Friday 20 December 2019

CFA Institute Investment Foundations Program: Chapter 17 – Investment Management (Part I)


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.





Systematic risk is the portion of total risk that:
 
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