chart represents risk (in terms of beta), and the y-axis of the chart represents expected
return. The market risk premium of a given security is determined by where it is plotted on the
chart relative to the SML.

Understanding the Security Market Line

The security market line is an investment evaluation tool derived from the CAPM—a model
that describes risk-return relationship  for securities—and is based on the assumption that
investors need to be compensated for both the time value of money (TVM) and the
corresponding level of risk associated with any investment, referred to as the risk premium.

KEY TAKEAWAYS

 The security market line (SML) is a line drawn on a chart that serves as a graphical
representation of the capital asset pricing model (CAPM). 
 The SML can help to determine whether an investment product would offer a favorable
expected return compared to its level of risk.
 The formula for plotting the SML is required return = risk-free rate of return + beta
(market return - risk-free rate of return).
The concept of beta is central to the CAPM and the SML. The beta of a security is a measure of
its systematic risk, which cannot be eliminated by diversification. A beta value of one is
considered as the overall market average. A beta value that's greater than one represents a risk
level greater than the market average, and a beta value of less than one represents a risk level
that is less than the market average.

The formula for plotting the SML is:

 Required return = risk-free rate of return + beta (market return - risk-free rate of
return)

 
Although the SML can be a valuable tool for evaluating and comparing securities, it should not
be used in isolation, as the expected return of an investment over the risk-free rate of return is
not the only thing to consider when choosing investments.

Using the Security Market Line

The security market line is commonly used by money managers and investors to evaluate an
investment product that they're thinking of including in a portfolio. The SML is useful in
determining whether the security offers a favorable expected return compared to its level of
risk.

When a security is plotted on the SML chart, if it appears above the SML, it is
considered undervalued because the position on the chart indicates that the security offers a
greater return against its inherent risk.

Conversely, if the security plots below the SML, it is considered overvalued in price because
the expected return does not overcome the inherent risk.

The SML is frequently used in comparing two similar securities that offer approximately the
same return, in order to determine which of them involves the least amount of inherent market
risk relative to the expected return. The SML can also be used to compare securities of equal
risk to see which one offers the highest expected return against that level of risk.

Single-index model
This article is about the asset pricing model in economics. For a description of its more general
application in semiparametric regression, see Semiparametric regression.
The single-index model (SIM) is a simple asset pricing model to measure both the risk and the
return of a stock. The model has been developed by William Sharpe in 1963 and is commonly
used in the finance industry. Mathematically the SIM is expressed as:
where:
rit is return to stock i in period t
rf is the risk free rate (i.e. the interest rate on treasury bills)
rmt is the return to the market portfolio in period t
 is the stock's alpha, or abnormal return
 is the stock's beta, or responsiveness to the market return
Note that  is called the excess return on the stock,  the excess return on the market
 are the residual (random) returns, which are assumed independent normally distributed
with mean zero and standard deviation 
These equations show that the stock return is influenced by
the market (beta), has a firm specific expected value (alpha)
and firm-specific unexpected component (residual). Each
stock's performance is in relation to the performance of a
market index (such as the All Ordinaries). Security analysts
often use the SIM for such functions as computing stock
betas, evaluating stock selection skills, and conducting event
studies.
Assumptions of the single-index model
To simplify analysis, the single-index model assumes that there is only 1 macroeconomic
factor that causes the systematic risk affecting all stock returns and this factor can be represented
by the rate of return on a market index, such as the S&P 500.
According to this model, the return of any stock can be decomposed into the expected excess
return of the individual stock due to firm-specific factors, commonly denoted by its alpha
coefficient (α), the return due to macroeconomic events that affect the market, and the
unexpected microeconomic events that affect only the firm.
The term  represents the movement of the market modified by the stock's beta, while  represents
the unsystematic risk of the security due to firm-specific factors. Macroeconomic events, such as
changes in interest rates or the cost of labor, causes the systematic risk that affects the returns of
all stocks, and the firm-specific events are the unexpected microeconomic events that affect the
returns of specific firms, such as the death of key people or the lowering of the firm's credit
rating, that would affect the firm, but would have a negligible effect on the economy. In a
portfolio, the unsystematic risk due to firm-specific factors can be reduced to zero by
diversification.
The index model is based on the following:

