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A Word a Day: "Dividend Yield"

December 8th, 2006 at 01:45 pm

A numerical measure that relates dividends to the current share price and puts ordinary dividends on a relative (percentage) rather than an absolute (dollar) basis. This makes it easier to compare the yields of different stocks.

The average dividend yield of the whole market (or a particular segment) is often compared to the typical (long-run) average dividend yield in order to determine if the market (or segment) is over-priced, fair value, or under-priced.

This is only an approximation however, because the dividend yield calculation is based on historic dividends and the current share price to try to predict the future. Some analysts will modify this measure to make use of estimated or "prospective" earnings to decide if current prices are fair value. Of course this is only as accurate as your estimation of prospective earnings.

A Word a Day: "Beta"

December 8th, 2006 at 01:40 pm

A measure of non-diversifiable, or market, risk that indicates how the price of a security reacts to market forces.

A Word a Day: "Market Order"

December 5th, 2006 at 12:48 pm

An order to buy or sell securities at the best price available when the order is placed.

A Word a Day: "Risk-return tradeoff"

December 5th, 2006 at 12:46 pm

The relationship (theoretical) between risk and return, in which investments with more risk should provide higher returns, and vice versa.

A Word a Day: "Tax Risk"

December 5th, 2006 at 12:42 pm

A Word a Day: "Tax Risk"

A Word a Day: "Pyramiding"

December 4th, 2006 at 10:59 am

The process of using unrealised gains to partly or fully finance the purchase of additioal securities using a margin loan.

A Word a Day: "Liquidity"

December 4th, 2006 at 10:54 am

The ability of an investment to be converted into cash quickly and with little or no loss in value.

A Word a Day: "Margin Lending"

December 2nd, 2006 at 02:01 pm

The use of borrowed funds to purchase securities. It magnifies returns (losses or gains) by reducing the amount of capital an investor must contribute to the investment.

A Word a Day: "Risk"

December 1st, 2006 at 12:42 pm

The chance (probability) that an investment's value or return will differ from its expected value or return.

A Word a Day: "Security"

December 1st, 2006 at 12:40 pm

Investments that provide evidence of a debt or of ownership of an asset, or the legal right to acquire or sell an ownership interest. Hence a "direct investment" is where an investor directly (personally) acquires a claim on a property or security. An "indirect investment" is where the investment has been made via third party portfolio eg. a managed fund or property trust.

A Word a Day: "Market Capitalisation"

December 1st, 2006 at 12:37 pm

The current value of a listed company, as measured by the number of issued shares in the company multiplied by the current market price for a share.

A Word a Day: "Gearing"

December 1st, 2006 at 12:35 pm

Gearing refers to the use of borrowings against equity to invest. It is calculated by dividing the total liabilities by the total assets.

I had a recent comment asking what level of gearing I thought was appropriate, especially for a 30 year old. Just to reiterate, I'm not a financial planner, so my thoughts are worth what you pay for them - nothing! And you should either make up your own mind after sufficient research, or go get some professional advice.

Having said that, many people have no qualms about borrowing 80% to buy a new home (gearing of 80/20 = 400%!), yet will be totally against any borrowing to invest in other assets such as shares. My views are
1. Gearing can be good to "convert" taxable income into tax-deferred capital gains when the tax-deductible interest you are paying on the loan is more than the investment income (eg. dividends) and IF it is deductible against other income (eg. wages), which is the case in Australia. Also, in case of Australia, capital gains get taxed at half your normal marginal tax rate if held more than 12 months.
2. Gearing should be against a diversified portfolio, NOT one or two "hot" stocks.
3. You must have a sufficient and secure income to cover the interest costs - don't just rely on dividends to meet the repayments (although if you only gear up to 50% or so your dividends may cover the interest costs - this is called "neutral gearing")
4. You should gear conservatively - for example if a share portfolio can be geared up to 70% LVR (about 225% gearing), you shouldn't gear up to the maximum. Generally I only gear up to 100% (a 50% LVR), so the market would have to drop considerably before I'd be worried about getting a margin call.
5. Have other assets and savings that you could use to meet a margin call. Ideally you should be in a position to buy more shares in the bottom of a bear market, not have to sell off your portfolio to avoid a margin call.
6. If you have lots of equity in your house you might consider borrowing against it to invest in a diversified share portfolio or, say, index share fund. This would be a viable alternative to using your real estate equity to borrow and buy a rental property (which many people do). I aim to balance my property assets (house and rental property) with my stock investments (direct stock portfolio, mutual funds and my retirement account investments).

This all assumes you have a high risk-tolerance like me. You really have to know your own risk tolerance before you can even consider gearing as an investment strategy. I'd suggest investing just your own capital to start with, and wait and see how you react to the first real bear market (-25% to -40% or more) before thinking about gearing. For many people gearing is TOTALLY INAPPROPRIATE as it doesn't match their personality, experience, knowledge, requirements or situation.

A Word* a Day: "Dividend Yield"

November 30th, 2006 at 02:32 pm

The rate of income generated by an investment is calculated by dividing the total dividend per share paid during the past one year period by the current share price, and expressing it as a percentage. Make sure you use the same unit for both dividend and share price (ie. cents and cents, or dollars and dollars).

