Chapter 1: A brief history of risk and return.

- If you buy an asset of any time, your gain or loss from that investment is the return on your investment.
- PV of a growing annuity:
periods of number n
period per rate growth g
period per return of rate r
payment first
1
1
1
=
=
=
=
(
(
(

=
|
.
|

\
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+
+
P
g r
P
PV
r
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n

- Total Dollar Return: The return on an investment measured in dollars that accounts for all cash flows and capital gains
or losses. = Dividend Income + Capital Gain (or loss). Total dollar return = ($1.40 x 40shs) + 40($49 $35). Total
dollar return = $56 + $560 = $616.
- Dividend Yield: The annual stock dividend as a percentage of the initial stock price. {Dividend Income/Org Stock Price}.
Dividend yield = $1.40 / $35 = 4%.
- Capital Gains Yield: The change in stock price as a percentage of the initial stock price. {(Ending stock price
Beginning Stock Price) / Beginning Stock Price}. Capital gain yield = ($49

$35) / $35 = 40%.

- Total Percent Return: The ROI measured as a % that accounts for all cash flows & capital gains or losses. = Dividend
Yield + Capital Gains Yield. OR (Gain orig investment) / orig investment. Total percentage return = 4% + 40% = 44%
- Effective Annual Return (EAR): The ROI expressed on a per-year or annualized basis.:::: 1+EAR=(1+Holding
Period Percentage Return)M (thats to the M power). ------ 1 + EAR = (1 + HPR)
m
-----

m = the number of holding
periods in a year.---In this example, m = 1.5 (12 months / 8 months). Therefore: 1 + EAR = (1 + .44)
1.5
= 1.7280. -----
EAR = (1.7280) 1. ------So, EAR = .7280 or 72.80%.
- Historical Average Return:
n
return yearly
Return Average Historical
n
1 i

=
=
- Large company Stock Stock portfolio based on the S&P 500 index, which has 500 of the largest company in US.
- Small Company Stock Corresponds to the smallest 20% of the companies listed on the NYSE.
- Long term corporate bond- Portfolio of high quality bonds with 20 years to mature.
- Long term US government bonds: Portfolio of US government Bonds with 20 years to maturity.
- US Treasury Bills: Portfolio of Treasury Bills (T-Bills) with a 3 month maturity.
- Total Market Capitalization (CAP): equal to its stock price multiplied by the number of shares of stock.
- Risk Free Rate The rate of return on a riskless investment.
- Risk Premium The extra return on a risky asset over the risk free rate; the reward for bearing risk.
- Variance: A common measure of volatility or return dispersion. Sometimes, return dispersion is also call variability.
- Standard Deviation: The square root of the variance. Sometimes the square root is called volatility
- Var: = The sum of the squared deviations but the number of returns less 1 = .027/(4-1)=.009
- Standard Deviation: SD = Square Root of Variance or .009 = .09487
- Normal Distribution: A symmetric, bell shaped frequency distribution that is completely defined by its avg & STD
- Geometric Average Return: the average compound return earned per year over a multiyear period.
- Arithmetic Average Return: The return earned in a average year over a multiyear period.
- Calculating the geometric average return: for numbers 10%, 12%, 3%, -9%. = (1.10 x 1.12 x 1.03 x .91) raised to
the power 1.
o Take each of the N annual return and add a 1 to each after converting to decimal.
o Multiple all the numbers from step 1 together.
o Take the result from step 2 and raise it to the 1/N power where N is number of components.
o Finally, subtract 1 from the result in 3.
Also you can use this formula: (Ending Compound dollar amount)/(Beginning amount
invested)^(1/N) 1
- Which one to use?: The geometric average tells you what you actually earned per year on average compounded
annually. The arithmetic average tells you what you earned in a typically year.
- Blumes Formula: A formula used to combine the two averages. R(T)= (T-1)/(N-1) * Geometric average + (N-T)/(N-1)
* Arithmetic average. On this, T is the number of years in the future we are forecasting for. N is observation period
o return arithmetic
1 - N
T - N
return geometric
1
1
) ( +

