Traditional investing: risk vs reward

1. Traditional investing: risk vs reward

We're back! Now, we'll cover some traditional finance decisions.

2. What is a market?

A market is one of the many infrastructures where parties exchange goods. Traditional markets, like the ones you can see on the slide, are regulated, with defined rules. For any good or service there is a demand and a supply curve. The higher price for a good, the less of it is demanded. For example, you wouldn't sell many ice cream cones for $10000 per cone compared to a $1 per cone. However, if ice cream was on every corner and people could get it anytime, you couldn't charge much for your cones regardless of whether if it was a hot day and everyone wanted it. The price for a good is the intersection of these supply and demand curves, the equilibrium.

3. Investment strategies

Overall, a traditional market, like stocks, will have four types of investment strategies: belief-based investing, high-frequency trading, financial fundamentals, and technical trading rules.

4. Belief-based investing

Let's start with the first one, belief-based investing. This investor obviously likes bread. She will buy stock in her favorite bread bakery because she "believes" others like the bakery's bread too. This applies to other examples as well.

5. High-frequency trading (HFT)

Another trading strategy is called High Frequency Trading, HFT. HFT executes programmatically, without a human. HFTs need speed, volume and volatility to succeed. When you place a stock order at say $100, a computer jumps you in line buying it for $99.99 then selling it to you at $100. HFTs jump you in line and make money on your stock order, doing this thousands of times per second. This is profitable but requires servers in the same data centers as the markets which is extremely expensive.

6. Financial fundamentals

Another approach, fundamental financial investing focuses on financial indicators regardless of the company's industry. Reviewing cash flow, revenue, earnings per share are fundamental indicators. This investor would say "I don't care if the company makes genetically modified food, which may be questionable, these earnings per share is good so I will invest."

7. Technical trading rules (TTR)

Another type of trading could employ technical trading rules, TTR. DataCamp has a TTR course with great examples. TTR employs non-financial mathematical indicators, like MACD or the relative strength indicator, to quantify risk or reward. For example, these rules help you spot a building momentum for a stock like Amazon, so you can buy it on the way up. Adjacent to TTR is the Capital Asset Pricing Model, CAPM covered next.

8. Capital Asset Pricing Model (CAPM)

Using CAPM an investment's expected return, ER, is equal to beta times expected market return minus the risk free rate. Beta measures how often a stock goes up when the market goes down and vice versa. Betas between 0 and 1 mean a stock is less volatile than the market and betas greater than 1 mean the stock is more volatile than the overall market. The risk-free rate is the rate of return for an investment that never defaults. It's hypothetical, but in practice the 3-month US Treasury bill's interest rate minus inflation is often used.

9. Capital Asset Pricing Model (CAPM)

Let's look at an example. If the risk-free rate is 3%, the expected market return is 9% and a stock's beta is 0.5 then the expected return is 0.03 plus 0.5 times 0.09 minus 0.03. That equates to 0.03 plus 0.5 times 0.06 and working through the arithmetic the expected Return is 0.06.

10. Interpreting a CAPM chart

A CAPM chart visualizes the beta on the x-axis and the expected return on the y. Visually, it's the trade-off between risk on the x-axis and reward on the y-axis. Note that the risk-free rate is located on the y-axis since the risk is zero. A line is drawn to the least risky, highest expected return investment. This line represents the best hypothetical portfolio you could construct. Investment options most near to the line represent the efficient investments, with the least risk for the best corresponding reward. For example, on the right, we've zoomed in. The right-most blue dot is less efficient than the uppermost. The uppermost has a higher return and essentially the same risk on the x-axis. You would select the investment closest to the line because you get better returns, on the y-axis for nearly the same risk on the x-axis. For any investment, not just stocks, if you model risk and reward, you can create this type of chart.

11. Data-driven investing!

Let's make some data-driven investments!

Create Your Free Account

By continuing, you accept our Terms of Use, our Privacy Policy and that your data is stored in the USA.