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Unit 2 Investing Notes
The Basics Of Portfolio Construction
Risk tolerance
-the comfort level you have with certain risks (mainly dependent on your time frame)
Types Of Risk
Risk Avoidance
-the risk of not investing
Single Stock Risk
-the risk of overconcentration in one area (want exposure to be broader not all in one place)
Systemic Risk
-risk from broad trends (ex. Bank failures, 2008)
Interest Rate Risk
-risk as a result of changes in monetary policy (fed policy)
Inflation Risk
-risk as a result of a general rise in prices (use cpi (output) and ppi (input) as our main measurement of this risk)
Macroeconomic Risk
-risk from large scale economics (ex. The business cycle, changes in the value of the dollar, wars, pandemic)
Volatility
-wide variety in price of a stock, big moves up and down (lacks price stability)
P/E Ratio
-allows us to value a company and make comparisons across an industry
Trailing P/E
-based off of realized eps
Forward P/E
-based off of guidance
S&P 500 Index
-broad diversified index which tracks the performance of 500 leading publicly traded companies
Breaking down the S&P 500
Sectors
-large groupings from a single part of the economy (ex. 11 sectors of the S&P)
Industries
-subgroupings of sectors
Sectors That Make Up The Index
Consumer Discretionary
-companies that rise and fall based on consumer demand (ex. retailers)
Consumer Staples
-Businesses that sell the necessities of life (ex. Grocery stores)(very defensive sector)
Communication Services
-companies that provide communication services (ex. Verizon)
Energy
-companies that participate in the production and distribution of energy
Financials
-companies from a variety of different financial industries (ex. Banking, insurance)
Health Care
-companies that provide health care (ex. Biotech, pfizer, J&J)
Industrials
-companies involved in the creation of infrastructure (ex. Railroads, caterpillar, steel)
Information Technology
-companies that develop, manufacture, and distribute tech related products (ex. FANG)
Materials
-companies that source, process, and distribute raw materials (ex. Nat gas, oil)(commodities)
Real Estate
-companies that build and develop real estate (ex. REITS)
What is the problem with rare earth metals?
-china has the most rare earth metals in the world and that poses a risk to the US
What is the Spread?
-the difference between banks lending rates and their deposit rates (interest they pay)(also known as net interest margins)
What do you not want when in a rising rate environment
-take on duration risk (don't lock in duration when rates are likely to go higher)
-we want short term treasuries so we are not exposed to our bonds potentially going to a discount if we may need to sell (ex. SVB bank)
What does the bond market act as an indicator for?
-the stock market
-stock market trades based off of the stock market
Asset Allocation
-selection of categories of investments
-allocation of capital across different investment classes
-balances risk and reward
-must pay attention to time frame, and risk tolerance
When allocating assets what things must you pay attention to? TQ
must pay attention to time frame/horizon and risk tolerance when allocating assets
Forms of asset allocation
-dividends (helps shareholders)
-buy back stock (increases eps)
Diversification
-don't keep all of your eggs in one basket
-avoiding concentrations within a category
-portfolio should be diversified across asset classes and within the asset classes
Trading/traders
-investing with a short time frame
Investing/investors
-investing with a long time frame
There's also growth vs value investors
Growth Investing
-higher potential growth but more volatility and risk
Value Investing
-investing in blue chip companies that are making cash
Dividends
-earnings redistributed to shareholders
-our form of compound interest
-also a form of income
-paid quarterly (take in cash or reinvest)
-form of a capital allocation strategy (doing what's in the best interest of their shareholders)
Two types of dividend payers
Dividend aristocrats
-increasing dividends for over 25 years
Dividend Kings
-increasing dividends for over 50 years
Asset Classes
-Cash
-Equities (stock)
-Bonds
Asset Classes play an important role in a portfolios
-growth
-income
-defense
-growth and income
-inflation protection
Bank products
-monetary assets (anything we keep in the bank)
Mutual Funds
-professionally managed and transparent funds
-liquid (stock is more liquid)
-good if you don't have the time
-price at the end of the day (day by day trading)
-downside is fees
-if mutual fund owner is a heavy trader you will have high tax liabilities
Why would someone buy a mutual fund? TQ
-don't have time to invest and low fees
Index Funds
-portfolio of stocks that track an index
-major ones are the S&P 500 (top 500 companies), and
-very low fees with better returns typically
-benchmark against portfolio managers
-liquid
Why would someone buy an index fund?
-low costs, liquid
Why would someone buy an ETF?
