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Chapter 11Charles P. Jones, Investments: Analysis and Management,Tenth Edition, John Wiley & Sons

Prepared byG.D. Koppenhaver, Iowa State University

Analyzing and Managing Common Stocks

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Impact of the Market

Pervasive and dominant The single most important risk affecting

the price movement of common stocks Particularly true for a diversified portfolio of

stocks Accounts for 90% of the variability in a diversified

portfolio’s return Investors buying foreign stocks face the

same situation

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Required Rate of Return

Minimum expected rate of return needed to induce investment Given risk, a security must offer some

minimum expected return to persuade purchase

Required RoR = RF + Risk premium Investors expect the risk free rate as well as

a risk premium to compensate for the additional risk assumed

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AB

C

kM

kRF

0 1.0 2.00.5 1.5

SML

BetaM

E(R)

Security Market Line

Beta = 1.0 implies as risky as market

Securities A and B are more risky than the market Beta >1.0

Security C is less risky than the market Beta <1.0

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Understanding the Required Rate of Return

Risk-free rate RF =Real RoR +Inflation premium

Real rate of return is basic exchange rate in the economy

Nominal RF must contain premium for expected inflation

The risk premium Reflects all uncertainty in the asset

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Passive Stock Strategies

Natural outcome of a belief in efficient markets No active strategy should be able to beat

the market on a risk adjusted basis Emphasis is on minimizing transaction

costs and time spent in managing the portfolio Expected benefits from active trading or

analysis less than the costs

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Passive Stock Strategies

Buy-and-hold strategy Belief that active management will incur

transaction costs and involve inevitable mistakes

Important initial selection needs to be made Functions to perform: reinvesting income

and adjusting to changes in risk tolerance

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Passive Stock Strategies

Index funds Mutual funds designed to duplicate the

performance of some market index No attempt made to forecast market

movements and act accordingly No attempt to select under- or overvalued

securities Low costs to operate, low turnover

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Active Stock Strategies

Assumes the investor possesses some advantage relative to other market participants Most investors favor this approach despite

evidence about efficient markets Identification of individual stocks as

offering superior return-risk tradeoff Selections part of a diversified portfolio

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Active Stock Strategies

Majority of investment advice geared to selection of stocks Value Line Investment Survey

Security analyst’s job is to forecast stock returns Estimates provided by analysts

expected change in earnings per share, expected return on equity, and industry outlook

Recommendations: Buy, Hold, or Sell

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Sector Rotation

Similar to stock selection, involves shifting sector weights in the portfolio Benefit from sectors expected to perform

relatively well and de-emphasize sectors expected to perform poorly

Four broad sectors: Interest-sensitive stocks, consumer durable

stocks, capital goods stocks, and defensive stocks

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Market Timing

Market timers attempt to earn excess returns by varying the percentage of portfolio assets in equity securities Increase portfolio beta when the market is

expected to rise Success depends on the amount of

brokerage commissions and taxes paid Can investors regularly time the market to

provide positive risk-adjusted returns?

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Efficient Markets and Active Strategies

If EMH true: Active strategies are unlikely to be

successful over time after all costs If markets efficient, prices reflect fair

economic value EMH Proponents argue that little time

should be devoted to security analysis Time spent on reducing taxes, costs and

maintaining chosen portfolio risk

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