Key Terms
Return
The profit or benefit you receive from an investment. Risk: the uncertainty about what that return will actually be.
EAR formula
(1 + holding period return) raised to the power of (m) minus 1 where m = number of holding periods in one year
EXAMPLE
14.62% return over 3 months m = 4 (four 3-month periods in a year) EAR = (1.1462)^4 - 1 = approximately 73.5%
Arithmetic average return
Add all annual returns, divide by number of years.
Geometric average return
Multiply (1 + return) for each year; raise the product to the power of (1/N); subtract 1.
Portfolio
A collection of investments held together.
Diversification
Spreading your money across multiple assets to reduce risk.
CAPM says
Investors who take on more systematic risk should be rewarded with a higher expected return.
Interpretation
For every unit of total risk taken, the portfolio earned 0.65 units of excess return.
CAPM
Re = Rf + Beta x (Rm - Rf)
Individual stock has two kinds of risk
1. Firm-specific (unsystematic): company-level events; diversifiable.
Performance measurement asks
Did you earn more than your beta justified? That is Jensen's alpha.