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Problems with Markowitz Analysis

Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

Lecture 6: Practical Matters - Asset

allocation, the CAPM and investing
SAPM [Econ F412/FIN F313]

Ramana Sonti
Term II, 2014-15

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Ramana Sonti

Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

Agenda

1 Problems with Markowitz Analysis

Example
2 Using the CAPM

4
5

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Factor models
Single index model
Estimating CAPM parameters
Application: Markowitz optimization
Empirical evidence
Black-Litterman Approach
Time diversification
True or false?
Resolution
Optimal investment mix and age
Half or half
The puzzle
Evaluation
Lecture 6: Practical Matters - Asset allocation, the CAPM and investing

Ramana Sonti

Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

Example

Features of Markowitz analysis

Accepts as inputs: expected returns and variance covariance matrix
Big Problem: Using historical returns to estimate inputs is fraught

with estimation error

Illustration
Monthly data on 8 equity market MSCI indices Nov 1998 through
Sep 2008 (119 months) from Datastream

Germany
Hong Kong
India
Japan
Singapore
United Kingdom
United States

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Example

Expected returns from historical averages

Every month, use 12 month (or 60 month) historical average returns

as estimates of expected return

Regress realized returns on expected returns as follows:

rj,t = j rj,t1 + j,t

If averages are any good (unbiased) as estimates of expected returns,

the beta coefficients in the above regressions must be close to one

Results for India and the USA
j
T (j = 1)
R2

India
12 months
60 months
0.451
0.494
-2.12
-0.99
0.028
0.016

USA
12 months
60 months
0.283
-0.946
-2.27
-2.42
0.008
0.023

Problem 1: Underlying means and variances/covariances may not be stationary

Problem 2: Estimation using finite samples brings with it estimation error

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Using the CAPM

Black-Litterman Approach

Time diversification

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Example

variance-covariance (VC) matrix

With (the first) 60 months of data, calculate historical mean vector

0 and VC matrix
Use these inputs to calculate 25 portfolios on the efficient frontier
Minimum exp. return portfolio: global minimum variance portfolio
Maximum exp. return portfolio: maximum expected return asset
23 intermediate portfolios

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Using the CAPM

Black-Litterman Approach

Time diversification

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Example

Mean return

The efficient frontier

0.040

0.045

0.050

0.055

Standard deviation

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Using the CAPM

Black-Litterman Approach

Time diversification

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Example

Resampling: A simulation approach

Return data are generated from unknown distribution
The 60 months of historical data represent only one possible sample
path
Assuming sample moments as the true moments leads to estimation
error
Exploratory framework: Resampling
0
Step 1: Generate historical mean vector
0 and VC matrix
Step 2: For trial i, draw a sample of T = 60 returns for N = 8 assets


0
from a multivariate normal distribution: N
0 ,
i . Use these inputs to form 25
Step 3: Estimate new inputs
i and
efficient frontier portfolios
Step 4: Evaluate the mean and variance of these 25 portfolios with

0
the original optimization inputs:
0 and
Step 5: Repeat Steps 2 through 4 for say, 500 trials

Idea: Estimation error in the inputs is translated into error in

optimal allocations
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Example

0.020

Resampling: Results

0.010
0.005
0.000

Mean return

0.015

0.005

0.04

0.05

0.06

0.07

0.08

0.09

Standard deviation

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Black-Litterman Approach

Time diversification

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Example

0.005
0.000

0.005

Mean return

0.010

0.015

Estimation error: Means and Covariances

0.040

0.045

0.050

0.055

0.060

0.065

Standard deviation

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Black-Litterman Approach

Time diversification

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Factor models

A single factor model

Factor models are useful ways of summarizing
the returns of each security
the relationship between returns of different securities

A single factor model can be written as ri = E (ri ) + i F + ei

Note that this is merely a way of breaking down returns, where F
represents unanticipated shocks to the only risk factor
In English, the above equation says that any return over and above
the expected return on a given security could be from one of two
sources
the impact of unanticipated macro events through the factor, in proportion to
the securitys factor sensitivity, i F

rI = E (rI ) + I [GDPG E (GDPG )] + eI

Here we have assumed that GDP growth, GDPG is the only risk factor affecting all
stocks. Notice that the factor F has been defined as GDPG E (GDPG ): the
unanticipated component of the macro risk factor
eI is the company specific part of Infosys return next quarter
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Black-Litterman Approach

Time diversification

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Factor models

Multi-factor models
Multi-factor models posit more than one factor, and are written as

ri = E (ri ) + i,1 F1 + + i,K FK + ei

Note that Fj represent unanticipated shocks to the the j th factor
Any return over and above the expected return on a given security

could be from one of two sources

the impact of unanticipated macro events through each of the
factors, in proportion to the securitys factor sensitivities, i,j Fj
unanticipated idiosyncratic or company specific events, ei
Note that E (Fj ) = 0 for all factors j , and

