A zoom-in, zoom-out, connect-the-dots tour of Investment and Portfolio Theory
Let's parse that
Using discussion forums
Please use the discussion forums on this course to engage with other students and to help each other out. Unfortunately, much as we would like to, it is not possible for us at Loonycorn to respond to individual questions from students:-(
We're super small and self-funded with only 2 people developing technical video content. Our mission is to make high-quality courses available at super low prices.
The only way to keep our prices this low is to *NOT offer additional technical support over email or in-person*. The truth is, direct support is hugely expensive and just does not scale.
We understand that this is not ideal and that a lot of students might benefit from this additional support. Hiring resources for additional support would make our offering much more expensive, thus defeating our original purpose.
It is a hard trade-off.
Thank you for your patience and understanding!
Earnings in excess of spendings is called savings. If savings are kept idle, they lose value because of inflation. Instead, savings is invested (consumption delayed) in order to increase the quantum of money through return on investment. The return is influenced by time value, inflation and the risk attached.
On investments, the investors develop an expected rate of return which increases with increase in payback time, inflation and risk. The investor has many avenues where he can invest his savings, one of which is term deposit, the simplest and least complicated asset.
Bonds are another asset available to investors who can earn return in the form of interest or capital appreciation. The risks in bond investment depend on whether they are issued by Govt or by Corporate.
Stocks is a lucrative investment option with a bit of speculative angles attached. Stocks tag along high potential return as well as risk. From the various options available, which should the investor choose from?
The Markowitz Modern Portfolio states that risk averse investors develop portfolios in order to optimise their return at given levels of risk. One of the main assumptions and a reasonable one is that all investors are risk averse and not risk preferring. We will look into each aspect of the theory in detail.
In order for investors to compare various assets in terms of the returns from them, return should be quantified. Return is expressed in terms of annualised yield. The yield of individual investments is the average return over the holding period, i.e. Mean which can be both arithmetic mean return or geometric mean return.
The portfolio return is measured as the weighted average of the yield of individual investments where the weights are the proportion of invested amount. Expected return is found using random variables and probability theory to plot the possible returns. The dispersion of possible return around the expected return indicate the risk involved.
Risk of individual investments and of portfolio can be measured using statistical measures: Variance and Standard Deviation. Standard Deviation is the most common measure of risk as it gives the deviation of possible returns around expected returns taking into consideration both the upward and downwards swing.
The risk of the portfolio is measured using standard deviation, covariance and correlation. The risk of the portfolio should be lower than the weighted average risk of the individual investments in the portfolio and this is the effect of achieving risk-return trade-off.
Correlation gives the degree and magnitude with which one asset reacts with all other assets in the portfolio. This measure is important so that the investor avoids risk of losing money from oppositely related assets. The portfolio risk is the function of standard deviation of individual investments, weights and the correlation.
The efficient frontier contains all portfolios which have the highest return for a given risk or lowest risk for a given return. Investors aim to achieve a portfolio on the efficient frontier curve depending on their risk appetite, i.e. investor utility curve. The risk inherent in investment are of two categories: Systematic and Unsystematic.
Systematic risk is the risk affecting all assets in the entire economy. This risk cannot be reduced but only unsystematic risk can be reduced through diversification of investments. The risk reduces as the investor continues to diversify his investments. At the point of diversification where the systematic risk is 0, he achieves the market portfolio.
There are certain assets which are risk-free like the Govt Treasury Bonds. These risk free assets formed the basis for yet another theory developed with the Markowitz theory as base: The Capital Asset Pricing Model, the most significant valuation model.
The CAPM gives the minimum required rate of return from investments and is a function of risk free rate of return, beta and the market risk premium. We take an example and compute the CAPM to understand the model. CAPM also helps investors to decide whether to buy, sell or hold investments.
Discounting risky cash flows presents a challenge: you can either increase the discount rate (by risk-adjusting it) or decrease the cash flow (replace it with its certainty equivalent). Almost everyone does the former.
Assets with the same risk should offer the same return. This is the principle underlying risk-return models. We see a simple example of a risk-return model, calculating the cost of debt for a firm from its credit rating and the duration of the borrowing.
The CAPM is the most widely known and widely used risk-return model for equities. Understand how the CAPM works, what market beta is, and how the ERP can (or rather can not) be cleanly measured.
The overall cost of capital for a firm with both debt and equity is given by the wacc. This is a weighted average of the costs of debt and equity. The weights used in the average? The market prices of debt and equity respectively.
Top-down betas are obtained from regression, but are very noisy (standard errors in regressions are quite large!) Instead, we should use bottoms-up betas, especially for conglomerates. Understand the intuition, as well as the outline of the procedure.
If you are valuing a private company, the beta you really ought to use in your WACC calculation is not the market beta, its the total beta.
The beta that we get via regression, or (on Yahoo FInance:-)) is a levered beta, which reflects the market co-movement of a company at its current level of leverage. There is a simple way to unlever and relever betas.
Loonycorn is us, Janani Ravi and Vitthal Srinivasan. Between us, we have studied at Stanford, been admitted to IIM Ahmedabad and have spent years working in tech, in the Bay Area, New York, Singapore and Bangalore.
Janani: 7 years at Google (New York, Singapore); Studied at Stanford; also worked at Flipkart and Microsoft
Vitthal: Also Google (Singapore) and studied at Stanford; Flipkart, Credit Suisse and INSEAD too
We think we might have hit upon a neat way of teaching complicated tech courses in a funny, practical, engaging way, which is why we are so excited to be here on Udemy!
We hope you will try our offerings, and think you'll like them :-)