 Most stocks have a positive covariance because they all respond similarly to
macroeconomic factors.
 However, some firms are more sensitive to these factors than others, and this firm-
specific variance is typically denoted by its beta (β), which measures its variance
compared to the market for one or more economic factors.
 Covariance among securities result from differing responses to macroeconomic
factors. Hence, the covariance of each stock can be found by multiplying their betas
and the market variance:
The single-index model assumes that once the market return is subtracted out the remaining
returns are uncorrelated:

which gives
This is not true, but it provides a simple model. A more detailed model would have
multiple risk factors. This would require more computation, but still less than computing
the covariance of each possible pair of securities in the portfolio. With this equation,
only the betas of the individual securities and the market variance need to be estimated to
calculate covariance. Hence, the index model greatly reduces the number of calculations
that would otherwise have to be made to model a large portfolio of thousands of
securities.
What Is the Arbitrage Pricing Theory (APT)?
Arbitrage pricing theory (APT) is a multi-factor asset pricing model based on the idea that an
asset's returns can be predicted using the linear relationship between the asset’s expected return
and a number of macroeconomic variables that capture systematic risk. It is a useful tool for
analyzing portfolios from a value investing perspective, in order to identify securities that may
be temporarily mispriced.

The Formula for the Arbitrage Pricing Theory Model Is

E(R)i=E(R)z+(E(I)−E(R)z) ×βn

where:

E(R)i=Expected return on the asset

Rz=Risk-free rate of return

βn=Sensitivity of the asset price to macroeconomic factor

  nEi=Risk premium associated with factor i

The beta coefficients in the APT model are estimated by using linear regression. In general,
historical securities returns are regressed on the factor to estimate its beta.

How the Arbitrage Pricing Theory Works

The arbitrage pricing theory was developed by the economist Stephen Ross in 1976, as an
alternative to the capital asset pricing model (CAPM). Unlike the CAPM, which assume
markets are perfectly efficient, APT assumes markets sometimes misprice securities, before the
market eventually corrects and securities move back to fair value. Using APT, arbitrageurs hope
to take advantage of any deviations from fair market value.

However, this is not a risk-free operation in the classic sense of arbitrage, because investors are
assuming that the model is correct and making directional trades—rather than locking in risk-
free profits.

Mathematical Model for the APT

While APT is more flexible than the CAPM, it is more complex. The CAPM only takes into
account one factor—market risk—while the APT formula has multiple factors. And it takes a
considerable amount of research to determine how sensitive a security is to various
macroeconomic risks.
The factors as well as how many of them are used are subjective choices, which means
investors will have varying results depending on their choice. However, four or five factors will
usually explain most of a security's return. (For more on the differences between the CAPM and
APT, read more about how CAPM and arbitrage pricing theory differ .)

APT factors are the systematic risk that cannot be reduced by the diversification of an
investment portfolio. The macroeconomic factors that have proven most reliable as price
predictors include unexpected changes in inflation, gross national product (GNP), corporate
bond spreads and shifts in the yield curve. Other commonly used factors are gross domestic
product (GDP), commodities prices, market indices, and exchange rates.

KEY TAKEAWAYS

 Arbitrage pricing theory (APT) is a multi-factor asset pricing model based on the idea
that an asset's returns can be predicted using the linear relationship between the asset’s
expected return and a number of macroeconomic variables that capture systematic risk.
 Unlike the CAPM, which assume markets are perfectly efficient, APT assumes markets
sometimes misprice securities, before the market eventually corrects and securities move
back to fair value.
 Using APT, arbitrageurs hope to take advantage of any deviations from fair market
value.

