One of the fundamental principles in Finance is the relationship between risk and return. In general, it is reasonable to assume that investors are only willing to undertake additional risk if they are adequately compensated with extra return. This idea is rather fundamental considering that risky assets rarely produce their expected rates of return, which makes investors risk averse. This means that if they have to choose between two assets with equal rates of return, they are more likely to choose the asset with the lower level of risk. In other words, investors are willing to maximize their return on investment for a given level of risk.
Risk is an inherent factor of investment returns and is defined as the possibility of not meeting one’s investment objectives because of return uncertainty over time. Risk arises as a result of the volatility of the capital markets that has an impact on asset returns over time. Investment risk may be the result of (1) fluctuations in expected income caused by varying dividends, or missed interest payments, (2) fluctuations in the expected future price of the asset caused by changing economic conditions, and (3) fluctuations in the amount available for re-investment and in returns earned from re-investment caused by changes in tax rates, interest rates or asset returns.
The risk of an asset can be considered either on a stand-alone basis, where the asset’s cash flows are analyzed in isolation or in a portfolio context, where the asset’s cash flows are analyzed in comparison to other asset’s cash flows in the same portfolio.
(a) Stand-alone Risk
To illustrate stand-alone risk, we suppose that an investor buys $100,000 of short-term T-bills with an expected return of 5 percent. In this case, the risk is estimated accurately and therefore the investment is considered as being essentially risk free. If, instead, the $100,000 were invested in the stock market, the expected return would be uncertain and one might analyze the expected rate of return based on statistical evidence, but without being able to precisely predict it. The expected return could even be 20 percent, which would define the investment as risky.
Stand -alone risk is measured in correlation to the probability distribution of expected returns: the tighter the probability distribution of expected returns, the lower the risk of a given investment. To measure the tightness of probability distribution, finance professionals use the standard deviation (σ), a statistical measure of dispersion around a central tendency. The smaller the standard deviation, the less risky is the investment because the dispersion of expected returns is tighter and therefore the investment is less volatile.
Example of measuring risk on a stand-alone basis
The standard deviation (σ) is actually the square root of the variance of the probability distributions (σ^2). To calculate the variance of the probability distributions (σ^2), we need to know the expected rate of return (r), the probability of occurrence (P) for its return, and the deviation (ri) – (r).
We assume that the demand for the products of company X is:
- strong, with a probability of occurrence (P) 0.30 andrate of return on stock (ri) 100%, if this demand occurs,
- normal, with a probability of occurrence (P) 0.40 and rate of return on stock (ri) 15%, if this demand occurs, and
- weak, with a probability of occurrence (P) 0.30 and rate of return on stock (ri) -70%, if this demand occurs
To calculate the expected rate of return (r), we multiply each probability of occurrence (P) with the expected rate of return per demand. That gives:
- For strong demand: 0.30 x 100% = 30%
- For normal demand: 0.40 x 15% = 6%
- For weak demand: 0.30 x (-70%) = – 21%
Summing up the individual expected rates of return, we derive that the expected rate of return (r) = 30% + 6% + (-21%) = 15%.
Then, we need to calculate the deviation (ri) – (r) of the expected rate of return (r) from each possible outcome (ri).
- For strong demand: deviation = (ri) – (r) = 100 – 15 = 85
- For normal demand: deviation = (ri) – (r) = 15 – 15 = 0
- For weak demand: deviation = (ri) – (r) = -70 – 15 = – 85
Then, we square each deviation and we multiply the result by the probability of occurrence (P) for its related outcome and sum up to obtain the variance of the probability distributions (σ2).
σ^2 = (85)^2 x 0.30 + (0)^2 x 0.40 + (-85)^2 x 0.30 = 2,167.5 + 0 + 2,167.5 = 4,335
Consequently, the standard deviation (σ) is the square root of 4,335, which is σ = 65.84%
The standard deviation (σ) provides an indication of how far above or below the expected rate of return the actual return is. Between two investments, the project with the larger standard deviation is considered riskier because it has larger dispersion of expected returns indicating that the actual return may be significantly lower than the expected return.
