Advanced Portfolio Management
ADMS 4501 – Winter 2012 – Lois King
Lecture 1 Part 1 – Chapter 1 – The Investment Setting – Jan 5
What is an Investment?
o Current commitment of money for a period of time in order to derive future
payments that will compensate for:
Time the funds are committed.
Expected rate of inflation.
Uncertainty of future flow of funds.
By investing (saving money now instead of spending it), individuals can trade off present
consumption for a larger future consumption.
Pure Rate of Interest
Exchange rate between future consumption (future dollars) and present consumption
o Market forces determine rate.
Pure Time Value of Money
People willing to pay more for the money borrowed and lenders desire to receive a
surplus on their savings (money invested).
The Effects of Inflation
o If the future payment will be diminished in value because of inflation, then the
investor will demand an interest rate higher than the pure time value of money to
also cover the expected inflation expense.
Uncertainty: Risk by any Other Name
o If the future payment from the investment is not certain, the investor will demand
an interest rate that exceeds the pure time value of money plus the inflation rate to
provide a risk premium to cover the investment risk.
Required Rate of Return on an Investment
Minimum rate of return investors require on an investment, including the pure rate of
interest and all other risk premiums to compensate the investor for taking the investment
Arithmetic vs. Geometric Averages
When rates of return are the same for all years, the AM and the GM will be equal. When rates of return are not the same for all years, the AM will always be higher than the
While the AM is best used as an ‘expected value’ for an individual year, while the GM is
the best measure of an asset’s longterm performance.
Portfolio Historical Rates of Return
o Mean historical rate of return for a portfolio of investments is measured as the
weighted average of the HPYs for the individual investments in the portfolio, or
the overall change in the value of the original portfolio.
The weights used in the computation are the relative beginning market values for each
investment, which is often referred to as dollarweighted or valueweighted mean rate of
Risk and Expected Return
Risk refers to the uncertainty of the future outcomes of an investment
o There are many possible returns/outcomes from an investment due to the
o Probability is the likelihood of an outcome
o The sum of the probabilities of all the possible outcomes is equal to 1.0.
Risk refers to the uncertainty of an investment; therefore the measure of risk should
reflect the degree of the uncertainty.
Risk of expected return reflect the degree of uncertainty that actual return wi