E (ei ) = 0 for all securities i

For example, we might write for Infosys stocks next quarter:

rI = E (rI ) + I ,1 [GDPG E (GDPG )] + I ,2 [INF E (INF )] + eI

Here we have assumed that in addition to GDP growth, GDPG ,

there is one more macro factor, inflation, INF affecting all stocks

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Using the CAPM

Black-Litterman Approach

Time diversification

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Factor models

Factor models and asset pricing

Asset pricing refers to models that relate expected return and risk

(factor betas)
For instance, the most general asset pricing model called the

arbitrage pricing theory (next lecture) posits that

E (ri ) = rf + i,1 1 + + i,K K
1 through K are called the factor risk premiums, i.e., the excess

expected return which is compensation for taking on one unit of risk

associated with the particular factor
As another example, the Capital Asset Pricing Model (CAPM), says

that E (ri ) = rf + i [E (rm ) rf ]

Here the market is the only factor, so 1 = E (rm ) rf , a.k.a. the

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Using the CAPM

Black-Litterman Approach

Time diversification

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The single index model

While using a single factor model, we need to take a stand on what

the factor is. Following from the CAPM logic, one might choose the
return on a market index as the only macro factor
A related model which is very popularly used is the single index
model ri rf = i + i (rm rf ) + i , where E (i ) = 0
Here, rm represents the return on an index, such as the BSE Sensex
Why is the single index model a valid single factor model?
Taking expectations on both sides, we have
E (ri ) rf = i + i [E (rm ) rf ]
Subtracting the second equation from the first, we have
ri E (ri ) = i [rm E (rm )] + i , which is a clearly a single factor
model

returns into systematic and idiosyncratic components

This single index model was first used to model security returns by

William Sharpe (of CAPM fame), and is also called the diagonal
model
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Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

Single index math

There are three fundamental assumptions of the single index model,

which is essentially a simple regression model:

E (i ) = 0: the idiosyncratic part of the security return is

unpredictable
Cov (i , rm ) = 0: the idiosyncratic part of the security return is

uncorrelated with the return on the index

Cov (i , j ) = 0 for all i 6= j: the idiosyncratic return of one security

is uncorrelated with that of another security

Using the first two assumptions, we already deduced that
i = 0 for all securities, if the CAPM is true,
2
i2 = i2 m
+ 2i ,i.e., total risk is the sum of systematic risk and
idiosyncratic risk
What about the covariance between the returns of two assets, i and

j?
Cov (ri , rj ) = Cov (i + i (rm rf ) + i , j + j (rm rf ) + j )
2
which reduces to Cov (ri , rj ) = i j m
after using the last two
assumptions above
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Ramana Sonti

Using the CAPM

Black-Litterman Approach

Time diversification

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Implications of the single index model

Consider a Markowitz portfolio allocation exercise with N = 50

assets. If we have to implement the optimization, we need the

following parameters as inputs
N = 50 estimates of expected returns
N = 50 estimates of variances
N(N 1)/2 = 1225 estimates of covariances

Thats a total of 1325 estimates, all estimated with error!

Besides, another problem is that expected returns are notoriously

tough to estimate from historical averages

The single index model helps us get around this problem. From the

N = 50 estimates of expected returns

N = 50 estimates of betas
N = 50 estimates of idiosyncratic (firm specific) variances
1 estimate for the variance of the factor (index)

Thats a total of 151 estimates, a vastly reduced number.

If we use the CAPM for expected return, we can use the betas,
provided we have an estimated market risk premium
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Using the CAPM

Black-Litterman Approach

Time diversification

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Beta estimation: The characteristic line regression

Consider monthly return data on 10 Indian stocks from 1999:01 through 2007:12
Let us estimate alpha and beta using the single index model for each stock
Typically use 5 years (60 months) of data: Parameter stationarity
Why monthly data? Bid-ask bounce and non-synchronous data at daily intervals

The following is a scatterplot of Reliance Energy excess returns versus index

excess returns, with the characteristic line superimposed
0.6
0.5
0.4

Stock excess returns

0.3
0.2
0.1
0.0
-0.30

-0.25

-0.20

-0.15

-0.10

-0.05

0.00
-0.1

0.05

0.10

0.15

0.20

-0.2
-0.3
-0.4
Index excess returns

i , i and i,t from this graph?
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Ramana Sonti

Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

Example: Reliance Energy

Consider estimating the beta of Reliance Energy stock
T = 60 months of return data from 1999:01 through 2003:12
Use COSPI index as the market portfolio proxy
Use NSE MIBOR data as risk-free rate proxy

associated t-statistic of 4.91. What do we conclude?

How do we decompose the variance of Reliance Energy?
Total risk of the stock is Var (ri rf ) = 0.0176
Systematic risk is i2 Var (rm rf ) = 0.0052
Idiosyncratic volatility must be 0.0176 0.0052 = 0.0124
In practice, we estimate idiosyncratic volatility by dividing the SSR
by T 2 (here, 58). this estimate yields 0.7349/58 = 0.0127
R-squared is the explained proportion of stock return variance,
0.0052/0.0176 = 0.2936
How could we use the CAPM to predict the expected return next

month (2004:01) of Reliance Energy?