Example of How Arbitrage Pricing Theory Is Used

For example, the following four factors have been identified as explaining a stock's return and
its sensitivity to each factor and the risk premium associated with each factor have been
calculated:

 Gross domestic product (GDP) growth: ß = 0.6, RP = 4%

 Inflation rate: ß = 0.8, RP = 2%
 Gold prices: ß = -0.7, RP = 5%
 Standard and Poor's 500 index return: ß = 1.3, RP = 9%
 The risk-free rate is 3%

Using the APT formula, the expected return is calculated as:

 Expected return = 3% + (0.6 x 4%) + (0.8 x 2%) + (-0.7 x 5%) + (1.3 x 9%) = 15.2%
 UNIT 3

BOND PORTFOLIO MANAGEMENT STRATEGIES

Bond portfolio management strategies are based on managing fixed income investments
in pursuit of a particular objective – usually maximizing return on investment by
minimizing risk and managing interest rates. The management of the portfolio can be
done by professional investment managers or by investors themselves.

Passive investing is for investors who want predictable income, while active investing is for
investors who want to make bets on the future; indexation and immunization fall in the middle,
offering some predictability, but not as much as buy-and-hold or passive strategies.
Passive Bond Management Strategy
The passive buy-and-hold investor is typically looking to maximize the income-generating
properties of bonds. The premise of this strategy is that bonds are assumed to be safe,
predictable sources of income. Buy and hold involves purchasing individual bonds and holding
them to maturity. Cash flow from the bonds can be used to fund external income needs or can
be reinvested in the portfolio into other bonds or other asset classes.

In a passive strategy, there are no assumptions made as to the direction of future interest rates
and any changes in the current value of the bond due to shifts in the yield are not important. The
bond may be originally purchased at a premium or a discount while assuming that full par will
be received upon maturity. The only variation in total return from the actual coupon yield is the
reinvestment of the coupons as they occur.

On the surface, this may appear to be a lazy style of investing, but in reality, passive bond
portfolios provide stable anchors in rough financial storms. They minimize or
eliminate transaction costs, and if originally implemented during a period of relatively high-
interest rates, they have a decent chance of outperforming active strategies.

One of the main reasons for their stability is the fact that passive strategies work best with very
high-quality, non-callable bonds like government or investment-grade corporate or municipal
bonds. These types of bonds are well suited for a buy-and-hold strategy as they minimize the
risk associated with changes in the income stream due to embedded options, which are written
into the bond's covenants at issue and stay with the bond for life. Like the stated coupon, call
and put features embedded in a bond allow the issue to act on those options under specified
market conditions.

Bond Laddering in Passive Investing

Ladders are one of the most common forms of passive bond investing. This is where the
portfolio is divided into equal parts and invested in laddered style maturities over the
investor's time horizon. Figure 1 is an example of a basic 10-year laddered $1 million bond
portfolio with a stated coupon of 5%.

Year 1 2 3 4 5 6 7 8 9 10
Princip $100,00 $100,00 $100,00 $100,00 $100,00 $100,00 $100,00 $100,00 $100,00 $100,00
al 0 0 0 0 0 0 0 0 0 0
Coupon
$5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000
Income
Figure 1
Dividing the principal into equal parts provides a steady equal stream of cash flow annually.

 
Bond investing is not as simple or predictable as it might seem to the casual observer; there are
many ways to build a bond portfolio and they each have risks and rewards.

Indexing Bond Strategy

Indexing is quasi-passive by design. The main objective of indexing a bond portfolio is to
provide a return and risk characteristic closely tied to the targeted index. While this strategy
carries some of the same characteristics of the passive buy-and-hold, it has some flexibility. Just
like tracking a specific stock market index, a bond portfolio can be structured to mimic any
published bond index. One common index mimicked by portfolio managers is the Barclays U.S.
Aggregate Bond Index.

Due to the size of this index, the strategy would work well with a large portfolio due to the
number of bonds required to replicate the index. One also needs to consider the transaction costs
associated with not only the original investment, but also the periodic rebalancing of the
portfolio to reflect changes in the index.

Immunization Bond Strategy

The immunization strategy  has the characteristics of both active and passive strategies in that it
Immunization matches the duration of assets and liabilities (such as discounted future cash
flows required by the portfolio) to protect against interest rate fluctuations. By definition, pure
immunization implies that a portfolio is invested for a defined return for a specific period of
time regardless of any outside influences, such as changes in interest rates.

Like indexing, the opportunity cost of using the immunization strategy is potentially giving up
the upside potential of an active strategy for the assurance that the portfolio will achieve the
intended desired return. As in the buy-and-hold strategy, by design, the instruments best suited
for this strategy are high-grade bonds with remote possibilities of default.

