Summary Investment Management 314 Summaries

Mr. JP Steyn

Equity Investments
Luschke Labuschagne
Textbook: Investment Analysis and Portfolio Management by Reilly




Reasons/ Events why financial markets were tough in 2022:
1. Global Inflation problem
2. Russian invasion of Ukraine
3. Tightening of monetary policy
4. Markets collapsed.
Impact of invasion of Ukraine
 Impact on commodity prices
 Impact on Europe
- Influx of Ukraine refugees
- Economic integration
- Dependence on Russian oil and gas
- Political repercussions (sanctions)
 Stronger NATO isolates Russia – increase risk!



Chapter 1: Investment Setting
What is an Investment?

 INVESTMENT: what you do with savings to make them increase over time
 PURE RATE OF INTEREST: the rate of exchange between future consumption and
current consumption
 PURE TIME VALUE OF MONEY: willingness to pay difference for borrowed funds and
their desire to receive surplus on their saving give rise to this interest rate.
 REASON FOR SAVING: trade-off of present consumption for a higher level of future
consumption
 INFLATION: if investors expect a change in prices, they will require a higher rate of
return to compensate for it
o purchase power decrease over time
 UNCERTAINTY: if the future payment from the investment is not certain, the investor will
demand an interest rate that exceeds the nominal risk-free interest rate
o The higher uncertainty, the higher we want the compensation for that risk to be.
o Investment risk
o Risk premium


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,Investment Defined

 INVESTMENT: the current commitment of dollars/capital for a period of time in order to
derive (expect) future payments that will compensate the investor for:
1. The time the funds are committed.
2. The expected rate of inflation during this time period
3. The uncertainty of the future payments
 The “investor”:
o Individual
o Government
o Pension fund
o Corporation etc.
 Investment examples:
o Corporations in plant and equipment
o Individuals in stocks, bonds, commodities, or real estate etc.
Measure of Return and Risk

 Historical rate of return on an individual investment over its holding period
 Average historical rate of return for an individual investment over a number of time
periods
 Average rate of return for a portfolio of investments
 Traditional measures of risk
o Variance and standard deviation
 Expected rate of return for an investment
Measure of Historical Rates of Return

 Holding Period Return (HPR): the multiple at which your capital increased (include
dividends)


 Holding Period Yield (HPY): rate of return (%)
HPY= HPR-1
 Annual HPR and HPY
1
Annual HPR = HPRn
Where n= number of years of investment
 HOLDING PERIOD RETURN
o example 1:
Assume that you invested $1690 in March 2020 and get back $3000 at mid-March
2021. What are the HPR and the HPY for your investment in Amazon?
HPR= Ending value/ Beginning value
= $3000/$1690
= 1.775
HPY= HPR-1
= 1.775-1
= 0.775
= 77.5%

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, o Example 2:
Your investment of $40 in Apple Stock is worth $120 in two years while the
investment of $400 in Netflix Stock is worth $580 in six months. What are the annual
HPRs and the HPYs on these two stocks?
- Apple stock
1
Annual HPR = HPRn
= (120/40)^0.5
= 1.7321
Annual HPY = Annual HPR -1= 1.17321-1= 73.21%
- Netflix stock
Annual HPR = HPR^(1/n)
= ($580/$400)^(1/0.5)
= 2.1025
Annual HPY = Annual HPR -1
= 2.1025 -1
= 110.25%
Mean Historical rates of return.

 Suppose you have a set of annual rates of return (HPYs or HPRs) for an investment.
 How do you measure the mean annual return?
o Arithmetic Mean Return (AM)
𝐻𝑃𝑌
𝐴𝑀 = 𝜀
𝑛
Where E HPY= the sum of all the annual HPYs
N= number of years
o Geometric Mean Return (GM)
1
𝐺𝑀 = [𝜋 𝐻𝑃𝑌]𝑛 − 1
Where π HPR= the product of all the annual HPRs
N= number of years
 Example 3:
Suppose you invested $100 three years ago and it is worth $110.40 today. The
information below shows the annual ending values and HPR and HPY. The example
illustrates the computation of the AM and the GM over a three-year period for an
investment.




AM = 5%
GM = 3.35%
Comparison of AM and GM

 When rates of return are the same for all years, AM = GM.


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,  When rates of return are not the same for all years, AM ˃ GM.
 While AM is the best used as an “expected value” for an individual year, while the GM
is the best measure of an asset’s long-term performance.
o For a single investment, you use HPR and for a portfolio investment you use
Geometric or arithmetic returns.
A Portfolio of Investments (use weights to calculate return)

 The mean historical rate of return (HPY) for a portfolio of investments is measured as
the weighted average of the HPYs for the individual investments in the portfolio, or the
overall percent change in value of the original portfolio.
 The weights used in computing the averages are the relative beginning market values
for each investment.
 This is referred to as dollar-weighted or value-weighted mean rate of return.
EXHIBIT 1.1




𝐁𝐞𝐠
 𝐰=
𝐓𝐨𝐭𝐚𝐥 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭

Calculating Expected Rates of Return
 RISK is the uncertainty of the future outcomes of an investment.
o There are many possible returns/ outcomes from an investment due to the
uncertainty.
o Probability is the likelihood of an outcome.
o The sum of the probabilities of all the possible outcomes is = 1.0
 The expected return from an investment is defined as:
𝐧

𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐫𝐞𝐭𝐮𝐫𝐧 = ∑(𝐏𝐫𝐨𝐛𝐚𝐛𝐢𝐥𝐢𝐭𝐲 𝐨𝐟 𝐑𝐞𝐭𝐮𝐫𝐧) × (𝐏𝐨𝐬𝐬𝐢𝐛𝐥𝐞 𝐑𝐞𝐭𝐮𝐫𝐧)
𝐢=𝟏




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