,1. INTRODUCTION: GENERAL CONCEPTS AND INVESTMENT PROCESS
Important: Many exam questions are from connect (same as multiple choice in the slides) take a look at these.
Also practical sessions are made for the assignment and do not need to be known for the exam. You will not
get a similar excel type exercise but they can help to understand the theory.
1.1 INTRODUCTION
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,Recent developments in global financial markets highlight diverse trends across asset classes, regions, sectors,
and currencies, offering valuable insights into the evolving investment landscape. Since the start of 2023, world
equities have experienced notable volatility, while government and corporate bonds have delivered more stable,
moderate returns in euro terms. This divergence reflects the varying risk-reward profiles of these asset classes
in a changing market environment.
Regional stock market performance, measured using MSCI indices in euros, reveals significant differences across
North America, Developed, Emerging, and Pacific markets. These disparities, observed both year-to-date and
over the past month, emphasize the influence of regional factors on equity returns. Similarly, sector-level analysis
highlights varied outcomes, with industries such as Information Technology and Healthcare outperforming
sectors like Energy and Real Estate. These trends underline the importance of strategic sector allocation in
achieving favourable results in equity markets.
In the bond market, long-term government bond yields across different regions have shown a recent decline
after previous increases, reversing a trend observed since 2021. This shift prompts questions about the
underlying drivers, such as revised growth expectations, adjustments in central bank policies, or a rising demand
for safe-haven assets. Meanwhile, bond returns across various categories, including high-yield bonds, emerging
market government bonds, and EMU government bonds, display distinct performance patterns, reflecting the
nuanced dynamics within fixed-income segments.
Currency movements against the euro add another layer of complexity for euro-based investors. Fluctuations in
major currencies like the USD and GBP, whether appreciating or depreciating, significantly impact investment
returns when converted back into euros. These exchange rate shifts further demonstrate the interconnectedness
of global financial markets and the importance of considering currency effects in portfolio management.
Together, these insights provide a comprehensive view of global market trends, underscoring the interplay
between asset classes, regions, sectors, and currencies. Such understanding is essential for navigating the
complexities of today’s financial environment and making informed investment decisions.
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,A historical analysis of the MSCI US REIT Index reveals strong long-term growth in the US real estate sector,
highlighting its resilience as an asset class. However, recent performance appears to have softened, reflecting
less favourable current market conditions and suggesting a potential shift in the sector’s dynamics.
In the cryptocurrency market, Bitcoin’s historical USD price chart illustrates extreme volatility, characterized by
dramatic surges and sharp declines over short periods. Although Bitcoin has achieved significant highs in the
past, its current price remains below those peaks, underscoring the inherent instability and unpredictability of
the crypto market.
A long-term comparison of total return indices, which include dividends and stock splits, highlights the
extraordinary growth delivered by some equities. Apple’s performance, for instance, far outpaces that of Ageas,
showcasing the potential for individual stocks to achieve exceptional returns over time. This comparison also
raises important considerations regarding currency risk and the broader conclusions that can be drawn from such
data.
Further analysis of historical total returns for various assets reveals the transformative impact of reinvested
dividends. For example, the S&P Composite’s total return, which accounts for reinvested dividends, significantly
outstrips its simple price performance, emphasizing the critical role dividends play in wealth accumulation over
the long term.
Comparing total return indices for equities and government bonds from the same base year underscores the
pronounced advantage of equities over decades. Reinvested dividends contribute to equities achieving far higher
growth than bonds, though this comes with the trade-off of increased risk. This distinction highlights the
importance of a long-term perspective and risk tolerance in investment strategies.
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,Investments differ in risk and return potential. Individual stocks can offer high returns but also large losses. Stock
indices, being more diversified, are less volatile and generally safer. Bond indices are more stable but with lower
returns. This leads to fundamental concepts: return and risk, their trade-off, market efficiency, asset pricing, and
the importance of diversification.
1.2 BASIS CONCEPTS:
1.2.1 RETURN AND RISK
Return:
• Why invest? To earn a return
o Holding cash has an opportunity cost. Which?
