In this series of revision posts, we ask your AB Maximus CFA® Program exam trainers to give you quick tips and essential advice for different chapters in the curriculum. Handy for revision or simply for a last minute review to make sure you’re thoroughly prepared – don't miss the chance to brush up on your knowledge and do a little extra prep!
3 must-know concepts are: risk-return tradeoff, systematic and unsystematic risks, and correlation.
1. Risk-Return tradeoffs
Remember that the higher the potential returns, the higher the risk for a particular investment. According to this principle, the diversity of a portfolio mix will affect its risk level and potential for returns, which can be adjusted by changing the allocations to specific asset classes, or investments in specific sectors.
To make up for this additional risk, risk premiums are a way for investors to be compensated for investing in risky assets compared to risk-free ones, sometimes in the form of higher interest yields. Risk premiums are essentially a return over the risk-free rate of return, and as a rule of thumb all risky investments should earn a risk premium over the risk free rate.
The cumulative risk-return tradeoff of the portfolio should be assessed to determine if it is a suitable allocation to help achieve the expected level of risk and long-term return. The exact risk-return tradeoff is determined by factors such as time, risk tolerance and potential to replace losses.
2. Systematic and unsystematic risks
Systematic risk is the risk that is present in all investments, which are subject to external events such as a recession, war, or daily stock volatility. Investors try to hedge against this by buying stocks that weather these events better, such as defensive industry stocks and bearish options strategies.
On the other hand, unsystematic risk is dependent on specific company or industry of investment choice. This can be reduced by portfolio diversification.
A portfolio will not perform at maximum effectiveness if a bunch of different securities and asset classes are simply invested in for the sake of diversification. To make diversification reap the highest possible returns within an acceptable range of risk tolerance, investors should consider the correlation between asset classes and securities.
We see this correlation express itself in the global equity markets, in markets within the European Union, and between emerging markets and American markets, from which trade (and sometimes currency pegging) occurs. Even the fixed income and equities markets have some kind of correlation, but this correlation can change over time.
Computing the correlation coefficient tells the investor how far two securities are correlated. Diversification into asset classes or securities with low correlation is a way to hedge against risk and mitigate losses.
Students often get confused when it comes to: explaining why portfolio diversification is important.
When the forecast on a particular stock or asset predicts an upswing or promises much higher returns than others, this makes it incredibly attractive to investors, who are likely to want to concentrate resources investing in this particular financial asset to reap higher gains. However, this means taking on additional risks.
Modern portfolio theory teaches us that the risk of holding a single stock or asset class is far higher than holding a portfolio of diverse stocks and asset classes, as this hedges against unexpected shifts in the market. Investors not only need to pick the right stocks, but also the right combination of stocks!
A great study resource is: reading financial newspapers for portfolio theory application tips or from CFA Institute website.
CFA Institute's website contains a huge amount of reading resources that will be beneficial to students. Apart from that, regular reading of finance news stories in Singapore’s major financial papers (like the The Edge and The Business Times) will provide students further insights and practical applications of modern portfolio theory. For example, students can gain insights about current sentiments and industry opinions on portfolio management, as this excerpt from a story - contributed by a financial advisory firm - shows:
"Many speculators bet that certain asset classes will continue to trudge indeterminately higher in the belief that this time it is truly different....
Portfolio matters. I continue to be wary of valuations in the developed markets. While they might head higher in the interim, I will be looking to start protecting the portfolio in due time."
(The Business Times, Sep 9, 2017, pg. 21)
About the author
Tolmas Wong, CFA is the AB Maximus trainer for Portfolio Management. He is currently Director (Sales), Private Clients Services at CIMB Securities & an adjunct lecturer at the Singapore Management University. He has held positions at United Overseas Bank, Citicorp Vickers and Schroder Securities, and was a board member of CFA® Society Singapore and the Asian Securities Analysts Federation.