💲Intro to Investments Unit 12 – Investment Performance and Strategies

Key Investment Concepts

• Investment involves allocating resources (money) with the expectation of generating future returns
• Risk is the potential for loss or variability in returns, while return represents the gain or loss on an investment
• Diversification spreads investments across different asset classes (stocks, bonds, real estate) to reduce overall portfolio risk
  • Ensures that poor performance in one investment does not significantly impact the entire portfolio
• Asset allocation determines the proportion of a portfolio invested in various asset classes based on risk tolerance and investment goals
• Time value of money concept states that money available now is worth more than an identical sum in the future due to its potential earning capacity
• Compounding refers to the process of generating earnings on reinvested earnings, leading to exponential growth over time
• Inflation erodes the purchasing power of money over time, necessitating investments that outpace inflation to maintain wealth

Types of Investment Strategies

• Passive investing involves buying and holding a diversified portfolio of assets to match market returns (index funds)
  • Requires minimal active management and often results in lower fees
• Active investing attempts to outperform the market through security selection and market timing
  • Relies on research, analysis, and the expertise of fund managers
• Value investing focuses on identifying undervalued securities trading below their intrinsic value with the expectation of price appreciation
• Growth investing targets companies with high potential for growth in earnings and revenue (technology startups)
• Income investing prioritizes generating steady cash flows through dividends or interest payments (bonds, dividend-paying stocks)
• Momentum investing involves buying securities that have recently outperformed and selling those that have underperformed
• Contrarian investing goes against prevailing market sentiment by buying assets that are out of favor and selling those that are popular

Risk and Return Analysis

• Systematic risk (market risk) affects the entire market and cannot be diversified away
  • Includes factors such as interest rates, inflation, and economic cycles
• Unsystematic risk (specific risk) is unique to individual securities and can be reduced through diversification
  • Encompasses company-specific events (management changes, product recalls)
• Beta measures the volatility of a security or portfolio relative to the overall market
  • A beta greater than 1 indicates higher volatility than the market, while a beta less than 1 suggests lower volatility
• Standard deviation quantifies the dispersion of returns around the mean, serving as a measure of total risk
• Sharpe ratio evaluates risk-adjusted returns by comparing the excess return of an investment to its standard deviation
  • Higher Sharpe ratios indicate better risk-adjusted performance
• Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for securities
  • Helps determine the required rate of return for an investment given its level of risk
• Risk premium is the additional return an investor expects to receive for taking on higher risk compared to a risk-free investment

Performance Measurement Techniques

• Total return measures the overall gain or loss of an investment over a specified period, including price appreciation and income (dividends, interest)
• Annualized return converts the total return into an average annual return, allowing for comparison across different time periods
• Benchmark comparison evaluates the performance of an investment or portfolio against a relevant market index (S&P 500 for U.S. equities)
• Jensen's alpha measures the excess return of a portfolio over its expected return based on its level of systematic risk (beta)
  • Positive alpha indicates outperformance, while negative alpha suggests underperformance
• Treynor ratio assesses risk-adjusted performance by comparing the excess return of a portfolio to its systematic risk (beta)
• Information ratio gauges the consistency of a portfolio's excess returns relative to a benchmark, considering the tracking error
• Attribution analysis decomposes portfolio returns into various factors (asset allocation, security selection) to identify sources of over- or underperformance

Portfolio Construction and Management

• Asset allocation determines the mix of asset classes in a portfolio based on risk tolerance, investment objectives, and time horizon
• Strategic asset allocation establishes long-term target weights for each asset class
  • Reviewed periodically and rebalanced to maintain desired risk-return profile
• Tactical asset allocation involves short-term deviations from strategic weights to capitalize on market opportunities or mitigate risks
• Rebalancing realigns the portfolio back to its target asset allocation by selling overweighted assets and buying underweighted ones
  • Helps maintain the desired level of risk and can be triggered by time (quarterly, annually) or threshold (5% deviation)
• Core-satellite approach combines a core portfolio of passive investments with satellite holdings of actively managed funds or individual securities
• Factor investing targets specific characteristics (value, size, momentum) that have historically generated superior risk-adjusted returns
• ESG investing incorporates environmental, social, and governance factors into investment decisions to align with personal values and mitigate long-term risks

Market Efficiency and Anomalies

• Efficient Market Hypothesis (EMH) states that asset prices fully reflect all available information, making it difficult to consistently outperform the market
  • Weak form efficiency suggests that past price and volume data are fully incorporated into current prices
  • Semi-strong form efficiency implies that all publicly available information is quickly reflected in prices
  • Strong form efficiency asserts that even private or insider information is fully incorporated into prices
• Market anomalies are patterns or discrepancies that contradict the EMH and offer potential opportunities for excess returns
• January effect refers to the tendency of small-cap stocks to outperform in January, possibly due to tax-loss selling in December
• Value effect describes the outperformance of value stocks (low price-to-book, low price-to-earnings) over growth stocks
• Momentum effect suggests that stocks that have performed well in the recent past tend to continue outperforming in the near future
• Size effect indicates that small-cap stocks have historically generated higher returns than large-cap stocks, albeit with higher risk
• Post-earnings announcement drift is the tendency for a stock's price to continue moving in the direction of an earnings surprise for several weeks after the announcement

Behavioral Finance Insights

• Behavioral finance combines psychology and economics to explain irrational investor behavior and its impact on financial markets
• Prospect theory suggests that investors are more sensitive to losses than gains and make decisions based on perceived gains and losses rather than final wealth
• Loss aversion is the tendency to prefer avoiding losses to acquiring equivalent gains, leading to risk-averse behavior
• Mental accounting refers to the tendency to treat money differently based on its source or intended use, rather than viewing wealth holistically
• Herd behavior occurs when investors follow the crowd and make decisions based on the actions of others rather than their own analysis
• Anchoring is the tendency to rely too heavily on an initial piece of information (the anchor) when making decisions
• Confirmation bias is the inclination to seek out and interpret information in a way that confirms pre-existing beliefs while discounting contradictory evidence
• Overconfidence bias leads investors to overestimate their abilities and the accuracy of their predictions, resulting in excessive risk-taking

Practical Application and Case Studies

• Constructing a balanced portfolio for a risk-averse investor nearing retirement
  • Emphasize fixed income (bonds) and stable, dividend-paying equities to generate income and preserve capital
• Analyzing the performance of a mutual fund relative to its benchmark and peer group
  • Consider factors such as expense ratios, turnover, and manager tenure in addition to risk-adjusted returns
• Evaluating the potential impact of a market anomaly (size effect) on portfolio construction
  • Determine whether to tilt the portfolio towards small-cap stocks based on risk tolerance and investment objectives
• Assessing the efficiency of a specific market (emerging markets) and its implications for active versus passive investing
  • Higher inefficiency may justify active management, while greater efficiency favors passive strategies
• Examining the role of behavioral biases in a specific investment decision (holding onto a losing stock)
  • Identify biases such as loss aversion and anchoring that may have influenced the decision
• Developing a factor-based investment strategy to capitalize on the value and momentum effects
  • Combine value and momentum factors to construct a portfolio with the potential to outperform the market
• Incorporating ESG considerations into the investment process for a socially responsible investor
  • Screen out companies with poor ESG ratings and select those with strong ESG performance and alignment with personal values