Assuming rf will remain at 0.4% (monthly), and E (rm ) rf is 1.25%

(monthly), the expected return of Reliance Energy is

0.4 + 0.79(1.25) = 1.39%
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Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

Other notes on estimated beta

Note that Merrill Lynch uses 60 months of data with the S&P 500

index as the U.S. market index proxy, and runs the regression:
ri,t = ai + bi rm,t + ei,t
Their estimate
of alpha is related to our alpha estimate as:

ai =
i + 1 i rf , where rf is the average risk-free rate over the
sample period
The beta estimates of both regressions are the same

Intuition: Nudging estimated beta towards one; think about

company growth and beta

Statistics: Estimation error

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Using the CAPM

Black-Litterman Approach

Time diversification

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Estimating CAPM parameters

Fundamental betas
Can betas estimated from historical data be used as predictors of future beta?
Note that historical beta is an unbiased estimator of the true historical beta
averaged over past periods. Whether this is a good predictor of the future
depends on whether the change in the true beta from past average to the future
value is zero or not

Why might we expect a change? Some examples:

Firm reduced leverage very recently; estimated historical average will be higher than
current firm beta, i.e., the fundamentals of the firm have changed during the
estimation period

A firms beta tends to drift about an industry norm. A good predictor of future beta
will have to incorporate a weighted average of the historical beta, and the industry
norm
Events to which a firm might have heavy exposure are expected to become more
important for the market portfolio in the future, although the firms exposure to such
events is not expected to change

A solution: calculate a so-called fundamental beta

Currentbeta = a + b(pastbeta) +

K
X
k=1

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ck firmchark +

J
X

dj inddumj + e

j=1

Ramana Sonti

Using the CAPM

Black-Litterman Approach

Time diversification

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Markowitz optimization: Ten Indian stocks

Lets take a real-life example of Markowitz optimization with 10

liquid stocks in India

Use data from 1999:01 to 2006:12 to
estimate variances and covariances of the stock returns by two
methods: (a) Sample variances and covariances (b) Using the single
index model
estimate expected returns on the stocks by two methods: (a)
Historical averages (b) CAPM estimates
Try to form the tangency (a.k.a. MVE) portfolio using both
estimates of expected return and both variance/covariance matrices
See which method works better for portfolio composition and future

performance

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Using the CAPM

Black-Litterman Approach

Time diversification

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Portfolio allocation: Composition results

Exp. return
Var-covar
Stock
Reliance Energy
Bajaj Auto
Coromandel Fert.
Essar Steel
Hindustan Unilever
ICICI Bank
Infosys
SBI
Tata Chemicals
Thermax

Sample
Single index
Weight(%)
Weight(%)
0.5
-4.5
30.7
29.6
52.2
43.0
-6.8
-0.2
-65.3
-61.1
41.5
33.2
31.7
32.7
5.6
10.4
-25.1
-8.6
35.0
25.5

CAPM expected returns

Sample
Single index
Weight(%)
Weight(%)
9.0
9.8
-0.3
8.4
8.0
7.1
4.0
5.0
19.3
17.0
4.4
5.8
22.5
12.1
14.0
14.6
16.9
11.8
2.1
8.4

Using historical average returns results in a portfolio with large positions (long
and short)

Problem is that average returns are a bad estimator of expected returns

Using CAPM returns results in much better behaved portfolios

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Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

for the next 12 months. How do the portfolios compare?

Exp. return
Var-covar
Average (%)
Standard deviation (%)
Sharpe ratio

Sample
Single index
4.34
3.80
12.02
10.57
0.361
0.360

CAPM expected returns

Sample
Single index
3.43
3.98
7.31
7.25
0.469
0.549

Portfolios formed on the basis of the CAPM and the single index

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Using the CAPM

Black-Litterman Approach

Time diversification

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Empirical evidence

Perhaps the most popular use of the CAPM is to calculate cost of

capital for capital budgeting

While using the CAPM, what should one plug in as the E (rm ) rf ?

What does history say?

Depends on where you are
Look at data

Country
U.S.A.
U.K.
Japan
Germany
France
Sweden
India
India
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Period
1926-2004
1947-1999
1970-1999
1978-1997
1973-1998
1919-2003
1981-1991
1991-2005

Equities (%)
8.0
5.7
4.7
9.8
9.0
11.1
23.23
22.96

Risk-free (%)
0.7
1.1
1.4
3.2
2.7
5.6
12.02
9.51

7.2
4.6
3.3
6.6
6.3
5.5
11.21
13.45
Ramana Sonti

Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

Big question
The US equity premium is between 7-8 %. Is this justified?
Did people know in say, 1925 or 1947 that stocks would earn 7%
more than bonds on average; and were somehow rationally unwilling
to hold more stocks?
Mehra and Prescott (1985): The 7% difference between stocks and
T-bills is too large to be explained by standard economic models:
This is the equity premium puzzle
Essentially, says that people are much more risk averse according to
economic models, compared to what they actually seem to be...