In fact, the purest form of immunization would be to invest in a zero-coupon bond and match
the maturity of the bond to the date on which the cash flow is expected to be needed. This
eliminates any variability of return, positive or negative, associated with the reinvestment of
cash flows.

Duration, or the average life of a bond, is commonly used in immunization. It is a much more
accurate predictive measure of a bond's volatility than maturity. A duration strategy is
commonly used in the institutional investment environment by insurance companies, pension
funds, and banks to match the time horizon of their future liabilities with structured cash flows.
It is one of the soundest strategies and can be used successfully by individuals.
For example, just like a pension fund would use an immunization to plan for cash flows upon an
individual's retirement, that same individual could build a dedicated portfolio for their own
retirement plan.

Active Bond Strategy

The goal of active management is maximizing total return. Along with the enhanced
opportunity for returns obviously comes increased risk. Some examples of active styles include
interest rate anticipation, timing, valuation, spread exploitation, and multiple interest rate
scenarios. The basic premise of all active strategies is that the investor is willing to make bets
on the future rather than settle with the potentially lower returns a passive strategy can offer.

What are “Bond Characteristics”?

Bonds, which are a form of debt instrument, all have certain common characteristics – whether it
be government bonds or corporate bonds. The most important common characteristics of a bond,
relate to the bond issuer, maturity date, coupon, face value, bond price, and bond yield. Much
like loans, a bond investor lends money to the issuer of the bond and the issuer promises to repay
the amount at a specific date in the future – termed as the ‘maturity date’. Between the bond
issue date and the maturity date, bond investors typically receive regular interest rate payments.
However, bonds differ from loans, as they are easier to trade in and out of so the ownership of a
bond can be sold. For most bonds, there is usually a relatively liquid secondary market.

This means that investors who lend money to the issuer of the bond, initially for a term of say 7
or 10 years in the primary market, can later decide to sell the bond to another investor in the
secondary market on any business day and get their money back – even if the maturity date has
not been reached.

Bond Characteristics – Most Common Ones

A bond is a contractual agreement between the issuer of the bond and its bondholders. The most
important common characteristics vis-à-vis all bonds refer to the bond issuer, maturity date,
coupon, face value, bond price, and bond yield. These common characteristics of bonds
determine the scheduled cash flows of a bond. Consequently, they are the main determinants of
an investor’s expected return and actual return.

Bond issuer: This is the entity or company seeking to borrow money from investors and is the
entity or company that should repay the money borrowed. Therefore, the bond issuer determines
the credit risk that investors will be exposed to. Sovereign governments, supranational
organizations and corporate issuers amongst others can all issue bonds and are given credit
ratings according to factors determined by the credit rating agencies. One issuer can have
multiple credit ratings – these are attributed to each individual debt issue.
Maturity date: This is the date at which the bond will be redeemed i.e. when the outstanding
principal amount is repaid back to the investor. Maturities of bonds can range from overnight to
30 years or more.

Coupon: This is the nominal rate of interest that an issuer agrees to pay to the bondholder each
year until the maturity date. It is usually expressed as a percentage (%) of the face value of a
bond and is almost always given as a per annum rate. For example, a bond with a coupon rate of
4% and a face value of $1,000, will pay an annual interest of $40.

Face Value (FV): This is also known as the notional or principal amount, which is the amount
that will be repaid to the bondholder upon maturity. This is given as a currency amount, for
example, $5 million.

Bond Price: The current market price of a bond is expressed as a percentage of face value.
Bonds are tradable in the secondary market and the prices at which bonds can be bought and sold
at are recorded in percentage terms. For example, a bond could have a price of 102%. Therefore,
if a bond trades at a price of 102% and the investor buys a bond of $100 million face value, the
current market price of the bond is $102 million.

Bond Yield: This refers to the returns an investor will derive by investing in a bond. It is
calculated by dividing the annual coupon on a bond by its current market price.

Bond Yield = Annual Coupon Payment on a Bond / Bond Price

The annual coupon payment is computed by multiplying the face value of a bond with its coupon
rate (%). Bond prices and bond yields have an inverse relationship. When the price of a bond
goes up (down), the yield goes down (up).

