Investing Chapter 1
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49 Terms
What is diversification?
Holding different investments so that one poor-performing investment has a smaller effect on the overall portfolio.
What type of risk does diversification help reduce?
Concentration risk (also called specific risk).
Does diversification eliminate all risk?
No. It reduces concentration/specific risk but does not eliminate market risk or guarantee a profit.
What is the risk-return tradeoff?
The relationship where higher expected returns generally require accepting greater uncertainty/risk.
Does higher risk guarantee a higher return?
No. Higher risk means greater uncertainty, not a guaranteed higher return.
What does owning common stock mean?
You are an owner/shareholder of the company.
How can a stockholder earn a return?
Through dividends and capital gains or losses from changes in the stock's price.
What does owning a bond mean?
You are lending money to the issuer and are a creditor/lender.
How can a bond investor earn a return?
Through interest/coupon payments and changes in the bond's value.
What is a nominal return?
The return before accounting for inflation.
What is a real return?
The return after accounting for inflation and its effect on purchasing power.
What is the approximate real return formula?
Real return ≈ Nominal return − Inflation rate.
What happens to purchasing power when inflation is high?
Purchasing power decreases because prices rise and each dollar buys less.
What is an investment?
Money or funds committed today to an asset with the expectation of receiving future income or growth.
What are the two basic components of investment return?
Income and capital gain/loss.
What does HPR stand for?
Holding Period Return.
What is the HPR formula?
HPR = (Income + Capital Gain/Loss) ÷ Beginning Value.
How do you calculate a capital gain?
Capital gain = Ending Value − Beginning Value.
What is a direct investment?
An investment where you directly own the underlying asset, such as owning a property or shares of a company.
What is an indirect investment?
An investment where you invest through a fund or intermediary that invests for you, such as a mutual fund or ETF.
What is an Investment Policy Statement (IPS)?
Framework that guides investment decisions by outlining:
goals
risk tolerance
constraints
investment guidelines
What does an IPS NOT do?
It does not predict the market or guarantee investment returns.
What does liquidity mean?
How easily an investment can be bought or sold without significantly affecting its price.
What extra risk comes with international investing?
Currency, political, tax, accounting, and market-related risks can be added to the investment.
How can currency movements affect your return?
Changes in exchange rates can increase or decrease your return when converted back into your home currency.
What is a realized gain/loss?
A gain or loss that occurs after an investment is sold.
What is an unrealized gain/loss?
A gain or loss on an investment that you still hold and have not sold.
What is the difference between investment income and a capital gain?
Investment income is money earned while holding an investment, such as dividends or interest
Capital gain is an increase in the investment's value when its ending value is higher than its beginning value.
Why is cash in a non-interest-bearing chequing account generally not considered an investment?
It does not generally generate income or growth and is primarily held for transactions, safety, and liquidity.
What is the difference between an ETF and a conventional mutual fund?
ETF: trades on an exchange throughout the day at market prices
Conventional mutual fund: normally priced and traded based on its end-of-day value
What type of investment is suitable for a short-term emergency reserve?
A highly liquid, low-risk investment with a maturity of one year or less.
Who typically supplies funds to the financial system?
Households are typically net suppliers of funds.
Who typically demands funds from the financial system?
Businesses and governments are typically net demanders of funds.
What is a derivative security, and how does its value change?
Security whose value is derived from an underlying asset, such as a stock.
Examples: options and futures.
Underlying asset changes → derivative's value changes
What is the difference between stated interest and discount basis?
Stated interest has a stated rate
Discount investments are bought below face value
What is the difference between active and passive mutual funds?
Active funds try to beat a benchmark
passive funds track an index
What is the difference between a marginal tax rate and an average tax rate?
Marginal = tax rate on the last dollar
Average = total tax ÷ total income
What is the difference between an individual and institutional investor?
Individual = person
institutional = organization investing large amounts.
Type: security or property
ownership: direct or indirect
claim: debt or equity
time: short-term or long-term
How do common stock, bonds, funds/ETFs, and property differ?
Stock = ownership + dividends/price change
bond = lending + coupon/principal
fund/ETF = indirect + distributions/NAV change
property = direct + rent/price change
allocates resources efficiently
funds productive projects
supports expansion and government spending
promotes economic growth