• Expected return versus Realized return
o Expected return: anticipated return for some future period
o Realized return: actual return over some past period
• Realized return is not always what you expected!! → RISK
Risk:
• Possibility that the realized return will be different than the expected return
• Uncertainty about the actual return that will be earned on an investment
Return represents the incentive for investing instead of holding cash. Expected returns are anticipated future
gains, while realized returns are the actual outcomes. Risk arises from the uncertainty and the chance that
realized returns differ from what was expected, making future outcomes uncertain.
A multiple-choice question asks whether higher-risk assets should have higher, lower, or the same expected
returns as lower-risk assets. The underlying principle is that greater risk should be rewarded with higher expected
returns.
1.2.2 TRADE-OFF BETWEEN RETURN AND RISK
How to earn return?
• Financial Markets are competitive
o No-free-lunch rule
o ANSWER 1: You need to take risk to earn a return (above risk-free rate)
• Investors are risk averse
o They dislike risk, unless they are compensated for it
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, o ANSWER 2 : Investor only take risk when they expect to earn a return
Underlying investment decisions: the trade-off between expected return and risk
How much risk do we want to take?
• Depends on investment horizon and risk tolerance (risk aversion)
• Investor risk tolerance affects expected return. Why?
Investors face a trade-off between risk and return. Earning more than a risk-free return typically requires
accepting uncertainty. Because investors are risk-averse, they demand higher expected returns for taking more
risk. Investment decisions thus involve balancing potential gains with the investor’s personal risk tolerance and
investment horizon.
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, The fundamental principle in finance is the trade-off between risk and expected return. Lower-risk assets, such
as corporate bonds, generally offer lower expected returns, while higher-risk assets, including stocks, warrants,
options, and futures, present the potential for greater returns. However, with higher risk comes the possibility
of unfavourable outcomes. Achieving higher expected returns requires a willingness to accept increased risk,
making this trade-off central to investment decision-making.
Long-term data from 1980 to 2021 illustrates this relationship, as equity markets, such as the MSCI US and MSCI
Europe, have delivered substantially higher returns compared to inflation and government bonds. While bonds
and inflation remained relatively stable, equities demonstrated significant growth, especially when accounting
for dividends and coupons. This underscores the long-term rewards of bearing higher risk.
Over the same period, asset class performance shows a clear risk-return pattern. Low-risk assets, like short-term
government bonds and inflation, provided modest returns, while long-term government bonds offered slightly
higher returns. Equities, particularly in markets like MSCI US and MSCI Europe, generated significantly higher
realized returns, albeit with greater associated risk. This affirms the classic relationship between risk and return
in the long term, where higher risk can lead to greater rewards for patient investors.
From 1999 to 2011, however, asset class performance varied widely, reflecting the complexity of market
behaviour over shorter periods. U.S. and European equities experienced substantial volatility and two major
downturns, while German government bonds remained relatively stable. Greek government bonds, on the other
hand, suffered severe losses during the debt crisis, demonstrating that even traditionally safe assets can fail
under extreme conditions. Inflation stayed low throughout, emphasizing that perceptions of safety and return
potential can shift dramatically in challenging times.
In this shorter time frame, the traditional risk-return relationship broke down. Inflation and bonds continued to
offer low returns with low risk, but equities carried significantly higher risk without delivering commensurately
higher returns. This highlights the volatile and unpredictable nature of risk over shorter intervals, reinforcing that
high risk does not guarantee higher realized returns in the near term, even for traditionally rewarding asset
classes.
Expected vs Realized Risk-Return Trade-Off
Stylized fact: In the shorter term the risk-return trade-off between may not always hold (from a historical point
of view)
• This is essential what risk is about: High risk implies higher returns in the long-term (most of the time),
but as risk is high this means in the short-term you could have low even negative returns
BUT Trade-off between risk and expected return still holds!!
• WHY?
• Higher-risk assets should be priced lower to offer higher expected return than lower-risk assets
Recent trend: What used to be safe is not safe anymore!!
In theory, higher-risk assets are priced to offer higher expected returns. However, realized returns over shorter
periods may deviate from this pattern, sometimes providing little or no reward for bearing risk. Still, the
fundamental principle remains: riskier assets must promise higher expected returns to attract investors. Recent
experiences show that perceptions of safety can change, illustrating that even traditionally “safe” assets can lose
value under stress.
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