-most commonly used to gain exposure to a specific segment of the market
-can buy snp through spy
-come in every shape and size and get there is one for every investor appetite
-very liquid trade like stocks
ETFs (Exchange Traded Funds)
-better liquidity (trade like stocks)
-diversified
-similar to index funds
-help provide specific exposure to any segment of the market (similar to index funds except for this)
Moral Hazard
-one party takes unnecessary risk because they believe they will be bailed out
-lack of incentive to prevent against risk
-term came about in 2008 when banks were bailed out being “too big to fail”
Stock Options
-derivatives (financial instrument based on the underlying security)(price of something is based on a security)
-use leverage
-used mainly to hedge risk
-time sensitive contracts
-1 contract = 100 shares of stock
Calls
-want stock to go up (bet on up direction)
Puts
-want stock to go down (bet in the down direction)
Treasury
-something that manages money
Federal Agencies
United States Department of the treasury
-steward of the us financial system
-job is to maintain systems critical to overall financial infrastructure of the us
-manage financial of the federal government
-collect taxes, issue debt, controls who issues debt
What government agency issues debt to the United States government? TQ
-the us treasury
Executive Agency
-agency responsible for promoting economic prosperity and ensuring financial security of the us
Treasury Secretary
-president's personal contact to the fed and they recommend policies to the president
-appointed by president
-janet yellen
Central Bank (Federal Reserve)
-perseus policy that that result in maximum employment and stable prices
-get a mandate from congress to do this
Feds Key Functions
-conduct monetary policy
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Federal Reserve Chairman
-4 year term
-jerome powell
-appointed by the president
Whats the feds two mandate (from the federal reserve) TQ
-stable prices
-maximum employment
Know Basic Valuation metrics
-pe ratio
-eps (earnings/shares outstanding)
-dividend yield (dividend amount/stock price) (similar to bond yield, due to changes in the price of stock)
Discounted Cash Flows
-when analyzing a company you need to discount cash flows when valuing it one example would be inflation
New Valuation Metrics
Relative value
-value compared to other companies
Intrinsic value
-companies actual value within itself
-inherent value
Price to book ratio (pb ratio)
-compares the net value of a company (assets-liabilities) to its market cap
-comparing what people are paying for it vs its book value
-equal to 1 is trading at its book value
-below one it its trading
-good for value investors
Price to sales ratio (p/s ratio)
-typically used if company does have a positive eps
-compares a stock price to company revenue not earnings (because these companies don't have positive earnings)
-revenue per dollar of sales
-lower the ratio the better
Why do we look at company sales/revenue instead of earnings in a price to sales ratio?
-because the company doesn't have earnings/profits
Debt to equity ratio
-helps investors determine how a company finances its assets
-how much debt does the company use to finance its assets
-don't want companies using too much debt to finance its assets
Which ratio do we use when a company is not profitable? TQ
-price to sales ratio
Options
-an options contract gives you the right to buy and sell a product for a specified period of time
-one contract gives you 100 shares of power (same exposure as someone who buys 100 shares of stock)
-very time sensitive contracts
-buyers have the right but not the obligation to sell (if the option is exercised buy the stock at a certain strike price)
Call option
-the right to buy (want stock to go up)
Put option
-the right to sell (want stock to go down)
Time value
-options are time sensitive contracts as time goes by you have less time value as time goes by value goes down
What does is mean if an option is in the money? TQ
-the option has intrinsic value
Call is in the money if… TQ
-the strike price is below the stock price
Put is in the money if… TQ
-strike price is above stock price
What does intrinsic value mean with regards to options?
-measure of what an asset is worth (if an option isn't at strike price is has no value)
What are the two types of values? TQ
Relative value (comparing to other things)
Intrinsic value (inherent value)
(know both)
Derivatives
-derive from the stock
-dependent on an underlying asset (the price effects the options)
-can impact stock price if it forces buying and selling
Market Value
-the price of something today
Strike price
-price at which you can sell the option (you don't have to actually exercise it many just trade option contracts)
-if you buy an option at like 165 and the strike price is 170 you essentially are buying a 170 dollar stock for 165 if you exercise
Premium
-the price you pay for the option (the most you can lose is the premium)
Intrinsic value in options
-the value of the option is based on the difference between the stocks market price and the option strike price
-we want intrinsic value (basically just means how much you have profit)
Expiration date
-date at which the option expires
In the money
-an option that has intrinsic value
-strike price is lower than the stock price
Out of the money
-when the option has no intrinsic value
-strike price is higher than the stock price
Why trade options?
-You get to define your risk
-allows investor to speculate using leverage
-allows investor to gain exposure to a security using the fraction of the capital
Pros to options
-limited downside
-using fraction of the capital
-flexible strategies (tons of strategies that can be used with these)
Cons to options
-Complex
-eroding time value
-requires a margin account
Hedging
-protecting yourself from risk
-you can protect gains by buying puts (gives you exposure to downside for a fraction of the price)(hedging can be expensive)
How do we know whether a call or put option is in the money?