What Is Bond Valuation?

Bond valuation is a technique for determining the theoretical fair value of a particular bond.
Bond valuation includes calculating the present value of a bond's future interest payments , also
known as its cash flow, and the bond's value upon maturity, also known as its face value or par
value. Because a bond's par value and interest payments are fixed, an investor uses bond
valuation to determine what rate of return is required for a bond investment to be worthwhile.

KEY TAKEAWAYS

 Bond valuation is a way to determine the theoretical fair value (or par value) of a
particular bond.
  It involves calculating the present value of a bond's expected future coupon payments, or
cash flow, and the bond's value upon maturity, or face value.
 As a bond's par value and interest payments are set, bond valuation helps investors
figure out what rate of return would make a bond investment worth the cost.

Understanding Bond Valuation

A bond is a debt instrument that provides a steady income stream to the investor in the form
of coupon payments. At the maturity date, the full face value of the bond is repaid to the
bondholder. The characteristics of a regular bond include:

 Coupon rate: Some bonds have an interest rate, also known as the coupon rate, which is
paid to bondholders semi-annually. The coupon rate is the fixed return that an investor
earns periodically until it matures.
 Maturity date: All bonds have maturity dates, some short-term, others long-term. When
a bond matures, the bond issuer repays the investor the full face value of the bond. For
corporate bonds, the face value of a bond is usually $1,000 and for government bonds,
the face value is $10,000. The face value is not necessarily the invested principal or
purchase price of the bond.
 Current price: Depending on the level of interest rate in the environment, the investor
may purchase a bond at par, below par, or above par. For example, if interest rates
increase, the value of a bond will decrease since the coupon rate will be lower than the
interest rate in the economy. When this occurs, the bond will trade at a discount, that is,
below par. However, the bondholder will be paid the full face value of the bond at
maturity even though he purchased it for less than the par value.1

Bond Valuation in Practice

Since bonds are an essential part of the capital markets, investors and analysts seek to
understand how the different features of a bond interact in order to determine its intrinsic value.
Like a stock, the value of a bond determines whether it is a suitable investment for a portfolio
and hence, is an integral step in bond investing.

Bond valuation, in effect, is calculating the present value of a bond’s expected future coupon
payments. The theoretical fair value of a bond is calculated by discounting the future value of
its coupon payments by an appropriate discount rate. The discount rate used is the yield to
maturity, which is the rate of return that an investor will get if they reinvested every coupon
payment from the bond at a fixed interest rate until the bond matures. It takes into account the
price of a bond, par value, coupon rate, and time to maturity.
How Equity Portfolio Management Works
Many investment research analysts frequently turn into portfolio managers  over time. After all,
the goal of virtually all investment analysis is to make an investment decision or advise
someone to make one. Analyzing equities and managing equity portfolios are closely linked:
That's why most analysts have a good educational background in both equity analysis and
subjects like modern portfolio theory (MPT).

However, in finance—as in many professions—the real-world application of theoretical or

academic concepts can involve thinking beyond one's specialty and training. Running a group of
stock portfolios involves attention to detail, software skills, and administrative efficiency.

In short, you need to know the mechanics of equity portfolio management to create and handle a
group of distinct portfolios, ensuring they not only perform well but that they perform as a
homogeneous element.

KEY TAKEAWAYS

 Certain mechanical elements to portfolio management must be learned before

constructing and running equity portfolios. 
 Portfolio managers may be constrained by the style, values, and approach of the
investment firm they work for.
 Understanding the tax consequences of portfolio management activity is of primary
importance in building and managing portfolios over time.
 Portfolio modeling is a good way to apply the analysis and evaluation of a key set of
stocks to a set of portfolios in one group or style. 
 Portfolio modeling can be an efficient link between equity analysis and portfolio
management.

UNIT 4

What is Portfolio Revision?

The art of changing the mix of securities in a portfolio is called as portfolio revision.

The process of addition of more assets in an existing portfolio or changing the ratio of funds
invested is called as portfolio revision.

The sale and purchase of assets in an existing portfolio over a certain period of time to maximize
returns and minimize risk is called as Portfolio revision.