*OK, this is actually two words Wink


A Word a Day: "Derivative"

November 30th, 2006 at 02:28 pm

Derivative: A financial contract whose value is based on, or derived from, another financial instrument (such as a bond or share) or a market index (such as the ASX100 index, or Nasdaq Index QQQQ)


The types of Investment Risk

November 24th, 2006 at 09:52 pm

A key component in deciding the asset mix you want to include in your total investment portfolio is "risk". In financial planning terms, market risk is defined as the variability of returns from an investment, or "the uncertainty of a future outcome". Although we are really only concerned by the likelihood of a LOSS, using volatility to measure risk is OK, as the standard deviation of investment returns is used to measure volatility, and this is directly related to the risk of an exceptional LOSS as well as the "risk" of an unusually GAIN.

Total risk = General risk + Specific risk
= Market risk + Issuer risk
= Systematic risk + Nonsystematic risk

The total risk of an asset is a combination of the many possible sources of risk.
Inflation risk - the chance the money you have invested will
decline in real value due to inflation.
Principal risk - the chance that your original investment will
decline in value or be lost entirely.
Credit risk - the chance a borrower will default on an
Market risk - the likelihood that a broad investment market,
such as the bond or stock market, will decline
in value.
Liquidity risk - the possibility you won't be able to sell or
convert a security into cash when you need the
Interest Rate Risk - the variability in a security�s return resulting
from changes in the level of interest rates
Regulation Risk - The risk of a regulatory change that could
adversely affect the stature of an investment
(eg. changes to the tax law)
Business Risk - the risk of doing business in a particular industry
or environment is called business risk
Reinvestment Risk - the risk that dividends/coupons will not be
reinvested, or cannot be reinvested at the same
rate, so that yield to maturity (YTM) isn't attained.
Exchange Rate Risk - the variability in returns on securities caused by
currency fluctuations (aka "currency risk")
Country Risk - the chance of loss due to stability and viability of
a country's economy (aka "political risk")
Valuation Risk - the chance that a an investment is overvalued
(eg. bubbles)
Timing Risk - the chance that other factors cause you to buy or
sell an investment at an inappropriate time
Forced Sale Risk - the chance that an investment is liquidated
involuntarily eg. takeover, fund closure
Some of these risks overlap eg. the principal risk may be a combination of market risk, business risk and regulation risk. It is not possible to measure of estimate some of these risks accurately, but it is still important to mentally run through this list whenever you are considering a new investment.

Standard deviation is a measure of the total risk of an asset or a portfolio, including therefore both systematic and unsystematic risk. For any investment, the "total risk" can be calculated from data on periodic (daily or monthly) valuations (prices) using the formula:

std dev = SQRT[{1/N}xSUM(Xi-mean)^2]
N is the number of data points,
Xi is the ith measured value,
mean is the mean (average) of all the values,
and the SUM is for all values (for i=1 to N).

Standard deviation for many investments is available online or in magazines. If you have an investment and have periodic (eg. daily) unit prices you can caluculate the standard deviation yourself. A tutorial on how to calculate standard deviation for your investment data using excel is available here.
Typically, the standard deviation of the annual returns for various asset classes are as follows:
Money market (cash): 2%-3%
Short-term bond: 3%-5%
Long bond: 6%-8%
Domestic stocks (conservative): 10-14%
Domestic stocks (aggressive): 15%-25%
Foreign stocks: 15%-25%
Emerging Markets stocks: 25%-35%
A couple of points to be in mind are that
a) standard deviation is a measure HISTORIC risk - ie. if you use this in your planning, you are automatically assuming that risk in the future will continue at the same levels as in the past - this isn't always true (the collapse of several hedge funds provide examples of coming undone when risk levels suddenly change).

"Although standard deviations based on realized returns are often used as proxies for expected standard deviations, investors should be careful to remember that the past cannot always be extrapolated into the future without modifications. Historic standard deviations may be convenient, but they are subject to errors. One important point about the estimation of standard deviation is the distinction between individual securities and portfolios. Standard deviations for well- diversified portfolios are reasonably steady across time, and therefore historical calculations may be fairly reliable in projecting the future. Moving from well- diversified portfolios to individual securities, however, makes historical calculations much less reliable. Fortunately, the number one rule of portfolio management is to diversify and hold a portfolio of securities, and the standard deviations of well-diversified portfolios may be more stable."
- Learing for Life.

b) you had to pick a particular period to use for calculating risk - did you use data for the past year, past 10 years, all available data?

If you have a figure for the risk level of a particular investment, and know its expected rate of return, and its covariance with the other investments in your portfolio you could then work out where your current/planned asset allocation sits in relation to the efficient frontier, and make any sensible adjustments.

Your Tolerance for Investment Risk

Each individual investor has a different level of tolerance for risk. This may depend on your age, salary and expenses, health, family, and personality.
Conservative investors are more concerned with safety of principal and minimizing risk, and can accept a lower rate of return in exchange for added peace of mind.
Aggressive investors prefer to maximize the return on investment with a more flexible strategy, and are willing to accept a higher degree of risk.

You should ask yourself the following questions to assess your risk tolerance.
- What Are Your Investment Goals?
- How much you can invest, and what rate of return on investment will you need to achieve these financial goals?
- When Will You Need the Investment Income? ie. What investment timeframe are you looking at?
- Are You Comfortable with the Possibility of Losing Money?

Once you know your own risk tolerance, you are in a position to evaluate any new investment in light of it's expected risk and return.

One school of thought is that it is best to be more aggressive and take more risks when you are starting out/younger as you will have more time to "catch up" if things go wrong. I personally think that even young investors should start out with more conservative investments and then start to add more risky investments into their portfolio over time. This way you'll get to know your risk tolerance based on actual experience rather than questionaires etc.