In a previous article, we introduced the
CFA Institute Investment Foundation Program (Read
more here). It is a free program
designed for anyone who wants to enter or advance within the investment
management industry, including IT, operations, accounting, administration, and
marketing. Candidates who successfully
pass the online exam earn the CFA Institute Investment Foundations Certificate.
There are total of 20 Chapters in 7
modules, covering all the essential topics in finance, economics, ethics and
regulations. This series of articles
will highlight the core knowledge of each chapter.
Chapter 17 provides an overview of the investment
management. The learning outcome of chapter 17 is as follows:
·
Describe
systematic risk and specific risk;
·
Describe
how diversification affects the risk of a portfolio;
·
Describe
how portfolios are constructed to address client investment objectives and
constraints;
·
Describe
strategic and tactical asset allocation;
·
Compare
passive and active investment management;
·
Explain
factors necessary for successful active management;
·
Describe
how active managers attempt to identify and capture market inefficiencies.
The returns on investments, such as
shares, bonds, and real estate, will be affected by general economic conditions.
Returns will also be affected by issues that are specific to the particular
investment. These two types of risk are called systematic risk and specific
risk, respectively.
Systematic risk: The risk created by general economic
conditions is known as systematic or market risk because the risk stems from
the wider economic system. For example, if the economy enters a recession, many
companies will see a downturn in their revenues and profits.
Specific risk: Risk that is specific to a certain
company or security is variously known as specific, idiosyncratic,
non-systematic, or unsystematic risk. Examples include the share price response
when a company launches a successful new product (e.g., the Apple iPad) or the
response to the negative news that a promising new drug has failed in trials.
Diversification is one of the most important principles
of investing. When assets and/or asset classes with different characteristics
are combined in a portfolio, the overall level of risk is typically reduced. Mathematically, a portfolio that combines two
assets has an expected return that is the weighted average of the returns on
the individual assets. Provided that the two assets are less than perfectly
correlated, the risk of the portfolio (measured by the standard deviation of
returns) will be less than the weighted average of the risk of the two assets
individually. Overall, this means the
risk–return trade-off, which is a key concern for investors, is better for a
portfolio of assets than for individual assets.
Most investors hold more than two
securities in their portfolios. Adding more securities to a portfolio will
reduce risk through diversification, although eventually the additional
benefits begin to lessen. Specific risk
is reduced by combining additional shares, but as the portfolio moves beyond 30
shares, the incremental risk reduction becomes small and the associated trading
costs may outweigh any incremental benefit of risk reduction.
Combining different asset classes can
also improve diversification and reduce a portfolio’s risk by reducing specific
risk. For example, an investor might combine investments in various stock and
bond markets with investments in real estate and commodities to reduce the
overall risk of a portfolio.
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