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Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

Potential ways out

Predictive ratios
Run a regression of past equity premia against dividend yield ratios.
The idea is that higher dividend yield today makes stocks more
attractive and predicts a higher future equity premium
Now plug in to your estimated regression the current dividend yield
to predict an equity premium next period
Unfortunately, this method does not work very well in terms of
predictability
Philosophical predictions
Try to reason what premium would be appropriate for investors to be
lured from bonds to stocks, after extra risk should be accompanied
by extra return.
People usually come up with an equity premium of 1-3%

25/48

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Using the CAPM

Black-Litterman Approach

Time diversification

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Consensus surveys
A recent survey (2007) of finance professors says the most common

equity premium estimate (USA) was 5%

Other surveys are inconclusive. Consider a WSJ survey on Feb 28,

2005:

26/48

Ramana Sonti

Using the CAPM

Black-Litterman Approach

Time diversification

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Conclusion

Responses to the equity premium puzzle

EPP is a result of survivorship bias
Search for more sophisticated (and complicated) utility functions
Look to investor participation in stock market as an explanation
Behavioral idea that maybe people are excessively risk averse, but
mistakenly so

27/48

Ramana Sonti

Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

A Bayesian method: Black and Litterman

Besides resulting in extreme portfolios, traditional Markowitz

optimization does not allow portfolio managers to incorporate their

subjective estimates of expected return and associated confidence
levels
Black and Litterman (1992)
Illustrate these problems in a global asset allocation framework
Build a Bayesian model that combines equilibrium expected

returns with subjective judgements, a.k.a views

Bayesian statistics is based on Bayes rule which is:

28/48

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Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

Black and Litterman framework

n method: Black and Litterman(1992)

Market weights

model tough highly sensitive to

in expected return inputs

Equilibrium/implied
expected returns

olios often involve extreme

few assets

w portfolio managers to
e confidence in their subjective
expected return

Subjective views on
expected returns

Degree of confidence
in subjective views

erman (1992)

mework

an model that combines

expected returns with subjective
.k.a views

stics is based on Bayes rule

| High midterm score) =
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Pr(High midterm score | Good student)Pr(Good student)

Pr(High midterm score)
Lecture 6: Practical Matters - Asset allocation, the CAPM and investing

Ramana Sonti

portfolio weights that would have performed best historically

Black-Litterman Approach
Time diversification
are in some sense neutral. In reality, of course, they are not
neutral at all, but rather are a very special set of weights
that go short assets that have done poorly and go long assets
that have done well in the particular historical period.

Half or half

Black and Litterman example 1

Equa
l MGlobal
eans
Recognizing the problem of using past returns, the investor
asset
allocation
The
BL example
might hope that assuming equal means for returns across all

7 countries
asset allocation
Global
3 asset
classes per country: Stocks, Bonds and Currencies

7 countries
Exhibit
20 risky assets: 7x3=21; USD
cash3is an idle asset

3 asset classes per country: Stocks, Bonds and Currencies

Data: January 1975
through
August 1991
Optimal
Portfolios
Based on

20 risky assets: 7x3=21; USD cash is an idle asset

Searching for an
Historical
Average
Approach
efficient portfolio
with
10.7% volatility (Global

Data: January 1975 through August 1991

(percent of portfolio value)
CAPM
equilibrium
portfolio)

Searching for an efficient portfolio with 10.7% volatility (Global CAPM equilibrium portfolio)

Results
using
meansasasexpected
expected
returns
usinghistorical
historical means
returns
Results
Unconstrained
Germany
Currency exposure
Bonds
Equities

78.7
30.4
4.4

France

Japan

U.K.

U.S.

15.5
40.4
15.5

28.6
1.4
13.3

54.5
44.0

Japan

U.K.

U.S.

18.0
88.8
0.0

23.7
0.0
0.0

0.0
0.0

46.5
40.7
4.4

65.0
95.7
44.2

5.2
52.5
9.0

With constraints against shorting assets

Germany
Currency exposure
Bonds
Equities

160.0
7.6
0.0

France
115.2
0.0
0.0

77.8
0.0
0.0

13.8
0.0
0.0

is the
asset
allocation?
Where
Where
is the
asset
allocation?
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INVA - Term 4 - Lecture

2007 -6:Indian
PracticalSchool
Mattersof
- Asset
allocation, the CAPM and investing

14 Sonti
Ramana

Fixed
Research

Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

Exhibit
Exhibit 66

Black and
LittermanEquilibrium
example
Risk
The BL example
...nnucontinued
Fixed
((ppeerrce
aali
cenntt aannu
lizzeedd exce
excess
ss rreettuurrnn))

Income
Research
Equilibrium
expected
excess
returns
(using
Blacks
global CAPM)
expected
excess
(using
Blacks
global
Equilibrium
expected
excess returns
returns
(using
Blacks
global CAPM)
CAPM)
Equilibrium
Germany
Germany
Currencies
Currencies
Bonds
Bonds
Equities
Equities

France
France

Japan
Japan
U.K.
Exhibit
Exhibit 77U.K.