However, there are cases that investors have to choose between two investments with one having the higher expected returns and the other having the lower standard deviation. In this case, another measure of stand-alone risk is the coefficient of variation (CV), which is the standard deviation (σ) divided by the expected return. The project with the lower coefficient of variation is the less risky.
(b) Portfolio Risk
Investors demand premium for undertaking risk. The higher the risk of an investment, the higher the expected return must be to induce investors to buy or hold a certain security. However, if investors are mostly preoccupied with the risk of their portfolio rather than the risk of their individual securities in the portfolio, then the model used to analyze the relationship between risk and return is the capital asset pricing model (CAPM).
Portfolio risk is associated to the systematic risk, which is measured by the beta coefficient (b) that indicates the volatility of a stock relative to the market. The beta coefficient measures the contribution of a stock to the risk to the portfolio, so basically beta is the theoretically correct measure of a stock’s risk. The market has by default beta equal to 1.0. In a diversified portfolio, stocks with beta = 1.0 are considered as risky as the market; stocks with beta < 1.0 are less volatile than the market; stocks with beta > 1.0 are more volatile than the market.
Measuring risk in a portfolio context
The standard deviation of a portfolio (σp) is measured by the standard deviations of its returns. Similarly like in the standard deviation of a single asset, to calculate the variance of the probability distributions we need to know the expected rate of return (rp), the probability of occurrence (P) for the portfolio return, and the deviation (rpi) – (rp). Only here, instead of one asset, we calculate the asset as a portfolio of assets.
Two major concepts in portfolio analysis are (1) covariance (Cov) that combines the volatility of a stock’s returns with their tendency to rise or decline while other stocks rise or decline accordingly and (2) correlation coefficient (ρ) that standardizes the covariance.
Overall, the CAPM model is broadly used by financial professionals and investors to analyze the relationship between risk and return. However, CAPM can be expanded with the use of other parameters that are related to stock returns such as a firm’s size and a firm’s market/book ratio. For instance, the multi-beta model, unlike traditional CAPM model, suggests that market risk is measured relative to several risk factors such as inflation, bond default premium and bond term structure premium and not only to market returns. In this context, CAPM model is challenged and the multi-beta model may be the answer to CAPM’s limitations.
As an undergraduate business student at a major private university in the northeastern United States, I had a bit of an epiphany during my junior year.
I was on track to receive my Bachelor of Science degree in Business Administration with a concentration in Marketing. I enjoyed marketing; I had a talent for it and was getting good grades.
But during a paid internship at a well known consumer goods company, my eyes were opened. Each day, it seemed, I came into direct contact with the inherent struggle that marketing had with other parts of the organization.
In particular, there was a constant struggle with the finance area. Marketing’s goals and finance’s goals were often, in fact were usually, at odds with each other. Marketing’s job was to sell as much of the company’s product as it possibly could while finance was there to protect the company. Finance was concerned about protecting the company from credit risk and keeping integrity in the pricing structure.
I saw firsthand the frustration and standstill that such circumstances could create. While I was a marketer at heart, I realized that it could be very valuable for me to ‘join the other side’ and double my concentration in school. I decided to do a dual concentration within my major and doubled up on my coursework. I added finance to marketing and did a double major.
To this day, I am thankful that I did. I have been in sales for most of my career, so my marketing bent will always come first. But as I sell high end software solutions to major financial institutions, the fact that I understand where the finance people are coming from, on both sides of the table, has proven to be invaluable.
While I am salesperson, the type of sales that I am in is focused on large, enterprise wide types of solutions. What I do is more than simply having the gift of a silver tongue. I need to understand the inner workings of an organization and how their operations and financial processes work.
Ironically, even though I have made a career in sales, my educational background in finance is clearly more valuable than my marketing education.
As I work with a customer and stand with them through business cycles and ROI models, my ability to fall back on my baseline finance education has proven to be invaluable.
My recommendation to young people today is to follow their innate strengths when selecting a major, but also to keep their minds open to learning something outside of their comfort zone as well.
You can take control of your personal finances by applying the lessons listed below.