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Options strategies
-long calls or long puts (directional bet on security going up or down)
-using options you can take risk at a fraction of the cost
Covered calls (learn more about this)
-investor purchases the underlying stock
-investor sells call against long position
-your basically selling the option and collecting the premium if your correct
-strategy to gain income while holding stock
-buyer of option owns right to call stock away from shareholder selling covered calls
-you could lose all your shares selling covered calls
Selling Upside Covered Calls
-an income producing strategy
Married puts
-strategy in which a person purchases a stock and the purchased put options on the same number of shares
-protects your downside
Three Main Asset Classes
-cash
-equities
-bonds
Asset classes play an important role in portfolios…
-growth
-diversification
-etc. s
Commodities
-know about futures
-betting on future prices of commodities
What are the two congressional mandates the fed has to follow, (price stability, maximum employment) TQ
What is an alternative asset TQ
-an asset that is speculative ex. Crypto, collectibles, art
Common stock
-you have ownership
-your long
-you have voting rights
Preferred stock TQ
-no voting rights
-aren't purchased to generate returns
-only buy preferred stock for its dividend
-preferred stock holders get money first when company goes bankrupt where common stock does not
-buy a preferred stock because it pays an above market dividend
Review Days
Risk Tolerance
-depends on your goals and objectives
-ex. Long term vs short term (older vs younger)
-risk for young investors is meeting long term retirement goals
-risk for older investors (big swings in investments you may not have time to make up)
-time frame less than 5 years you should not invest in the stock market
Treasury
Us Treasury
-safeguard financial interests of the us govt
Functions of the us treasury
-collect taxes (IRS)
-manage currency (US Mint)
Federal Reserve Key Functions
-conduct monetary policy
-promote stability in financial systems
-supervise and regulate financial institutions
-operate the notions payment and settlement system
-promote consumer protection
Federal reserve
-central bank of the us
-manage the banking system
-keep the banking system healthy
Huge revenues can be misleading
Balance sheet doesnt lie
What sheet do we calculate financial ratios off of
-balance sheet
Eps is a valuation metric we want positive eps
What index do we use to see volatility in the market
-VIX
What changes and what does not change with a bond
-coupons dont change
-price changes
Option Decay
-as time goes by
Capital markets
-wall street
-debt market, equity market, currency markets etc.
Coupon, premium discount
Selling covered calls
-when your long a stock (don't plan on selling) and you sell calls to someone on your underlying stock
-income generating strategy
-risk is that you can get the stock called away from you
-with 1000 shares you can sell 10 covered calls
-until strike date there's a possibility a person can call stock away from you if it hits the strike (slightly risky)
Review Day 2
What would you do to hedge your portfolio in fear of a downside? (Cheaply and efficiently)
-buy S&P 500 puts to protect against broad downside
-gives you exposure to overall market downside
Options are very useful for what two things?
-hedging
-generating returns
Asset allocation, treasuries, dividends, different types of , inverted yield curve(be compensated for duration)
What is an inverted yield curve
-when long term rates are lower than short term rates
-signal for recession
-you need to be compensated for duration risk
Fed funds rate should be higher than inflation rates
Fed funds rate
-overnight lending rates for banks
What are the three benefits of a 401k TQ
-reduces taxable income
-money grows tax deferred
-employer matching contributions (free money)
What are the three types of us treasuries
-t bills
-t notes
-t bonds
Does a t bill pay interest
-no only t notes and t bonds pay interest
-1 year duration
What is the problem with IPOs
-very risky
What are the most important aspects of a bond TQ
-coupon (how much interest will I earn)
-credit quality (most important)
-duration (how long will it take to get my money back)
Can you lose money in a us treasury
-yes if you trade it
-no if you hold it to maturity
How do we determine if a bond is above or below par
-coupon (interest rate the bond pays)
S&P 500 is a passive investment strategy (PROJECT)
Individual stock picking and mutual funds are active strategies
-don't want mutual funds who trade a lot because of high tax liabilities
-active (buying and selling) individual stocks
-passive (not doing much buying and selling) index fund (S&P 500)
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you give me the definition i give you the term
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Definition: The comfort level you have with certain risks, mainly dependent on your time frame.
User
risk tolerance
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Correct! Risk tolerance is the term corresponding to the given definition. Well done! Here's the next one:
Definition: The risk of not investing.
User
lack of risk
ChatGPT
I'm sorry, but that's not the correct term. The term corresponding to the definition "The risk of not investing" is actually "Risk Avoidance." It refers to the potential risk or opportunity cost associated with not participating in investment activities. Let's move on to the next one:
Definition: The risk of overconcentration in one area, where you want exposure to be broader and not all in one place.
User
concentration risk
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Apologies for the confusion in my previous response. You are correct this time! The term corresponding to the given definition is "concentration risk." It refers to the risk that arises from having an excessive concentration of investments in a particular asset, sector, or region, which can potentially lead to significant losses if that area performs poorly. Well done! Let's proceed to the next definition:
Definition: Risk from broad trends, such as bank failures or significant market events like the financial crisis of 2008.
User
systemic risk
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That's correct! The term corresponding to the given definition is "systemic risk." It refers to the risk that is inherent in the overall system or economy, affecting a large number of participants or assets. Events like major market downturns, economic crises, or widespread failures can contribute to systemic risk. Well done! Here's the next one:
Definition: Risk as a result of changes in monetary policy, particularly related to interest rates set by the central bank.
User
interest rate risk
ChatGPT
Absolutely right! The term corresponding to the definition is "interest rate risk." It refers to the risk faced by investors or bondholders due to changes in interest rates. When interest rates fluctuate, the value of fixed-income securities such as bonds can rise or fall, impacting their market prices. Great job! Here's the next definition:
Definition: Risk as a result of a general rise in prices, measured by metrics like Consumer Price Index (CPI) and Producer Price Index (PPI).