=
N
T
T R
o % 76 . 10 % 7 . 11
1 - 84
40 - 84
% 7 . 9
1 84
1 40
) ( = +

= T R
- If They say Average Return they are meaning Arithmetic average unless stated otherwise:
- Dollar Weighted Average Return: average compound rate of return earned per year over a multiyear period
accounting for investment inflows, and outflows. Use the IRR function in excel for this type of problem.
o Example: So we invest $1000 at the start and get a 10% return. The next year we invest $4000 and get a
return in year 2 of -5%. What was the net return? So the 1
st
year we had 1000 and a 10% return so we have
$1100. The next year we add $4000 to is, so we have $5100 but then we have a -5% return which gives us an
ending total of $4845. So we map out our cash flow each year in order to find the Dollar weighted average
return. Year 0: -1000, Year 1: -4000, Year 2: $4845. = IRR of -2.6%.
o IRR: Internal rate of return. On the calculator, go to Apps, Finance, #8. Enter it like this IRR=(-1000, {-4000,
4845}). = -2.59%.



1) Risky assets, on average, earn a risk premium. Or there is a reward, on average, for bearing risk.
2) The greater the potential reward, the greater is the risk.
3) Invest as Early as Possible

Chapter 2: The investment Process.
- Investment Policy Statements: Divided into 2 sections: Objectives and Constraints.
o Objectives (Risk and Return): Most investors are risk averse, meaning that, all else equal, they dislike risk
and want to expose themselves to the minimum risk level possible.
o Investor Constraints: We will discuss the 5 most common
Resources: Certain investments have certain requirements.
Horizon: Refers to the planned life of the investment. How long will you have the investment.
Liquidity: How fast can you sell the investment to get cash?
Taxes: Different types are taxed differently.
Unique Circumstances: Almost everyone will have some special or unique requirements or
opportunities. For example, some companies will match certain types of investments.
- Strategies and Policies: Once the IPS is in place, the investor must determine the appropriate strategies to achieve the
stated objective. Need to address 4 key areas when they devise their initial strategy.
o Investment management: Who manages the investment. Some will manage all decisions, others none.
o Market Timing: Buying and selling in anticipation of the overall direction of the market. Some will move money
to try to get short term gains. Others are less active. But it can be difficult to time the market.
o Asset Allocation: The distribution of investment funds among broad classes of assets. How much in stocks and
how much in bonds. A rule of thumb is your equity percentage should be equal to your age subtracted from 100.
So a 22 year old would 100-22=78 have 78% in stocks.
o Security Selection: Selection of specific securities within a particular class. For example, you might decide that
you want 30% of your money in small stocks. That is an asset decision but then you must decide what stocks.
Security Analysis: Investigating particular securities within a broad class in an attempt to identify
superior performers.
Security selection vs Asset Allocation: A useful way to distinguish asset allocation from security
selection is to note that asset allocation is a macro-level activity. That is, the focus is on whole markets or
classes of assets. Security Selection is a much more micro-level activity The focus of security selection is
on individual securities.
Asset
Allocation
Secutity Selection
Active Passive
Active I II
Passive III IV
Strategy I: We actively move money b/t asset classes based on our beliefs and expectations about
future performance. In addition, we try to pick the best performers in each class. This is a full active
strategy.
Strategy II: We actively vary our holdings by class, but we dont try to choose particular securities
within each class. With this strategy, we might move back and forth between short term government
bonds and small stocks in an attempt to time the market.
Strategy III: We do not vary our asset allocations, but we do select individual securities. A diehard
stock picker would fall into this category. Such an investor holds 100% stocks and concentrates solely on
buying and selling individual companies.
Strategy IV: is a fully passive strategy. In this strategy, we seldom change asset allocations or attempt
to choose the likely best performers from a set of individual securities.
- Investment Professionals: Important considerations that you need to take into account before you actually begin.
o Choosing a broker/advisor: First step in opening an account is choosing a broker. Brokers are traditionally
divided into three groups: full service, discount, and deep discount.
Deep Discount Broker: Essentially the only services provided are account maintenance and order
