RISK PREFERENCES

The trade off between Risk and Return

Most, if not all, investors are risk averse

To get them to take more risk, you have to offer higher expected returns

Conversely, if investors want higher expected returns, they have to be willing

to take more risk.

Ways of evaluating risk

Most investors do not know have a quantitative measure of how much risk that
they want to take

Traditional risk and return models tend to measure risk in terms of volatility or
standard deviation

The Mean Variance View of Risk

In the mean-variance world, variance is the only measure of risk. Investors

given a choice between tow investments with the same expected returns but
different variances, will always pick the one with the lower variance.
 Estimating Mean and Variance

• In theoretical models, the expected returns and variances are in terms of

future returns.
• In practice, the expected returns and variances are calculated using
historical data and are used as proxies for future returns.

Illustration 1: Calculation of expected returns/standard deviation using

historical returns

GE The Home Depot

Year Price at Dividends Returns Price at Dividends Returns
end of year during year end of year during year
1989 $ 32.25 $ 8.13
1990 $ 28.66 $ 0.95 -8.19% $ 12.88 $ 0.04 58.82%
1991 $ 38.25 $ 1.00 36.95% $ 33.66 $ 0.05 161.79%
1992 $ 42.75 $ 1.00 14.38% $ 50.63 $ 0.07 50.60%
1993 $ 52.42 $ 1.00 24.96% $ 39.50 $ 0.11 -21.75%
1994 $ 51.00 $ 1.00 -0.80% $ 46.00 $ 0.15 16.84%
Average 13.46% 53.26%
Standard Deviation 18.42% 68.50%

Concept Check:

• While The Home Depot exhibited higher variance in returns, much of

the variance seems to come from the stock price going up dramatically
between 1989 and 1992? Why is this ìupsideî considered risk?
• Should risk not be defined purely in terms of "downside" potential
(negative returns)?

Variance of a Two-asset Portfolio

µ portfolio = wA µ A + (1 - wA) µ B

σ 2
portfolio = wA2 σ 2
A + (1 - wA)2 σ 2
B + 2 wA wB ρ ΑΒ σ Aσ B

where

wA = Proportion of the portfolio in asset A

The last term in the variance formulation is sometimes written in terms of the covariance
in returns between the two assets, which is

σ AB =ρ ΑΒ σ Aσ B

• The savings that accrue from diversification are a function of the correlation
coefficient.

Illustration 2: Extending the two-asset case - GE and The Home Depot

Step 1: Use historical data to estimate average returns and standard deviations in
returns for the two investments.

Standard Deviation (1990-

Stock Average Return (1990-94)
94)
General Electric 13.46% 18.42%
The Home Depot 53.26% 68.50%

Step 2: Estimate the correlation and covariance in returns between the two investments
using historical data.

Returns on Returns on HD (RGE- (RH- (RGE- Avge(RGE)

Year
GE(RGe) (RH) Avge(RGE))2 Avge(RH))2 (RH-Avge(RH)
1990 -8.19% 58.82% 0.04686 0.00309 (0.01203)
1991 36.95% 161.79% 0.05518 1.17786 0.25494
1992 14.38% 50.60% 0.00008 0.00071 (0.00024)
1993 24.96% -21.75% 0.01322 0.56265 (0.08625)
1994 -0.80% 16.84% 0.02034 0.13265 0.05194
Total 0.13568 1.87696 0.20835

Variance in GE Returns = 0.13568/4 = 0.0339 Standard Deviation in GE Returns =

0.03390.5 = 0.1842

Variance in HD Returns = 1.87696/4 = 0.4692 Standard Deviation in HD Returns =

0.46920.5 = 0.6850
Covariance between GE and The Home Depot Returns = 0.20835/4 = 0.0521

Correlation between GE and The Home Depot Returns =ρ GH = σ GH / σ G σ H =

0.0521/(0.1842*0.6850) = 0.4129

Step 3: Compute the expected returns and variances of portfolios of the two securities
using the statistical parameters estimates above ñ

Consider, for instance, a portfolio composed of 50% in GE and 50% in The Home Depot
ñ

Average Return of Portfolio = 0.5 (13.46%) + 0.5 (53.26%) =

Variance of Portfolio = (0.5)2 (18.42%)2 + (0.5)2 (68.50%)2 + 2 (0.5) (0.5) (0.4129)