Problem #1. Spending Without Knowing Your Limits
As in business, you will not last long financially if you spend without regard to your income. Knowing your spending limits is not hard to do. Just find the answers to these 4 easy questions:
Question #1. What is my take-home income per pay? (that is your total income less taxes)
Question #2. What do I need to spend to live?
Question #3. What is the difference after taking spending from income?
Question #4. Can I save enough for my future from the answer in Question #3?
There are many tools to help you gain answers to these questions. You can find many on the Internet. Helpful Hint: Find one that helps you set your savings targets, checks your ability to meet the targets and then shows your progress towards your goals.
Problem #2. Spending Without Setting Savings Targets
It’s OK to spend to the limits of your income but that does not provide you with any buffer for urgent purchases, or protect you from a financial emergency. Urgent purchases could be renewing a broken fridge or stove, calling a plumber to fix a broken pipe or having to spend for major car repairs. Financial emergencies could be temporary loss of income or hospitalization of a family member. How would you survive financially in any of these situations?
You can begin to save today, it’s easy. What if you went without your bought lunch each day at work? That saves you $1,000 per year on $5/day. What if you reduced your Starbuck’s coffee by 1 each working day? That’s another $1,000 per year on $5/day. Just those two amounts alone can mean a holiday for you, the beginnings of a savings plan, or an emergency buffer.
If you set a target of 10% of your take-home pay each payday that would be a good start. If you think creatively, you are sure to come up with ways to achieve this. Think of the peace of mind that would bring.
Problem #3. Spending Without Knowing How to Save
There are many easy ways for you to save money that allow you the freedom to spend when you see something you really want. Some of these are:
1. Don’t buy on impulse. Ask yourself 2 or 3 times “Do I really NEED this?” before you buy. If you cannot answer with a resounding “YES ” let it go.
2. Don’t buy things JUST because they are on sale. Only buy things you need. If you do need them wait a few weeks the price may fall even further.
3. Don’t buy the latest fashion items at the height of the season. Just wait a while. The prices usually reduce.
4. Don’t compare yourself with others and what they have. They may have purchased making the same finance mistakes as you.
5. Set yourself a savings target. Put this money aside each payday BEFORE spending any of your pay.
Problem #4. Spending Without Feeling Satisfied
Spending can leave you feeling pretty shallow and unrewarded when you purchase on a whim or fancy when you really know you cannot afford the item. What’s more you may not even use it. What a waste!
To really FEEL GOOD ABOUT SHOPPING and spending you need to know these 4 things:
1. My budget allows me the freedom to purchase this item
2. I have the cash put away already for this purchase (even though I will use my credit card for the transaction).
3. This purchase is something that I really want and will use.
4. I have purchased this item at the best possible price, saving as much as I can.
Problem #5. Spending Without Caring About Your Future
Unless you are planning for your future and financial security, you cannot be really happy. There are always worries lurking in your mind about how you would survive in a financial emergency if you have no savings. It can be very rewarding to see how quickly your savings multiply over time with only a small investment each payday.
Did you know that by saving just $5 every day this would grow into $1,867 in 12 months at 5% interest and then it grows into a whopping $10,343 in 5 years? Isn’t your future worth investing in?
Why not start to overcome your personal finance problems today? Looking back you’ll be so glad you did!
If you click on the links below you will be taken to a great budget solution. It helps you set your savings targets, checks your ability to meet the targets and then shows your progress towards your goals.
What Are Values, and Why Are They Important?
Values are principles, standards or qualities you consider worthwhile or desirable. Values will vary greatly from person to person because they depend on your personal judgment. What principles, standards, or qualities do you consider worthwhile or desirable? In other words, what are your personal values?
If you cannot answer this question confidently, you may want to continue reading. Knowing your personal values is extremely important because those values shape everything about you. Your relationships, behavior, choices, and personal identity are all affected by your values. Even if you cannot name all your values, they are still influencing every aspect of your life.
However, we are easily distracted – especially with all of the busyness and media in our lives today. It’s far too easy to get sidetracked and led away from your values. This is why it’s vitally important to know your personal values. Those values are your compass for the day to day decisions you must continually make, and they help draw the map of your entire life.