execution that is buying and selling.
Full Service Broker: Will provide investment advice regarding the types of securities and investment
strategies that might be appropriate for you to consider.
Discount Broker: fall somewhere in the middle, offering more investment counseling than the deep
discount and lower commissions or fees that full service.
o Online Brokers: With an online broker, you place buy and sell orders over the internet.
o Investor Protection:
The Federal Deposit Insurance Corporation: FDIC, protects money deposed into bank accounts.
The FDIC does not insure stocks, bonds, mutual funds,, or other investments offered by banks, thrift
institutions, and brokerage firms even those calling themselves investment banks.
Investment Fraud: Suppose someone swindles you by selling you shares in a fictitious company, or
sells you shares in a real company but doesnt transfer ownership to you. Both are fraud.
Securities Investor Protection Corporation: Insurance fund covering investors brokerage accounts
with member firms. Almost all brokerage firms operating in the US are required to be members of the
SIPC. Insures account up to $500,000 in cash and securities, w/ a max $250,000 cash.
Broker Customer Relations: Things to keep in mind when dealing with a broker. First, any advice you
receive is not guaranteed. There is risk involved. Your broker does have a duty to exercise reasonable
care in formulating recommendations and not recommend anything grossly unsuitable, but that is
essentially the extent of it. Second your broker works as your agent and has a legal duty to act in your
best interest; however, brokerage firms are in the business of generating commissions. Finally, in the
unlikely event of a significant problem, your account agreement will probably specify very clearly that you
must waive your right to sue and /or seek a jury trial. Instead, you agree that any disputes will be settled
by arbitration and that arbitration is final and binding.
- Types of accounts: Multiple kinds:
o Cash account: A brokerage account in which all transactions are made on a strictly cash basis.
o Margin Account: An account in which, subject to limits, securities can be bought and sold on credit.
Call Money Rate: The interest rate brokers pay to borrow bank funds for lending to customer margin
accounts. You pay some amount over the call money rate, called the spread; the exact spread depends
on your broker and the size of the loan.
Margin: the portion of the value of an investment that is not borrowed. Margin is usually expressed as a
percentage.
o Initial Margin: The minimum margin that must be supplied on a securities purchase. This is set by the Fed,
however the exchanges and individual brokerage firms may require higher initial margin amounts.
o Maintenance Margin: The minimum margin that must be present at all times in a margin account. For
example, the NYSE requires a minimum of 25% mtc margin.
Margin Call: A demand for more funds that occurs when the margin in an account drops below the
maintenance margin. In some cases, you will be asked to restore your account to the initial margin level.
o Effects of Margin: Margin is a form of financial leverage. Any time you borrow money to make an invest, the
impact is to magnify both your gains and losses, hence you use the term leverage.
- Annualizing Returns on a Margin Purchase: Things get a little more complicated when we consider holding periods
differ from a year on a margin purchase.
o Hypothecation and street name registration:
Hypothecation: Pledging securities as collateral against a loan.
Street Name Registration: An arrangement under which a broker is the registered owner of a security
o Retirement account:
Company Sponsored Plans: 401k , etc.
Individual Retirement Accounts: (IRA) In 2010 max contribution per year was $5000.
Other Account Issues: Advisory Account In this case you pay someone else to make buy and sell
decisions on your behalf. You are responsible for paying any commissions or other costs.
- Wrap Accounts: You choose a money manager or set of money managers from a group offered
by the brokerage firm.
- Asset Management Accounts Most of the large brokerage firms offer accounts that provide
for complete money management including check writing privileges, credit cards, and margin
loans.
- Types of Positions: Once you have created your investment policy statement and decided which type of investment
professions you employ next step is to determine the types of positions you will hold in account: long or short. Long
Position: An investor who buys or owns shares of a stock is said to be long in the stock. Will make money if the price of
stock increases and lose if goes down. Short Sale: A sale in which the seller does not actually own the security being
sold.
o Basics of a short sale: