Define systematic risk, unsystematic risk and beta.
Explain the concept of diversification.
Diversification is investing in multiple stocks within your portfolio so that you reduce the amount of risk you are taking. Should something happen to a few of your stocks, it won’t completely break you. Diversification is an investment strategy. The overarching goal is to keep risk down while receiving higher long-term returns. We all just want to make a few dollars towards retirement.
2. Discuss which type of risk matters to investors and why.
There are two type of risk Market (systematic) and Diversifiable (unsystematic). If you have a portfolio that is diversified, then the Diversifiable risk is not nearly as important. That is because any random event that may occur against a firm can be offset by the others within your portfolio. Market risk, however; cannot be eliminated and affect most firms. So, while both risks matter, Market risk takes precedence over Diversifiable risk
3. Define systematic risk, unsystematic risk and beta.
Systematic risk is a risk that would affect the whole entire market or a specific portion of the market. An example Systematic risk was the crash in 2008. Those of us that were invested in the market during that bursting bubble spent years trying to get back to where we were. Investments changed drastically because of this economic event.
Unsystematic risk affects a specific company or firm or organization. If you have a diverse portfolio you can eliminate unsystematic risk. An example would be if you buy stock in Gerber and then a new baby food company came on board, it would affect your Gerber stock but not the rest of the portfolio.
Beta is the relevant measure of risk. It helps investors determine the market risk of a stock. It really measures how volatile that specific stock is and whether or not it is high risk or low risk. It really goes back to how much risk are you willing to take to potentially get a huge rate of return. But you could also lose that same return should the market go down. I know we tend to err on the side of caution.
4. Discuss the tradeoff between dividends and growth; elaborate on the use and limitations of the Dividend-Discount model.
Dividends are cash flow returned to the shareholder. Growth is using what you have earned and investing back into your company now. While dividends may give shareholders instant gratification with payback, growth could give them future dividends at a higher rate. If you are willing to be patient. The Dividend-Discount model(DDM) is used to give value to a stock. The DDM tries to predict potential dividend incomes. The problem with this is, it can’t evaluate stocks that don’t pay dividends I.E like those companies that are currently in growth mode. Another downfall is that it “assumes” a lot. And I’m sure most of us know that old adage.
5. What is the efficient markets hypothesis, what are its three forms, and what are its implications?
The Efficient Market Hypothesis (EMH) states that stocks are always at equilibrium price, and it’s impossible for those of us investing to ever “beat the market.” The value of the stock moves so fast within the market that we (the people trying to profit) really don’t have enough time to profit from the change in price. We will never be able to get a higher rate of return than the stocks risk. Also, let’s be real, constantly watching the stock market makes some of us anxiety ridden.
The three forms of EMH are as follows:
Weak-Form efficiency. This basically states that all information that you have about a stock from the past, is reflected in the current prices. Any data from past stock price information moves so fast from past to present prices that there isn’t enough time to make a profit. If this is true, then having historical data on a stock would not help anyone when choosing which stock to invest in.
Semi strong-Form efficiency. This essentially says that all data is reflected in the current price so therefore it is of no use to research past reports because the price was adjusted when the good or bad news came out. An implication of this is that stock prices will only change significantly if news that comes out is different than what they originally thought.
Strong-Form efficiency. Current prices show all the data and therefore it is going to be hard to earn any return from the stock market.
Explain the concept of diversification.
Diversification relies on the concept of minimizing the effect of a single variable by incorporating a large number of other variables, which is an important risk mitigation strategy. In the context of an investment portfolio, diversification can be applied by having several different types of investments (stocks, bonds, real estate, cash, etc), or even several different vehicles within an investment type (technology vs. retail stocks, growth vs. value stocks, etc.). The goal of investment diversification should be to make a portfolio less susceptible to losses from a single event; for example, a portfolio only consisting of mega-cap technology stocks would be much more negatively affected by legislation passed to break up monopolistic internet marketplaces than a portfolio that contained real estate holdings, bonds, and energy stocks in addition to the same technology stocks.
Discuss which type of risk matters to investors and why.
Since the goal of investing is to make a return on one’s resources, all risk matters to investors because it acknowledges the probability of poor or even negative return on investment. The broad category of risk can be divided into two areas: market risk, which consists of factors that can’t be eliminated such as war, inflation, recessions, etc., and diversifiable risk, which includes factors that can be eliminated through diversification, such as lawsuits, strikes, failed major contracts, etc. Of these two broad categories, market risks matter more to investors, because it is more difficult to mitigate and is not eliminated through diversification.
Define systematic risk, unsystematic risk and beta.
Systematic risk is the risk that remains after diversification; it is also known as market risk and nondiversifiable risk. Unsystematic risk is risk that exists in the absence of diversification; it is also known as diversifiable risk or company-specific risk, and includes factors that are unique to a particular company. Beta is the relevant measure of risk that indicates how much risk a single stock contributes to a portfolio, or how risky one portfolio is relative to another portfolio.
Discuss the tradeoff between dividends and growth; elaborate on the use and limitations of the Dividend-Discount model.
The tradeoff between dividends and growth is centered around the best use of retained earnings. Any use of retained earnings for dividend distribution limits the amount that can be used for activities that will promote company growth (new infrastructure, human capital, research, etc.) and vice versa. The Dividend-Discount Model (DDM) is a method for predicting a company’s stock price by using the sum of all its future dividend payments discounted back to their present value. The limitations of the model lie in its assumptions. First, the model assumes that each company will have a constant dividend growth rate into perpetuity; however, dividends do not always grow at a constant rate, and in some cases, are reduced or even eliminated. Secondly, slight variations in the inputs can have significant effects on the output; for instance, a 6.5% variation in dividend growth rate could produce a 20% variation in predicted price! Therefore, the DDM is best used for companies who have established and consistent dividend growth rates, and are large enough to weather major market-shifting events.
What is the efficient markets hypothesis, what are its three forms, and what are its implications?
The Efficient Market Hypothesis (EMH) is the premise that stocks are always in equilibrium based on available information, and it is therefore impossible to consistently earn a higher rate of return than is justified by the stock’s risk. This hypothesis has three forms in which each focuses on a different type of information availability. The first, weak-form efficiency, asserts that all past information is already included in the current market price, and therefore the sole use of trends or technical analysis is ineffective in accurately predicting future price. The second form, semistrong efficiency, asserts that all publicly available information is currently priced into the stock’s market price, and price moves are only the result of new or unexpected public information. The third, strong-form efficiency, states that all pertinent information is included in a stock’s price, even privately held information. The implications of this hypothesis is that the market accurately and adequately reacts to information as it is made available, correctly assessing a stock’s risk is key to accurate price evaluations, and it is critical to always consider the risk of a stock when making investment decisions.
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