The Role of Values in Personal Finance
Now why would I be discussing values in a personal finance article? Isn’t that more of a personal development topic? Well, yes – it is. But the truth is that your values will have an impact on your financial decisions. There is no use in looking at numbers, giving you advice, or talking about investments until you can list your personal values. As I mentioned above, your values shape everything about you. Your values affect your behavior and choices. Your behavior and choices affect your personal finances. Therefore, you must recognize and understand your values before you can really start to work on your personal finances.
For example, let’s say you want to start using a budget to track your spending and find ways to save money. If your values include frugality, thrift, and organization, then this will probably be an easy goal. But if your top values include extravagance and liberation, you’re probably going to run into some problems trying to stick to a budget.
So before you spend any more time reading about personal finance, take a few minutes to identify your personal values. There are different ways to do this, but I’ll explain the method I’ve used. If this doesn’t work for you, then a quick Google search will provide you with other ways to accomplish the task. If you are married, have a partner, or your finances somehow involve other people, then you may want to do this exercise with the other people involved. This will elicit an important discussion and make sure you are in agreement about your guiding principles.
Identifying Your Values
To start this process, you will want to make sure you have time to focus. Sit down with some paper, and ask yourself this question: What is most important to me in life? Write down your values to answer this question. Try to make these one or two word phrases, and don’t worry about the order yet.
If you are having trouble listing specific values, you can try using Steve Pavlina’s list of values (http://www.stevepavlina.com/articles/list-of-values.htm) as a starting point. Go through this list and write down the values that you feel are most important. Try not to choose the values you think you should have, but choose the ones you find truly important in your life. If you’d rather not write these down on paper, I have included a link to Steve Pavlina’s List of Values in a Microsoft Word Document (www.crackerjackgreenback.com/wp-content/uploads/2008/05/list-of-values.doc) so you can edit it in an electronic format.
Prioritizing Your Values
Now try to narrow down this list by combining similar values into a single value (or two if you need to). You want to get this list down to no more than 10-15 values. Then you need to prioritize your list of values. You can do this by listing your top value first, then your second highest value, and so on until you’ve prioritized your entire list. If you are having difficulty prioritizing this list, then you might want to try CNN Money’s “The Prioritizer” calculator at cgi.money.cnn.com/tools/prioritize/prioritize_101.jsp. The Prioritizer allows you to list up to 15 items and then asks you a series of questions that forces you to choose between each possible pair of goals. Once you’re finished, the calculator will give you a list of your values in priority order according to your choices.
Examine Your Values
Now that you have your prioritized list of personal values, it’s time to examine these values closely. Are there any that you feel do not fit? Are there any you’d like to change? This can mean dropping a value, adding a value, or tweaking your priorities. Some of your financial goals may require changing your values or priorities, so feel free to reexamine this list at any time.
Evaluate How Your Values Should Affect Your Life
Finally, it’s time to consider how your specific list of values will affect your life. If these are the things that are most important to you in your life, how should they steer your decisions? You might feel like you’re not following your values very well at this point in your life, but you have the ability to change that right now. With your list of values in hand, you can evaluate any decision with intelligence and confidence. You just have to ask yourself: What should I do in this situation if these are my guiding principles in life? Apply this method to every area of your life, and you’re sure to see your life becoming more aligned with your values. As your situation changes, you might need to revise your values. Adapting to changes in your life will be crucial to your success in accomplishing your goals.
Now that you have your list of personal values, you can proceed with evaluating and planning your personal finances. These values should help lead you in making the necessary decisions about your goals, priorities, necessities, and the things you’re willing to sacrifice. All of these are important in reaching a financial future that will ultimately make you happy and fulfilled.
The Six Golden Rules of Personal Finance Should Be Part of Every College Students Repertoire While in College
An exceptional resource for today’s busy world is the podcast. Podcasts provide the latest news and breaking trends in an easy listening format, making it a highly preferred method of obtaining information for people on the go. This is especially true for citizens looking for information on the finance industry. There are plenty of high quality podcasts that focus on the world of business and finance if you know where to look. Here is a look at the podcasts I currently subscribe to.