U.S.
U.S.

1.01
1.10
1.40
0.91
1.01
1.10
1.40
0.91
Equilibrium
Optimal
Portfolio
2.29
2.23
2.88
3.28
1.87
2.29
2.23
2.88
3.28
1.87
6.27
8.48
8.72
6.27
8.48
8.72
7.32
((ppeerrce
ppoorrttfo
vvaalluue)
cenntt of
of
foli
lio10.27
o10.27
e) 7.32

0.60
0.60
2.54
2.54
7.28
7.28

Australia
Australia
0.63
0.63
1.74
1.74
6.45
6.45

Results
using
equilibrium
expected
returns
using
equilibrium
returns
Results
using
equilibrium expected
expected
returns
Results
Germany
Germany
Currency
Currency exposure
exposure
Bonds
Bonds
Equities
Equities

France
France Japan
Japan

1.1
1.1
2.9
2.9
Exhibit
Exhibit
2.6
2.6

0.9
0.9
1.9
1.9
shows
shows
2.4
2.4

U.K.
U.K.

5.9
2.0
5.9
2.0
1.8
6.0
1.8
the
equilibrium
the6.0
equilibrium
23.7
8.3
23.7
8.3

U.S.
U.S.

Australia
0.6
0.6

0.3
0.3

16.3
1.4
0.3
16.3
1.4 for
0.3as66
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risk
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all
as29.7
1.6
1.1
29.7
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given this
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It
the
views. Exhibit
Exhibit
shows the
the
optimal
portfolio.
It is
is simply
simply
the
use
quantitative
asset
allocation
models
is
how
to
use
quantitative
asset
allocation
models
is
how
to

Mid-1991
was
a
time
of
recession:
(not-so-confident)
views
are
that...
Mid-1991
a time
of recession:
(not-so-confident)
are
that...
Mid-1991
waswas
a time
of
recession:
(not-so-confident)
views
are
market
capitalization
portfolio
80%
currency
risk
market
capitalization
portfolio with
withviews
80% of
of the
the
currency
risk

that...

31/48

translate
translate their
their views
views into
into aa complete
complete set
set of
of expected
expected

hedged.
Other
portfolios
on
the
frontier
with
different
levels
hedged.returns
Other
portfolios
onthat
the can
frontier
with
different
levels
...stocks
equilibrium
expected
returns
2.5%
...stocks will
will underperform
underperform
equilibrium
expected
returns
by
2.5%
excess
on
be
used
as
for
excess
returns
on assets
assets
that
can
be by
used
as aa basis
basis
for

of
correspond
combinations
of
borrowof risk
risk would
would
correspond
towe
combinations
of risk-free
risk-free
borrowportfolio
optimization.
As
will
show
the
is
portfolio
optimization.
Asto
we
will
show
here,
the problem
problem
is
outperform
equilibrium
expected
returns
by
0.8%
...bonds
will
outperform
equilibrium
expected
returns
by here,
0.8%
...bonds
...stocks
willwill
underperform
equilibrium
expected
returns
by model
2.5%
ing
lending
plus
or
of
portfolio.
ing or
or
lending
plus more
more
or less
less
of this
this
portfolio.
that
optimal
portfolio
weights
from
aa mean-variance
that
optimal
portfolio
weights
from
mean-variance
model
Simply
the
expected
return
vector
to
reflect
this
the
expected
return
vector
to
reflect
this
...bonds
will outperform
equilibrium
returns
by 0.8%
are
sensitive
minor
in
excess
are incredibly
incredibly
sensitive to
toexpected
minor changes
changes
in expected
expected
excess
By
the
equilibrium
is
but
particularly
By itself,
itself,The
equilibrium
is interesting
interesting aa
but
not equilibrium
particularly
of
global
returns.
The
of incorporating
incorporating
global
equilibrium
Why not simplyreturns.
the
expected
return
vector
tonot
reflect
this?
useful.
The
real
value
of
the
equilibrium
is
to
provide
aa
useful.
The
real
value
of
the
equilibrium
is
to
provide
will
become
apparent
will
become
apparent when
when we
we show
show how
how to
to combine
combine it
it with
with
INVA
School
of
15
INVA -- Term
Term 44 -- 2007
2007 -- Indian
Indian
School
neutral
framework
to
which
the
investor
can
his
own
neutral
framework
to
which
the
investor
can
his
own 15
an
an investors
investors views
views to
to generate
generate well-behaved
well-behaved portfolios,
portfolios, withwithperspective
in
terms
of
views,
optimization
objectives,
and
perspective
in
terms
of
views,
optimization
objectives,
and
out
out requiring
requiring the
the investor
investor to
to express
express aa complete
complete set
set of
of exexLecture 6: Practical
Matters - Asset
allocation,
CAPM
and investing
Ramana Sonti
constraints.
These
are
the
issues
to
constraints.
These
arethe
the
issues
to which
which we
we now
now turn.
turn.

