HS 328 Investments
Risk and return
Total return combines income and price change. Standard deviation measures total risk; beta measures only systematic risk. Unsystematic risk is diversifiable, systematic risk is not. The capital asset pricing model prices systematic risk: expected return = risk-free rate + beta × (market return − risk-free rate). Alpha is the difference between actual and required return; the security market line graphs the relationship.
Portfolio construction
Markowitz diversification works through imperfect correlation, producing an efficient frontier of portfolios offering the highest return for each level of risk. Asset allocation explains most of the variability of returns over time. Rebalancing enforces discipline. Performance measures differ: Sharpe uses total risk (standard deviation), Treynor uses beta, and Jensen's alpha is a risk-adjusted excess return.
Fixed income and equity valuation
Bond prices move inversely to yields; modified duration approximates the percentage price change for a small yield change, and convexity refines it. Immunization matches duration to the investment horizon. Equity valuation uses dividend discount models, price multiples, and present value of growth opportunities.
Traps
- Treating beta as a measure of total risk.
- Confusing variance with standard deviation.
- Using the arithmetic mean when a compound (geometric) return is required.
- Comparing nominal returns across periods with different inflation.
- Forgetting that a bond selling at a premium has a yield to maturity below its coupon.
Worked example
The risk-free rate is 4%, beta is 1.2, and the expected market return is 9%. Required return = 4% + 1.2 × (9% − 4%) = 10%. If the analyst expects 11%, alpha is +1%. Separately, a bond with modified duration 6 should fall about 3% if yields rise 50 basis points.