Need for Portfolio Revision

  An individual at certain point of time might feel the need to invest more. The
need for portfolio revision arises when an individual has some additional money to
invest.
 Change in investment goal also gives rise to revision in portfolio. Depending on
the cash flow, an individual can modify his financial goal, eventually giving rise to
changes in the portfolio i.e. portfolio revision.
 Financial market is subject to risks and uncertainty. An individual might sell off
some of his assets owing to fluctuations in the financial market.
Portfolio Revision Strategies
There are two types of Portfolio Revision Strategies.

1. Active Revision Strategy

Active Revision Strategy involves frequent changes in an existing portfolio over a
certain period for maximum returns and minimum risks.
Active Revision Strategy helps a portfolio manager to sell and purchase securities on
a regular basis for portfolio revision.
2. Passive Revision Strategy
Passive Revision Strategy involves rare changes in portfolio only under certain
predetermined rules. These predefined rules are known as formula plans.
According to passive revision strategy a portfolio manager can bring changes in the
portfolio as per the formula plans only.

Portfolio Performance Evaluation Methods

The objective of modern portfolio theory is maximization of return or minimization of risk. In

this context the research studies have tried to evolve a composite index to measure risk-based
return. The credit for evaluating the systematic, unsystematic and residual risk goes to Sharpe,
Treynor and Jensen.

The portfolio performance evaluation can be made based on the following methods:

1. Sharpe’s Measure
2. Treynor’s Measure
3. Jensen’s Measure

1. Sharpe’s Measure
Sharpe’s Index measure total risk by calculating standard deviation. The method adopted by
Sharpe is to rank all portfolios on the basis of evaluation measure. Reward is in the numerator as
risk premium. Total risk is in the denominator as standard deviation of its return. We will get a
measure of portfolio’s total risk and variability of return in relation to the risk premium. The
measure of a portfolio can be done by the following formula:

SI =(Rt — Rf)/σf
Where,

 SI = Sharpe’s Index
 Rt = Average return on portfolio
 Rf = Risk free return
 σf = Standard deviation of the portfolio return.

2. Treynor’s Measure
The Treynor’s measure related a portfolio’s excess return to non-diversifiable or systematic risk.
The Treynor’s measure employs beta. The Treynor based his formula on the concept of
characteristic line. It is the risk measure of standard deviation, namely the total risk of the
portfolio is replaced by beta. The equation can be presented as follow:

Tn =(Rn – Rf)/βm
Where,

 Tn = Treynor’s measure of performance

 Rn = Return on the portfolio
 Rf = Risk free rate of return
 βm = Beta of the portfolio ( A measure of systematic risk)

3. Jensen’s Measure
Jensen attempts to construct a measure of absolute performance on a risk adjusted basis. This
measure is based on Capital Asset Pricing Model (CAPM) model. It measures the portfolio
manager’s predictive ability to achieve higher return than expected for the accepted riskiness.
The ability to earn returns through successful prediction of security prices on a standard
measurement. The Jensen measure of the performance of portfolio can be calculated by applying
the following formula:

Rp = Rf + (RMI — Rf) x β

Where,
  Rp = Return on portfolio
 RMI = Return on market index
 Rf = Risk free rate of return

What Is Market Timing?

Market timing is the act of moving investment money in or out of a financial market—or
switching funds between asset classes—based on predictive methods. If investors can predict
when the market will go up and down, they can make trades to turn that market move into a
profit.

Timing the market is often a key component of actively managed investment strategies, and it is
almost always a basic strategy for traders. Predictive methods for guiding market timing
decisions may include fundamental, technical, quantitative, or economic data.

Many investors, academics, and financial professionals believe it is impossible to time the
market. Other investors—in particular, active traders—believe strongly in market timing.
Whether successful market timing is possible is a matter for debate, though nearly all market
professionals agree that doing so for any substantial length of time is a difficult task.

