Equity Investments
Luschke Labuschagne
Textbook: Investment Analysis and Portfolio Management by Reilly
Reasons/ Events why financial markets were tough in 2022:
1. Global Inflation problem
2. Russian invasion of Ukraine
3. Tightening of monetary policy
4. Markets collapsed.
Impact of invasion of Ukraine
Impact on commodity prices
Impact on Europe
- Influx of Ukraine refugees
- Economic integration
- Dependence on Russian oil and gas
- Political repercussions (sanctions)
Stronger NATO isolates Russia – increase risk!
Chapter 1: Investment Setting
What is an Investment?
INVESTMENT: what you do with savings to make them increase over time
PURE RATE OF INTEREST: the rate of exchange between future consumption and
current consumption
PURE TIME VALUE OF MONEY: willingness to pay difference for borrowed funds and
their desire to receive surplus on their saving give rise to this interest rate.
REASON FOR SAVING: trade-off of present consumption for a higher level of future
consumption
INFLATION: if investors expect a change in prices, they will require a higher rate of
return to compensate for it
o purchase power decrease over time
UNCERTAINTY: if the future payment from the investment is not certain, the investor will
demand an interest rate that exceeds the nominal risk-free interest rate
o The higher uncertainty, the higher we want the compensation for that risk to be.
o Investment risk
o Risk premium
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,Investment Defined
INVESTMENT: the current commitment of dollars/capital for a period of time in order to
derive (expect) future payments that will compensate the investor for:
1. The time the funds are committed.
2. The expected rate of inflation during this time period
3. The uncertainty of the future payments
The “investor”:
o Individual
o Government
o Pension fund
o Corporation etc.
Investment examples:
o Corporations in plant and equipment
o Individuals in stocks, bonds, commodities, or real estate etc.
Measure of Return and Risk
Historical rate of return on an individual investment over its holding period
Average historical rate of return for an individual investment over a number of time
periods
Average rate of return for a portfolio of investments
Traditional measures of risk
o Variance and standard deviation
Expected rate of return for an investment
Measure of Historical Rates of Return
Holding Period Return (HPR): the multiple at which your capital increased (include
dividends)
Holding Period Yield (HPY): rate of return (%)
HPY= HPR-1
Annual HPR and HPY
1
Annual HPR = HPRn
Where n= number of years of investment
HOLDING PERIOD RETURN
o example 1:
Assume that you invested $1690 in March 2020 and get back $3000 at mid-March
2021. What are the HPR and the HPY for your investment in Amazon?
HPR= Ending value/ Beginning value
= $3000/$1690
= 1.775
HPY= HPR-1
= 1.775-1
= 0.775
= 77.5%
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, o Example 2:
Your investment of $40 in Apple Stock is worth $120 in two years while the
investment of $400 in Netflix Stock is worth $580 in six months. What are the annual
HPRs and the HPYs on these two stocks?
- Apple stock
1
Annual HPR = HPRn
= (120/40)^0.5
= 1.7321
Annual HPY = Annual HPR -1= 1.17321-1= 73.21%
- Netflix stock
Annual HPR = HPR^(1/n)
= ($580/$400)^(1/0.5)
= 2.1025
Annual HPY = Annual HPR -1
= 2.1025 -1
= 110.25%
Mean Historical rates of return.
Suppose you have a set of annual rates of return (HPYs or HPRs) for an investment.
How do you measure the mean annual return?
o Arithmetic Mean Return (AM)
𝐻𝑃𝑌
𝐴𝑀 = 𝜀
𝑛
Where E HPY= the sum of all the annual HPYs
N= number of years
o Geometric Mean Return (GM)
1
𝐺𝑀 = [𝜋 𝐻𝑃𝑌]𝑛 − 1
Where π HPR= the product of all the annual HPRs
N= number of years
Example 3:
Suppose you invested $100 three years ago and it is worth $110.40 today. The
information below shows the annual ending values and HPR and HPY. The example
illustrates the computation of the AM and the GM over a three-year period for an
investment.
AM = 5%
GM = 3.35%
Comparison of AM and GM
When rates of return are the same for all years, AM = GM.
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, When rates of return are not the same for all years, AM ˃ GM.
While AM is the best used as an “expected value” for an individual year, while the GM
is the best measure of an asset’s long-term performance.
o For a single investment, you use HPR and for a portfolio investment you use
Geometric or arithmetic returns.
A Portfolio of Investments (use weights to calculate return)
The mean historical rate of return (HPY) for a portfolio of investments is measured as
the weighted average of the HPYs for the individual investments in the portfolio, or the
overall percent change in value of the original portfolio.
The weights used in computing the averages are the relative beginning market values
for each investment.
This is referred to as dollar-weighted or value-weighted mean rate of return.
EXHIBIT 1.1
𝐁𝐞𝐠
𝐰=
𝐓𝐨𝐭𝐚𝐥 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
Calculating Expected Rates of Return
RISK is the uncertainty of the future outcomes of an investment.
o There are many possible returns/ outcomes from an investment due to the
uncertainty.
o Probability is the likelihood of an outcome.
o The sum of the probabilities of all the possible outcomes is = 1.0
The expected return from an investment is defined as:
𝐧
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