Test 2 - Investments - Returns and Risks of Investing

I)      ANALYSIS OF RETURNS

  • Review past performance to make future predictions

A)  TOTAL RETURN (from previous chapters)--Annualized

 Best return to use if you are trying to measure the total effect of returns over time given some stated beginning amount

NOTE:

 

 

 

 

Calculation of TR Return in $ and in % for TSX

From page 161 to see how the TR % of TSX is calculated:

Year

Ending & Opening Prices

Change in Value

DIV

TR

TR%

1987

3160.05-3066.18

93.87

97.32

191.19

 

 

 

 

 

 

 

2007

13833.06-12,908.39

924.67

 

344.44

1269.11

 

 

 

 

 

B)    Return Relative (RR)

  • Total return +1

 

Example:

Purchased a share that cost $100.  A year later the value is $90.  During the year received a dividend of $5 per share.  Calculate the Return Relative.

 

 

 

 

 

 

  • Converts total return to positive
  • Used for cumulative wealth index and geometric mean

 

 

 

Problem 6-2 page 178 (Demo problem) — excel handout will be used to highlight Arithmetic Mean and Geometric Mean


 

 

C)  Arithmetic Mean

  • Better measure of average performance over single periods (average)
  • Used to estimate performance for the next year

 

 

 

Formula

  • Sum of ( total return %1  + total return %2  + total return % nth year)

                              Number of years measured

 

Arithmetic Mean = Annual Average Return

 

D)  Geometric mean

  • Arithmetic mean is acceptable to evaluate estimated performance of next period but can be misleading when analyzing several years
  • Geometric Mean:

1)      shows true average compound rate of growth or the rate at which the dollar grows, taking into account the variability of the returns

2)      better measure of the change in wealth over more than a single period

3)      always less than arithmetic mean because it allows for the compounding effect

Formula

Geometric Mean = (RR1*RR2*…RR3)1/n   - 1

 

 

E)    Cumulative Wealth index –Excel handout on TSX to be used to illustrate calculations

  • Measures the cumulative effect of total returns (income & price change) over time
  • Measures change in wealth over time
  • Uses index values (TSX/NASDAQ, NYSE) to have a specified beginning value

Formula

CWI   = Beginning index * return relative 1* return relative 2 * etc.

 


 

 




 

F)     International Returns (covered this in chapter 4) — We will use same method used in chapter 4.

TR C

 

 

 

G)   Inflation adjusted returns

Total return (adjusted for inflation) =                         (1+total return)     - 1

                                                                                   (1+inflation rate)

 

            Assume the following

 

 

Nominal Return for a share

          6.02%

 

 

Inflation Rate

 

          2.%

 

 

Calculate:  Real Rate of Return

(1 + .0602)

(1 = .02)

 

Real return = 1.039 – 1= 3.9%

 

 

 






  • Real Return (adjusts for inflation) = 3.9%
  • Nominal Return (does not adjust for inflation) = 6.02%

 

II)  FACTORS THAT AFFECT INVESTMENT RISK

  • Interest Rate Risk
    • Changes in interest rates will affect investment value. 

 

 

 

 

 

  • Market Risk
    • Political, economic, social events

 

  • Inflation  (Purchasing Power)  Risk
    • interest rates usually rise with inflation

 

 

  • Business Risk
    • Risk of doing business in a particular industry or environment
    • Certain investments have higher risks

Examples:

 

 

Banks shares vs resource shares

Airline industry (costly security issues)

 

 

  • Similar business types have similar risk although differences in management, costs, and location can affect risk levels

(a)    Arrival of marshals in Ontario & target inn Canada

 

 

 

 

 

 

  • Financial Risk
    • Mix of debt and equity
    • Big interest payments may lead to default and bankruptcy or forced sale (takeover)

 

 

  • Liquidity Risk
    • Not being able to liquidate an investment conveniently and at a reasonable price
    • Stocks on NYSE, TSX, and T-Bills have lower liquidity risk
    • Private companies and shares listed on OTC have higher liquidity risk

 

 

 

  • Exchange Rate (Currency) risk

 

  • Country or Event Risk
    • Something happens that has an immediate and material impact on its financial condition

Plane crash, contaminated product side effects of medical drugs, accusations of fraud, ceo leaving the company, health of top individual in company

 

 

Types of Risk

  • Systematic Risk (Market risk)
    • Risks that are pervasive in nature (company cannot control this risk)
    • When stock markets decline most stockswill decline,when stock market goes up, most stovks go up.
    • Bank of Canada interests rates
    • Inflation and how governments deal wth it

 

 

  • Non-Systematic Risk--Specific Security risk
    • Risks that affect a specific security e.g. business or financial risk (Not a market risk)
    • Investment vehicle type, quality of management, how investment is financed and customer base of the issuer

 

 

 

 

 

StudyUp Author: James Bagshaw
Business Administration, Accounting and Management Technology
Major: Business Administration

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