Income
Research

Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

Exhibit 8

Portfolios
Based on a Moderate View
InvestorInvestor
views:Optimal
Naive
views:
(perNaive
o value)

Results
usingusing
expected
returns
expected
returns
Results
Unconstrained

Currency exposure
Bonds
Equities

Germany

France

1.3
13.6
3.7

8.3
6.4
6.3

Japan

U.K.

U.S.

3.3
15.0
27.2

6.4
3.3
14.5

112.9
30.6

Japan

U.K.

U.S.

5.0
0.0
28.3

3.0
0.0
13.6

35.7
0.0

8.5
42.4
24.8

1.9
0.7
6.0

With constraints against shorting assets

Germany
Currency exposure
Bonds
Equities

2.3
0.0
2.6

France
4.3
0.0
5.3

9.2
0.0
13.1

0.6
0.0
1.5

to earlier asset allocation with equilibrium expected returns

Compare
Compare
to earlier asset allocation with equilibrium expected returns. We see

We see that:
that:
bonds. This lack of apparent connection between the views
Allocation
decreases
and
US
(expected)
AllocationtotoUS
USstocks
stocks
decreases
andthat
that
USbonds
bonds
increases
(expected)
the investor
attempts
tototo
express
andincreases
the optimal
portfolio
Allocation to German
bonds
sharply
(unforeseen)
theand
model
generates
is decreases
a pervasive
problem
with standard

Allocation to German and Canadian bonds decreases sharply (unforeseen)

mean-variance
arises because,
as we returns
saw in
Problem: Optimal allocation
a highlyoptimization.
non-linear It
function
of expected

trying
to generate
a portfolio
representing
no views,
in the
Optimal
allocation
a highly
non-linear
function
of expected
returns
Big problem:
(involving
variances
and correlations
optimization
there is a complex interaction between expected
(involving variances
and correlations

32/48

excess returns and the volatilities and correlations used in

measuring risk.
INVA - Term 4 Lecture
- 20076: -Practical
IndianMatters
School
- Asset
allocation, the CAPM and investing
Ramana Sonti 16

Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

Foundations of the B-L approach

BL start with single factor model: ri = i + i f + i
In plain English, the return on asset i will equal its equilibrium
expected return plus a factor surprise plus an asset-specific surprise
The world is not in equilibrium, i.e., E (f ) 6= 0, and E (i ) 6= 0
In the BL framework, there is uncertainty regarding E (ri ) which

arises from uncertainty in E (f ) and E (i )

Assume that uncertainty in expected returns is normally distributed

with mean and variance matrix

Uncertainty in returns ... summarized by
Uncertainty in expected returns ... summarized by

In addition, investors hold views regarding the expected returns of

assets
e.g., the expected return on stocks will be 2% more than that on

bonds in the next quarter, and I believe in this view with 90%
confidence
Mathematically all the investors views are written as
0
P E (r ) = Q + ;  N (0, )
33/48

Ramana Sonti

Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

Example of views
Imagine 3 views:
IBM will have an expected return of 1% next month (65%
confidence)
GE will outperform GM by 0.4% next month (75% confidence)
MSFT return will be 0.2% more than that of IBM next month (90%
confidence)
These views can be succinctly written as:
0

P E (r ) = Q + ;  N (0, ), where:

1
P = 0
1
E (r ) =

0
1
0

E (rIBM )

0
0
1

E (rGM ) E (rGE )

1%)
Q = 0.4%
0.2%

34/48

0
1
0

1/0.65
0
0

0
1/0.75
0

E (rMSFT )

0
1/0.90

Ramana Sonti

Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

Revised expected return

Using Bayesian statistics, B-L come up with the following formula

for (posterior) expected return:

h
i1 h
i
0
0
1
1
E (r ) = ( ) + P 1 P
( ) + P 1 Q
Intuitively, a weighted average of equilibrium expected return and

the expected returns implied by subjective forecasts (limiting cases)

More confidence in subjective forecast more weight given

Where do we get equilibrium expected returns?

Sensible models: e.g. CAPM, APT
Implied equilibrium return from market data thru reverse optimization

35/48

Ramana Sonti

Using the CAPM

directly.
directly.

Black-Litterman Approach

Time diversification

Half or half

In
InExhibit
Exhibit99we
weshow
showthe
thecomplete
completeset
setofofexpected
expectedexcess
excess
returns
returns when
whenwe
weput
put100%
100%confidence
confidenceininaaview
viewthat
thatthe
the
differential
of
expected
excess
returns
of
U.S.
equities
Fixed
differential
of expected excess returns of U.S. equitiesover
over
Fixed
bonds
is
2.0
percentage
points,
below
the
equilibrium
differIncome
bonds
is 2.0 percentage points, below the equilibrium differIncome
ential
ofof5.5
Research
ential
5.5percentage
percentagepoints.
points.Exhibit
Exhibit10
10shows
showsthe
theoptimal
optimal
Research
portfolio
portfolioassociated
associatedwith
withthis
thisview.
view.