KEY TAKEAWAYS

 Market timing is the act of moving investment money in or out of a financial market—or
switching funds between asset classes—based on predictive methods.
 If investors can predict when the market will go up and down, they can make trades to
turn that market move into a profit.
 Market timing is the opposite of a buy-and-hold strategy, where investors buy securities
and hold them for a long period, regardless of market volatility.
 While feasible for traders, portfolio managers, and other financial professionals, market
timing can be difficult for the average individual investor.
 For the average investor who does not have the time or desire to watch the market daily
—or in some cases hourly—there are good reasons to avoid market timing and focus on
investing for the long run.
Advantages of Market Timing
 Bigger profits
 Curtailed losses
 Avoidance of volatility
 Suited to short-term investment horizons

Disadvantages of Market Timing

 Daily attention to markets required
 More frequent transaction costs, commissions
 Tax-disadvantaged short-term capital gains
 Difficulty in timing entrances and exits
What Is Diversification?
Diversification is a risk management strategy that mixes a wide variety of investments within a
portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles
in an attempt at limiting exposure to any single asset or risk.

The rationale behind this technique is that a portfolio constructed of different kinds of assets
will, on average, yield higher long-term returns and lower the risk of any individual holding or
security.

KEY TAKEAWAYS

 Diversification is a strategy that mixes a wide variety of investments within a portfolio

to reduce portfolio risk.
 Diversification is most often done by investing in different asset classes such as stocks,
bonds, real estate, or cryptocurrency.
 Diversification can also be achieved by buying investments in different countries,
industries, sizes of companies, or term lengths for income-generating investments.
 Diversification is most often measured by analyzing the correlation coefficient of pairs
of assets.
 Investors can diversify on their own by investing in select investments or can hold
diversified funds that diversify on their own.

Understanding Diversification
Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25
to 30 stocks yields the most cost-effective level of risk reduction. The investing in more
securities generates further diversification benefits, albeit at a drastically smaller rate.

Diversification strives to smooth out unsystematic risk events in a portfolio, so the positive
performance of some investments neutralizes the negative performance of others. The benefits
of diversification hold only if the securities in the portfolio are not perfectly correlated—that is,
they respond differently, often in opposing ways, to market influences.

A benchmark is a standard or measure that can be used to analyze the allocation, risk, and return
of a given portfolio. Individual funds and investment portfolios will generally have established
benchmarks for standard analysis. A variety of benchmarks can also be used to understand how
a portfolio is performing against various market segments.

Investors often use the S&P 500 index as an equity performance benchmark since the S&P
contains 500 of the largest U.S. publicly traded companies. However, there are many types of
benchmarks that investors can use, depending on the investments, risk tolerance, and time
horizon.

KEY TAKEAWAYS
  A benchmark is a standard or measure that can be used to analyze the allocation, risk,
and return of a given portfolio.
 A variety of benchmarks can also be used to understand how a portfolio is performing
against various market segments.
 The S&P 500 index is often used as a benchmark for equities while U.S. Treasuries are
used for measuring bond returns and risk.

Understanding Benchmarks
Benchmarks include a portfolio of unmanaged securities representing a designated market
segment. Institutions manage these portfolios known as indexes. Some of the most common
institutions known for index management are Standard & Poor’s (S&P), Russell, and MSCI.

Indexes represent various investment asset classes. A benchmark can include broad measures,
such as the Russell 1000 or specific asset classes like U.S. small-cap growth stocks, high-yield
bonds, or emerging markets.1

Many mutual funds in the investment industry use indexes as the base for a replication strategy.
Mutual funds contain pool of investment funds that are actively-managed by portfolio managers
and invested in various securities, such as stocks, bonds, and money market
instruments.2 Fund money managers attempt to produce capital gains or income for the fund's
investors. 

Exchange-traded funds (ETFs) also use indexes as the base for a passive replication strategy.
ETFs typically track an index, such as the S&P 500 for equity ETFs. ETFs invest in all of the
securities of the underlying index, which is why they're considered passively managed funds.3

Investing in a passive fund is primarily the only way that a retail investor can invest in an index.
However, the evolution of ETFs has brought about the introduction of smart beta indexes,
which offer customized indexes that rival the capabilities of active managers. Smart beta
indexes use advanced methodologies and a rules-based system for selecting investments to be
held in a portfolio.4 Smart beta funds represent essentially the middle ground between a mutual
fund and an ETF.