(18.42%) (68.50%) = 1518%

Standard Deviation of Portfolio = 38.96%

From Two Assets To Three Assets to n Assets

The variance of a portfolio of three assets can be written as a function of the

variances of each of the three assets, the portfolio weights on each and the
correlations between pairs of the assets. The variance can be written as follows
-

σ p2= wA2 σ 2A + wB2 σ 2B + wC2 σ 2

C + 2 wA wB ρ AB σ A σ B+ 2 wA wC ρ AC

σ A σ C+ 2 wB wC ρ BC σ B σ C

where

wA,wB,wC = Portfolio weights on assets

σ 2
A ,σ 2
B ,σ 2
C = Variances of assets A, B, and C

ρ AB , ρ AC ,ρ BC = Correlation in returns between pairs of assets (A&B, A&C,

B&C)

The Data Requirements

Number of covariance terms = n (n-1) /2

where n is the number of assets in the portfolio

Number of Covariance Terms as a function of the number of assets in

portfolio
Number of Number of
Assets covariance terms
2 1
5 10
10 45
20 190
100 4950
1000 499500
Some Closing Thoughts on Risk

Most Investors do not measure their risk preferences in terms of standard

deviation
For other investors, risk has to be assessed by using

• Scoring Systems (where investors are asked for information or questions

to answers which can be used to analyze how much risk an investor is
willing to take)
• Risk categories (High; Average; Low)
• Life cycle theories of investing

A Life Cycle View of Risk

General Propositions:

As investors age, there will be a general increase in risk aversion, leading to

greater allocation to safer asset classes.

PORTFOLIO VALUE

• The value of a portfolio constrains your choices at later stages.

• This is because trading individual securities creates costs - brokerage
costs, bid-ask spreads and price impact
• There is a critical mass value, below which it does not pay to actively
manage a portfolio - it is far better to invest in funds.
• The larger a portfolio, the more choices become available in terms of
assets - this is largely because some components of trading costs - the
brokerate costs and the spread - may get smaller for larger portfolios.
• If a portfolio becomes too large, it might start creating a price impact
which might cause trading costs to start increasing again.
 Taxes do matter: Individuals should care about after-tax returns
Stock and Bond Returns: 1926-1989 - Before and After Taxes
Stocks Bonds
Market Returns $ 534.46 $ 17.30
After Transactions Cost $ 354.98 $ 11.47
After Income Taxes $ 161.55 $ 4.91
After Capital Gains Taxes $ 113.40 $ 4.87
After Inflation $ 16.10 $ 0.69

Transactions Costs: 0.5% a year; Income taxes: at 28%; Capital Gains at 28%
every 20 years;

The Effect of Turnover on After-tax Returns

CASH NEEDS & TIME FRAME

- What is a long time horizon?

- Determinants of time horizon

* Age

* Level of Income
* Stability of Income

* Cash Requirements

- Time Horizon and Asset Choice

Proposition: The cost of keeping funds in near-cash investments increases with

the time horizon of the investor.

THE IMPORTANCE OF ASSET ALLOCATION

• The first step in all portfolio management is the asset allocation decision.
• The asset allocation decision determines what proportions of the
portfolio will be invested in different asset classes.
• Asset allocation can be passive,
o It can be based upon the mean-variance framework
 o It can be based upon simpler rules of diversification or market
value based
• When asset allocation is determined by market views, it is active asset
allocation.

Passive Asset Allocation: The Mean Variance View of Asset Allocation

Efficient Portfolios
Return Maximization Risk Minimization
Maximize Expected Return Minimize return variance
Objective Function

Constraint

where,
2
σ = Investor's desired level of variance

E(R) = Investor's desired expected returns

Markowitz Portfolios

The portfolios that emerge from this process are called Markowitz portfolios.
These portfolios are considered efficient, because they maximize expected
returns given the standard deviation, and the entire set of portfolios is referred
to as the Efficient Frontier. Graphically, these portfolios are shown on the
expected return/standard deviation dimensions in figure 5.7 -

Figure 5.7: Markowitz Portfolios

Application to Asset Allocation

• If we have information on the expected returns and variances of different

asset classes and the covariances between asset classes, we can devise
efficient portfolios given any given level of risk.
 • For example, if the following is the information of 4 asset classes:

Standard
Asset Class Mean
deviation
U.S. stocks 12.50% 16.50%
U.S. bonds 6.50% 5.00%
Foreign Stocks 15.00% 26.00%
Real Estate 11.00% 12.50%
Correlation Matrix for Asset Classes
Foreign
U.S. Stock U.S. Bonds Real Estate
Stocks
U.S. Stocks 1.00 0.65 0.35 0.25
U.S. Bonds 1.00 0.15 -0.10
Foreign Stocks 1.00 0.05
Real Estate 1.00
The More General Lesson: Diversification Pays

Passive Asset Allocation: Market Value Based Allocation

 Active Asset Allocation: The Market Timers

The objective is to create a portfolio to take advantage of 'forecasted' market

movements, up or down. Strategies could include:

* Shifting from (to) overvalued asset classes to (from) undervalued asset

classes if you expect the market to go up (down).

* Buying calls (puts) or buying (selling) futures on a market if you expect the
market to go up (down).

Assumption: You can forecast market movements

Advantage: If you can forecast market movements, the rewards are immense.

Disadvantage: If you err, the costs can be significant.

Does Active Asset Allocation Work?

Tactical asset allocation funds do not do well ..
Fairly unsophisticated strategies beat these funds..
 SECURITY SELECTION

• Once the asset allocation decision has been made, the portfolio manager
has pick the securities that go into the portfolio.
• Again, the decision can be made on a passive basis or on active basis.
• Active security selection can take several forms:
o it can be based upon fundamentals
o it can be based upon technical indicators
o it can be based upon ìinformationî

Passive Security Selection: The Index Fund

Index funds are created by holding stocks in a wider index in proportion to their
market value. No attempt is made to trade on a frequent basis to catch market
upswings or downswings or select 'good' stocks.

Assumptions: Markets are efficient. Attempts to time the market and pick good
stocks are expensive and do not provide reasonable returns. Holding a well
diversified portfolio eliminates unsystematic risk.

Advantages: Transactions costs are minimal as is the cost of searching for

information.

B. Markowitz Portfolio: A Markowitz efficient portfolio is created by

searching through all possible combinations of the universe of securities to find
that combination that maximizes expected return for any given level of risk.

Assumptions: The portfolio manager can identify the inputs (mean, variance,
covariance) to the model correctly and has enough computer capacity to run
through the optimization exercise.

Advantages: If historical data is used, the process is inexpensive and easily

mechanised.

Disadvantages: The model is only as good as its inputs.

II. ACTIVE STRATEGIES

The objective is to use the skills of your security analysts to select stocks that
will outperform the market, and create a portfolio of these stocks. The security
selection skills can take on several forms.

(1) Technical Analysis, where charts reveal the direction of future price
movements

(2) Fundamental Analysis, where public information is used to pick

undervalued stocks

(3) Access to private information, which enables the analyst to pinpoint mis-
valued securities.

Assumption: Your stock selection skills help you make choices which, on
average, beat the market.
Inputs: The model will vary with the security selection model used.

Advantage: If there are systematic errors in market valuation andyour model

can spot these errors, the portfolio will outperform others in the market.

Disadvantage: If your security selection does not pay off, you have expended
time and resources to earn what another investor could have made with random
selection.Security Selection strategies vary widely and can lead to
contradictory recommendations..

• Technical investors can be

o momentum investors, who buy on strength and sell on weakness
o reversal investors, who do the exact opposite
• Fundamental investors can be
o value investors, who buy low PE orlow PBV stocks which trade
at less than the value of assets in place
o growth investors, who buy high PE and high PBV stocks which
trade at less than the value of future growth
• Information traders can believe
o that markets learn slowly and buy on good news and sell on bad
news
o that markets overreact and do the exact opposite

They cannot all be right in the same period and no one approach can be right in
all periods.
A Caveat.. There are not very many great stock pickers either...
 III. Trading and Execution

• The cost of trading includes the brokerage cost, the bid-ask spread and
the price impact
 The Trade offs on Trading

• There are two components to trading and execution - the cost of

execution (trading) and the speed of execution.
• Generally speaking, the tradeoff is between faster execution and lower
costs.
• For some active strategies (especially those based on information) speed
is of the essence.