Back to the B-L example

Back
Back to
to the
the BL
BL example
example

Exhibit
9views
Using their formula, BL
can incorporate
Exhibitinexplicable
9
This
Thisisisinincontrast
contrasttotothe
the inexplicableresults
resultswe
wesaw
sawearlier.
earlier.
We
see
here
a
balanced
portfolio
ininwhich
the

Expected
Excess
Returns
They
try
a
simple
view
that
says
US
stocks
will
outperform
UShave
BL
can
views
WeExpected
see
hereincorporate
a balanced
portfolio
which
theweights
weights
have
Using
Excess
Returns
Usingtheir
theirformula,
formula,
BL
can
incorporate
views
tilted
away
from
market
capitalizations
toward
U.S.
bonds
Combining
Investor
With
Equilibrium
tilted
away
from Views
market
capitalizations
toward
U.S.
bonds
bonds
(with
100%
confidence).
Note
that
this
isweless
than
the
Investor
Views
With
Equilibrium

They by
try Combining
a2%
simple
view
that
says
US
stocks
will
outperform
US
bonds
by
2%
(100%
away
from
U.S.
equities.
Given
our
view,
now
obtain
They try a simple and
view
that says
US
outperform
US bonds
by 2%
(100%
and away
U.S.
our view,
we now
obtain
(from
a(annu
aalistocks
zzeeequities.
ddppewill
rece
nn
tGiven
)t)
nnu
liconsider
rce
confidence
view).
Note
that
this
is
less
than
the
equilibrium
difference
of
5.5%
equilibrium
difference
of
5.5%
a
portfolio
that
we
reasonable.
confidence view). Note
that this
lessconsider
than the
equilibrium difference of 5.5%
a portfolio
thatiswe
reasonable.
Revised
expected
returns
Revisedset
set of expected
returns
Revised set of expected returns Exhibit 10
Exhibit 10

Germany
France
Japan
U.K.
U.S.
Germany
France
Japan
U.K.
U.S.
Optimal
Portfolio
Optimal
Currencies
1.32
1.28
1.73 Portfolio
1.22
0.44
0.47
Currencies
1.32
1.28
1.73
1.22
0.44
0.47
Investor
Views
Equilibrium
Bonds Combining
2.69
2.39
3.29
3.40
2.39
2.70
1.35
Investor
ViewsWith
With
Equilibrium
Bonds Combining
2.69
2.39
3.29
3.40
2.39
2.70
1.35
Equities
5.28
6.42
7.71
7.83
4.39
4.58
3.86
(6.42
p(peerrcecennt tofof7.71
ppoortrfo
Equities
5.28
4.58
3.86
tfolilioov7.83
vaalulue)e) 4.39

Revised portolio
allocation
weights
Revised
Revised
portolio
allocation
weights
set
of portfolio
allocations
Currency exposure
Currency exposure
Bonds
Bonds
Equities
Equities

22
22

Germany
France
JapanAboveU.K.
U.S. only
Australiato
accordingly.
we
the
Germany
JapanAboveU.K.
U.S. only
Australiato
accordingly.
thereturns
returns
U.S.
and
U.S.
other
1.4 bonds1.1
7.4equities,
2.5holding fixed all0.8
0.3
U.S.
and U.S.7.4equities,2.5holding fixed all0.8
otherexpectexpect1.4 bonds1.1
0.3
3.6
2.4
7.5
2.3
67.0
1.7
0.3
ed
excess
Another
difference
isisthat
3.6
2.4
7.5
2.3
67.0
1.7 we
0.3
ed
excessreturns.
returns.
Another
difference
thathere
here
wespecify
specify
3.3
2.9
29.5
10.3
3.3
2.0
1.4
aa differential
letting
3.3
2.9 ofofmeans,
29.5
10.3 the
3.3
2.0 determine
1.4
differential
means,
letting
theequilibrium
equilibrium
determine

the
theactual
actuallevels
levelsofofmeans;
means;above
abovewe
specifythe
thelevels
levels
Well-behaved portfolio;
changes are in line with views, with no strange sidedirectly.

Well-behaved portfolio;
changes are in line with views, with no strange sideWell-behaved
portfolio;directly.
changes
are in line with views, with no
effects
effects
9 we show the complete set of expected excess
strange side effects InInExhibit
Exhibit 9 we show the complete set of expected excess

returns when we put 100% confidence in a view that the

returns when we put 100% confidence in a view that the
differential of expected excess returns of U.S. equities over

differential
of expected excess returns of U.S. equities over
INVA - Term 4 - 2007 - Indian School
of
20
2.0 percentage points, below the equilibrium differINVA - Term 4 - 2007 - Indianbonds
School
20
bonds of
2.0 percentage points, below the equilibrium differ36/48

ential -of
5.5allocation,
percentage
points.
Exhibit 10 shows the optimal
Lecture 6: Practical Matters
the CAPM
and investing
Ramana Sonti
ential Asset
of 5.5
percentage
points.
Exhibit 10 shows the optimal

Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

True or false?

