Investment Strategies & Portfolio Management Flashcards

Which investment strategy focuses on buying undervalued securities with strong fundamentals?

Answer: Value investing

Value investing is an investment strategy focused on identifying and purchasing securities that are trading for less than their intrinsic value. Value investors look for companies with strong fundamentals, such as solid balance sheets, consistent earnings, and competitive advantages, but whose stock prices are temporarily depressed. The goal is to profit when the market eventually recognizes the true value of these companies.

What is the primary goal of asset allocation in portfolio management?

Answer: Reducing risk through diversification

Asset allocation is the strategic process of dividing an investment portfolio among different asset classes, such as stocks, bonds, and cash equivalents. Its primary goal is to reduce overall portfolio risk by diversifying investments across assets that react differently to market conditions. This helps to smooth out returns and protect against significant losses, aligning the portfolio with the investor's risk tolerance and financial goals.

Which metric measures a portfolio's risk-adjusted return relative to a benchmark?

Answer: Sharpe Ratio

The Sharpe Ratio measures the excess return (or risk premium) per unit of total risk (standard deviation) in an investment portfolio. It helps investors understand the return of an investment compared to its risk, relative to a risk-free rate, making it a key metric for risk-adjusted performance. A higher Sharpe Ratio indicates a better risk-adjusted return.

What does 'rebalancing' a portfolio involve?

Answer: Adjusting holdings to maintain target asset allocation

Portfolio rebalancing involves periodically buying or selling assets to bring a portfolio back to its original target asset allocation. Over time, market fluctuations can cause certain asset classes to grow or shrink, deviating from the desired risk profile. Rebalancing helps maintain the intended risk-return characteristics and ensures the portfolio remains aligned with the client's financial goals.

Which strategy is commonly used to reduce risk in a concentrated stock position?

Answer: Selling call options

Selling call options against a concentrated stock position is a common strategy to reduce risk, known as a covered call. This generates income (premium) and provides a limited buffer against a decline in the stock's price. While it caps potential upside gains, it helps mitigate downside risk and can be part of a diversification or risk management plan for highly concentrated holdings.

What is the 'efficient frontier' in Modern Portfolio Theory (MPT)?

Answer: The set of portfolios with maximum diversification

In Modern Portfolio Theory (MPT), the efficient frontier represents the set of optimal portfolios that offer the highest expected return for a given level of risk, or the lowest risk for a given level of expected return. Portfolios on the efficient frontier are considered optimally diversified because they maximize return for each unit of risk.

Which factor is NOT part of the Fama-French Three-Factor Model?

Answer: Momentum

The Fama-French Three-Factor Model explains asset returns based on three factors: market risk (excess return of the market over a risk-free rate), size (small-cap stocks tend to outperform large-cap stocks), and value (value stocks tend to outperform growth stocks). Momentum is a separate factor, often included in extended models like the Fama-French Five-Factor Model, but it is not part of the original three-factor model.

What is a key advantage of dollar-cost averaging (DCA)?

Answer: Minimizing emotional investing and lowering average cost

Dollar-cost averaging (DCA) involves investing a fixed amount of money at regular intervals, regardless of market fluctuations. This strategy helps to minimize the impact of market volatility by buying more shares when prices are low and fewer shares when prices are high, potentially lowering the average cost per share over time. It also removes the emotional decision-making of trying to time the market.

Which type of risk can NOT be diversified away in a portfolio?

Answer: Systematic (market) risk

Systematic risk, also known as market risk or non-diversifiable risk, refers to the risk inherent to the entire market or market segment. It is caused by factors such as interest rate changes, recessions, or wars, which affect all investments. Unlike unsystematic (company-specific) risk, systematic risk cannot be eliminated through diversification because it impacts all assets to some degree.