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More About the Markets

More About the Markets. Abhijan Khosla (Director of Mentorship). Who Am I?. NO MENTORSHIP THURSDAY TEST IS TEUSDAY OCTOBER 1 st !. A quick review. There are two kinds of markets Primary Secondary Securities can be listed in two ways Listed OTC

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More About the Markets

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  1. More About the Markets Abhijan Khosla (Director of Mentorship)

  2. Who Am I? GTSF Investments Committee

  3. NO MENTORSHIP THURSDAYTEST IS TEUSDAY OCTOBER 1st! GTSF Investments Committee

  4. A quick review • There are two kinds of markets • Primary • Secondary • Securities can be listed in two ways • Listed • OTC • The Efficient Market Hypothesis has 3 “levels” • Strong • Semi-strong • Weak GTSF Investments Committee

  5. A quick review • The 3 main styles of investing • Value • Growth • Momentum • What is the difference between going long and short? How do we “short” a stock? • Different levels of market cap • Large • Mid • Small • What does “liquidity” mean and why is it so important? GTSF Investments Committee

  6. What we’re doing today • We use statistics to measure risk • Some basic concepts • Properties of data sets • Mean • Median - “middle number” • Mode - occurs most often • Normal Distributions • Standard Deviations GTSF Investments Committee

  7. Normal or “Gaussian” Distributions GTSF Investments Committee

  8. Measuring Risk in Markets • Name some major risks people lending money may face • How do we measure the risk of a stock? • We use the Standard Deviation of returns to compare similarly performing companies • Standard Deviation formula GTSF Investments Committee

  9. Risk Practice Problems • You are thinking about investing in 2 companies. One of them (let’s call it ABC) following monthly returns • 4% • 2% • 3% • 1% • -8% • What is this stocks average return and standard deviation? GTSF Investments Committee

  10. Risk Practice Problems • The next company (DEF) has the following returns; • 1% • 2% • 1% • 3% • 2% • What is this stocks average return and standard deviation? • Which stock would you most likely invest in? • What other factors should influence your decision? GTSF Investments Committee

  11. Risk and Return • The basic assumption about financial markets is that greater risk is met with greater return • If you invest in a risky security you expect to be compensated with a greater return • The risk/return relationship is central to determining if securities are mispriced in the market GTSF Investments Committee

  12. More Risk! • Standard deviation is a good measure of risk for an individual securities • What about a stock’s sensitivity to the market? • When the broader market is down individual company stocks are often down, why is that? • Traders use stocks as a way to express their views on the market, often movements in stocks are not due to company news but market news GTSF Investments Committee

  13. More Risk! • The most common way to see how a stock moves in relation to the broader market (represented by the S&P 500) is Beta • Beta (or market risk) is a measure of a securities relative volatility as compared to the broader market • Beta > 1 means the stock is more volatile than the market • Beta < 1 means the stock is less volatile than the market GTSF Investments Committee

  14. Beta GTSF Investments Committee

  15. Beta Practice • Consider the following security beta’s; • 1.3 • 1.4 • .6 • .4 • .35 • 1.9 • If the market rose 10% by how much would you expect each of the securities to rise? GTSF Investments Committee

  16. Using Beta to determine return • We previously calculated expected return by taking the average of past returns • With Beta we know how a security compares to the market return • Using this information we can calculate the E(r) of a security without knowing its previous returns • E(r) = Risk Free Rate + Beta (Market Risk Premium) • Market risk premium = market return - risk free rate GTSF Investments Committee

  17. CAPM • The use of Beta, Market Return and the Risk Free Rate to determine expected return is called the Capital Asset Pricing Model or CAPM • What do you think we use for the risk free rate? • If a stock’s beta is 1.2 and the market has returned 10% on average while the risk free is 2% what is the stock’s expected return? GTSF Investments Committee

  18. GTSF Investments Committee

  19. Alpha • If everything perfectly followed CAPM then we would be able to very accurately predict what a given stock would return • If this was true then we would not need actively managed funds to gain outsized returns • Alpha is the portion of returns associated with a given security or set of securities • Alpha represents a greater return for lower risk GTSF Investments Committee

  20. Risk/Return Payoff • Which portfolio manager did a better job last year and why? Bill - 25% return Carl - 20% return • What does the information above NOT tell us about the returns of the portfolios in question? GTSF Investments Committee

  21. The Risk Return Payoff • RISK! • We haven’t accounted for the risk each manager took so we don’t know if they got those returns by picking smart investments or simply taking a lot of risk GTSF Investments Committee

  22. Risk Adjusted Returns • Let’s take another look at those returns Bill – (25% return, stdev of 20%) Carl – (20% return, stdev of 25%) GTSF Investments Committee

  23. What does the Sharpe Ratio Tell Us? • A sharpe ratio tells us how much return the portfolio gets for every “unit” of risk it takes • A sharpe ratio of > 1 means for every unit of risk we get more than 1 unit of return • A sharpe ratio of > 2 means that we are getting double the return for every unit of risk we take GTSF Investments Committee

  24. Where does “risk” come from? • Beta measures risk compared to markets • Alpha measures risk of individual assets • If we hold multiple securities at the same time can we increase/decrease our risk? • Correlation - the degree to which two things move together • If we have a portfolio of highly correlated stocks then our entire portfolio will rise and fall at the same time GTSF Investments Committee

  25. Correlation • Correlation - a measure of how closely two things move together GTSF Investments Committee

  26. Why We Care About Correlation GTSF Investments Committee

  27. Diversification • We can increase our portfolio’s risk/return relationship by diversifying • If we hold non-correlated assets then they will move separately eliminating moves cause by correlations • Say you have a portfolio of only Tech stocks (GOOG, APPL, MSFT) how would you diversify your holdings so a drop in the tech sector wouldn’t bankrupt you? GTSF Investments Committee

  28. Diversification GTSF Investments Committee

  29. Quiz Time! What is Beta? • Security Risk • Market Risk • Treasury Risk • Interest Rate Risk

  30. Quiz Time! What is Beta? • Security Risk • Market Risk • Treasury Risk • Interest Rate Risk

  31. Quiz Time! How many low correlation stocks do we need to achieve the diversification benefit • 5 • 20 • 30 • 33

  32. Quiz Time! How many low correlation stocks do we need to achieve the diversification benefit • 5 • 20 • 30 • 33

  33. Quiz Time! What is NOT a component of CAPM • Market Risk • Risk Free Rate • Beta • Market Return

  34. Quiz Time! What is NOT a component of CAPM • Market Risk • Risk Free Rate • Beta • Market Return

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