Kiplinger is a trusted source for information on the financial world, and with their bi-monthly podcast, even the busiest among us can stay up to date on financial news. Kiplinger’s podcast is released every other Tuesday and focuses on personal finance topics. I find this podcast to be exceedingly informative and highly easy to follow. You can listen to the podcast on Kiplinger’s website, via RSS feed or downloading it directly from iTunes.
Another podcast I find to be a fantastic point of reference is hosted by Financial Post. Financial Post’s podcast is updated frequently and episodes are divided into three different categories: FP Tech Desk, Executive and Big Picture. Financial Post’s podcasts delve into business news, ever-changing finance information and informative updates on the world of technology. You can listen to the Financial Post podcast on their website, via RSS feed and iTunes.
Standard and Poor
Standard and Poor’s podcast is a formidable source for information on the global financial market. This podcast is updated constantly, with multiple episodes per day. I find the information provided by the Standard and Poor podcast to be exceedingly helpful. You can listen to Standard and Poor’s podcast on by visiting their website, or by downloading via RSS feed or iTunes.
Wall Street Journal
A source that is synonymous with business and finance is the Wall Street Journal. I follow the Wall Street Journal’s podcast very closely, and without any difficulty. The beauty of the Wall Street Journal’s podcast is that there are so many ways to tune in, including calling by phone to listen, following the podcast feed on Twitter, tuning in to Stitcher Radio, downloading via iTunes or visiting the Wall Street Journal’s website. This podcast is updated daily, and their are plenty of current episodes to catch up on.
If you’re looking for a new career—or a career goal for when you finish college—you might want to consider the banking and finance industry. Not only are many of these jobs exciting and rewarding, but they are also unlikely to phase out of workforce, which means you’ll have almost certain job security. Following are six of the top jobs in banking and finance, which come with lucrative benefits and bonuses.
1. Financial Analyst
If you have a head for numbers and a stalwart attention to detail, you might want to consider becoming a financial analyst. As banking and finance jobs go, this is one of the more exciting options, because it allows you to assist business and individual clients with their investment portfolios. You’ll need a Bachelor’s degree in finance or statistics, and MBAs are strongly desired. The average salary including benefits and bonuses is just over $73,000 per year.
2. Financial Adviser
If you like working one-on-one with clients, you might want to become a financial advisor in the banking and finance industry. This job involves helping clients prepare for their futures, from investment advice to purchases to career changes. This is a great job for anyone with accounting or economics degrees, and successful individuals can strike out on their own as independent consultants. The average salary including benefits and bonuses is around $85,000.
No, you don’t have to work for the IRS to be a financial auditor. In the banking and finance industry, an auditor helps business clients to examine and correct financial reports, depending on their needs. Some auditors work in-house as employees, while others are outsourced consultants. Either way, you can make a decent living and provide your expertise to businesses in need. With benefits and bonuses, the average salary comes to about $72,000.
4. Loan Officer
If you enjoy helping people meet their financial needs, you can try out a loan officer career in the banking and finance industry. These professionals usually have a degree in accounting or general finance, and help customers fill out and submit loan applications, process loan applications, review credit histories and help customers select the right loans for their needs. The average salary after bonuses and benefits comes to around $58,000.
5. Collection Agent
This is more of the rotten side of the banking and finance industry, but collection agents are necessary to keep businesses from going bankrupt. A collection agent helps to settle past-due accounts with customers, sometimes offering payment plan solutions or writing letters to request payment. A high school education is all that’s required for this career, though experience in the financial world is certainly helpful. Collection agents can make around $30,000 after bonuses and benefits, though high commissions can increase this number considerably.
If you love to shop, a career as a buyer might be your ticket to the banking and finance industry. A buyer is responsible for scouting, trying and ordering new products for a store, usually in retail. Some buyers work for large department store chains like Macy’s and Dillard’s, while others work for smaller stores in a local capacity. Either way, they have to find the right products in the right price range, and can make an average of $55,000 after benefits and bonuses.
April is Financial Literacy Month, a great time to consider your financial situation and to review some of the basics of personal finance. You probably understand the importance of having good credit, paying down debt and the necessity of spending less than you earn. However, it is important to understand some other financial concepts as well.