Maximize: Speed of Execution

Subject to: Cost of execution < Excess returns from strategy

• For other active strategies (such as long term value investing) the cost
might be of the essence.

Minimize: Cost of Execution

Subject to: Speed of execution < Specified time period.

• The larger the fund, the more significant this trading cost/speed tradeoff
becomes.

MEASURING PERFORMANCE

* Who should measure performance?

Performance measurement has to be done either by the client or by an objective
third party on the basis of agreed upon criteria. It should not be done by the
portfolio manager.

* How often should performance be measured?

The frequency of portfolio evaluation should be a function of both the time

horizon of the client and the investment philosophy of the portfolio manager.
However, portfolio measurement and reporting of value to clients should be
done on a frequent basis.

* How should performance be measured?

I. Market Indices (No adjustment for risk): There are some who do not like
models for risk and return and prefer comparison to broad market indices (S&P
500, NYSE composite, ..)

The limitation of this approach is that it does not explicitly control for risk.
Thus, an advantage is given to risky funds and money managers.

Tracking Error as a Measure of Risk

Tracking error measures the difference between a portfolioís return and its
benchmark index. Thus portfolios that deliver higher returns than the
benchmark

II. Against other portfolio managers

In some cases, portfolio managers are measured against other portfolio

managers who have similar objective functions. Thus, a growth fund manager
may be measured against all growth fund managers.

III. Risk-Adjusted Models

A. The CAPM: The capital asset pricing model provides a simple and intuitive
measure for measuring performance. It compares the actual returns made by a
portfolio manager with the returns he should have made, given both market
performance during the period and the beta of the portfolio created by the
manager.

Abnormal Return = Actual Return - Expected Return

> 0: Outperformed

< 0: Underperformed

where,

Actual Return = Returns on the portfolio (including dividends)

Expected Return = Riskfree rate at the start of the period + Beta of portfolio *
(Actual return on market during the period - Riskfree Rate)

This abnormal return is called Jensen's Alpha. It can also be computed by

regressing the returns on the portfolio against a market index, and then
comparing the intercept to Rf (1- Beta).

Variants: Define Rp to be the return on the portfolio and Rm to be the return on

the market.

Treynor Index = (Rp - Rf)/ Beta of the portfolio

> (Rm - Rf) : Outperformed

< (Rm - Rf) : Underperformed

Sharpe Index = (Rp - Rf)/ Variance of the portfolio

> (Rm - Rf)/σ m : Outperformed

< (Rm - Rf)/σ m : Underperformed

Information Ratio = Jensenís alpha / Unsystematic Risk

> 0: Outperformed the market

< 0 : Underperformed

Tracking Error as a Measure of Risk

• Tracking error measures the difference between a portfolioís return and

its benchmark index. Thus portfolios that deliver higher returns than the
benchmark but have higher tracking error are considered riskier.
• Tracking error is a way of ensuring that a portfolio stays within the same
risk level as the benchmark index.
 • It is also a way in which the ìactiveî in active money management can be
constrained.

Performance Attribtion

This analysis can be carried one step forward, and the overall performance of a
money manager can be decomposed into ìmarket timingî and ìsecurity
selectionî components.

• If money managers are good market timers,

o they should hold high beta stocks, when the the return on the
market > risk free rate
o they should hold low beta stocks, when the return on the market <
risk free rate
• Thus, the market timing capabilities of a money manager can be
evaluated by looking at the managerís performance over time relative to
the market. For instance, consider the following funds ñ

In some cases, better estimates of market timing can be obtained by fitting a

quadratic curve to actual returns.

where c is a measure of the market timing ability of a fund (money manager).

B. The APT: The arbitrage pricing theory defines the expected return in terms
of statistical factors (instead of just the market as in the CAPM). A beta is
defined relative to each factor.

C. Multi-Index Models: Multi-index models allow the performance evaluator to

bring in economic factors that may influence expected returns.

* Window Dressing and other Phenomena that cloud measurement

1. Marking up the merchandise (thinly traded stocks)

2. Tricking the technicians (stocks with breakout points)

3. Playing catch up (Buying hot stocks just before evaluation)

4. Dumping the losers just before evaluation