Here are three personal finance terms that you should know to get an even better grip on your financial situation.
1. Net worth. If you want a measure of how your wealth is growing, you can use net worth. To figure out your net worth, you first need to add up all of your assets. This includes things of value that you have — things you can sell for cash. Assets include property (including the market value of your home), cash, investments and other similar items. After you have added up your assets, you add up your total liabilities. These are obligations that you have, including credit card debt, medical bills and your mortgage balance. Now, subtract your liabilities from your assets. What remains is your net worth. You can use your net worth as a good way to measure the financial progress you are making.
2. Cash flow. Understanding the concept of cash flow is vital if you want financial freedom. Cash flow is a way of tracking your money as it moves through your own personal system of finances. It illustrates where your money comes from (your income) and where it is spent (your expenses). Cash flow also looks at the timing of expenses in relation to when you receive income. Knowing when bills are due and how much money you have to cover them is important, and part of understanding your cash flow.
3. Asset allocation. It is vital to understand where your assets are and how they are contributing to your long-term prosperity. Asset allocation involves looking at different types of holdings and making sure they are spread out in a way that helps you reach your goals. For example, your home might fall into the asset class of real estate. Asset allocation also includes how much of your portfolio is in stocks, bonds or other investments. Asset allocation requires that you consider risk and return, and whether or not your portfolio will help you beat inflation and build wealth at a rate that will help you live in comfort later on.
Those looking for careers in finance are certain to discover that there are near limitless opportunities. The finance industry continues to grow year after year, and financial professionals are needed regardless of the economic climate. However, some finance careers earn higher salaries than others.
1- Chief Financial Officer
Might as well start at the top of the food chain. A chief financial officer (CFO) can earn between $85,980 and $174,594 or higher, according to PayScale.com. You must have significant experience in other finance careers, however, in order to bag this level of position. You’ll earn more if you work at a large, multi-national corporation rather than a small- or medium-sized business.
2- Corporate Controller
A corporate controller is similar to a CFO, and observes many of the same roles within the corporate structure. These professionals are responsible for overseeing the entire financial department of a business, from accounting to investments, and they can make up to $96,000 per year according to PayScale.com.
3- Tax Manager
Tax managers are generally responsible for creating and implementing tax plans for their employers. This means keeping up with the latest changes in the tax code and often includes managing other employees. Salaries for this position start lower than those for corporate controllers and CFOs, but can actually be higher at the top of the range.
4- Financial Adviser
I have used a financial adviser for years, and these professionals can earn top salaries while enjoying diverse careers. They can work for themselves, banks, or corporations, depending on their goals, and they can earn up to $73,000 per year in straight salary. Keep in mind, however, that financial advisers often bring home considerable income from bonuses and profit sharing programs in addition to that base salary.
5- Investment Banker
This group of finance careers comes in lower on the list only because there is a wide range of potential salary figures. Investment bankers, particularly hedge fund managers, can earn millions each year through studious application of education and understanding of the investment market. However, according to PayScale.com, those on the lower end of the totem pole might bring home as little as $58,000.
6- Certified Public Accountant
If you like numbers and people, finance careers as a certified public accountant (CPA) might be right up your alley. There is also a large range of potential salaries in this career group, from $48,183 to $70,797 according to PayScale.
7- Senior Accountant
These professionals are well-versed in general accounting practices and are responsible for recording and evaluating all financial transactions for a company. If you’re looking for finance careers in a stable, predictable environment, this is perfect for you. Salaries range from $50,000 to $67,000 on average.
8- Private Banker
Some careers in finance have you working with people more than numbers, and this is the case with finance careers in private banking. Earn an average of $76,967, according to Salary.com, while helping wealthy customers manage their investments and income.
9- Financial Analysis Manager
The salaries for some finance careers are all over the map, and such is the case of the financial analysis manager. The median salary is nearly $100K, according to Salary.com, but some professionals make much less in this finance career.
10- Financial Analyst
Financial analysis managers and financial analysts occupy two of the most common finance careers in the United States, and serve similar functions. However, the average salaries for financial analysts are much lower at $58,000, and they are not afforded as much seniority in larger companies as their manager counterparts.