Time diversification

the long run

Over time, good returns and bad will cancel out, hence, stocks are

less risky as the investment horizon increases

Does this idea have economic merit?

fallacy

37/48

Ramana Sonti

Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

True or false?

Defining returns
Suppose the prices of a risky asset are P0 and P1 on consecutive

days. Then we can define the following returns over one period
P1
The gross return is (1 + R1 ) = P
0
The continuously compounded return is

z1 = log (1 + R1 ) = log (P1 /P0 )

Over two periods, the gross return is

P2
P0

= (1 + R1 )(1 + R2 )
1

The annualized rate of return is r0,2 = [(1 + R1 )(1 + R2 )] 2 1

The two period continuously compounded return is

z0,2 = log (P2 /P0 ) = z1 + z2

In general, over T periods, we have
The annualized rate of return satisfies
(1 + r0,T )T = [(1 + R1 )(1 + R2 ) (1 + RT )]
The continuously compounded return is
z0,T = log (PT /P0 ) = z1 + z2 + + zT

38/48

Ramana Sonti

Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

True or false?

The time diversification argument

Suppose every period, the continuously compounded (iid) return of

the stock market has an expected value and variance 2

Now, if we look at the logarithm of annualized return, we have
1
T

[ + + + ] =


2
Var [log(1 + r0,T )] = T12 2 + 2 + + 2 = T
Standard deviation of annualized return =
T
Expected return stays constant with horizon, while risk (standard
deviation) decreases with time. This is why there is so much popular
advice saying stocks are less risky in the long run
E [log(1 + r0,T )] =

Suppose we look at total return instead, we have

E [z0,T ] = [ + + + ] = T


Var [z0,T ] = 2 + 2 + + 2 = T 2

Standard deviation of total return = T

Expected return and risk (standard deviation), both increase with
time
What matters to investors is total return, i.e., their terminal wealth

39/48

Ramana Sonti

Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

True or false?

Example: Annualized versus Total return

Assume that the continuously compounded (iid) stock market return

every year has an expected value of 10% and a standard deviation of

15%
Standard deviation of annualized return decreases with time
Standard deviation of total return increases with time

Horizon (years)
1
5
10
20

Exp. ret. (%)

10
50
100
200

Sdev(total)(%)
15.00
33.54
47.43
67.08

Sdev(annualized)(%)
15.00
6.71
4.74
3.35

40/48

Ramana Sonti

Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

Resolution

Comparison with risk-free bonds

Assume the alternative investment is in risk-free bonds with a

with investment in stocks versus risk-free bonds

Terminal wealth with risky stocks: WT = 1000e z0,T
Terminal wealth with risk-free bonds: BT = 1000e 0.03T

Years
1
5
10
20

Bonds (\$)
1030.45
1161.83
1349.86
1822.12

Lower (\$)
Upper (\$)
823.66
1482.90
854.36
3181.66
1072.82
6887.51
1984.15
27517.11

32.04
14.84
7.00
1.84

Risky asset spreads increase with time, around an increasing mean

By year 20, the lower end of the 95% confidence interval of the risky

asset overtakes the risk-free investment

The probability that stocks underperform bonds decreases with the

horizon
41/48

Ramana Sonti

Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

Resolution

However...
Consider the expected value of terminal wealth with investment in

Years
1
5
10
20

300.35
146.44
77.82
26.92

69.97
85.36
92.22
97.31

97% of their wealth!

The growing improbability of such underperformance is accompanied

by a growing magnitude of potential loss

Investors care not just about the probability of losses, but also about

the magnitude of such losses

Risky asset choice should not depend upon horizon as long as
asset returns are random
future wealth depends only upon investment income
there are no taxes or transaction costs
42/48

Ramana Sonti

Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

Should older people invest more in bonds?

An idea closely related to time diversification: Practitioners

frequently recommend that an investors portfolio should consist of a

greater proportion of bonds (and less stocks) as she ages
Time diversification cannot be the reason
We have shown that stocks are not less risky in the long run
Besides, if an investor can rebalance her portfolio regularly, the long

run is essentially a series of short runs anyway what matters is the

interval between rebalancings
A plausible reason for shifting to bonds as one ages is

non-investment income: As one ages, the present value of labor

income decreases (even if you are very good at what you do). How
should the investor re-optimize her portfolio in response?
If your labor income is risk-free, or at least not positively correlated

with stock returns (finance professors): you should decrease your

exposure to stocks as you age, to make up for loss in labor income
If your labor income is highly correlated with stock returns (mutual
fund managers): you should increase your exposure to stocks as you
age, again to make up for loss in labor income
43/48

Ramana Sonti

Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

The puzzle

Half stocks all the time or all stocks half the time?
Which alternative is better?
1 Invest half your wealth in stocks and half in risk-free bonds all the
time
2 Invest all your wealth in stocks half the time and risk-free bonds for
the other half
To analyze this, lets make the following assumptions:
We expect stocks to have a higher average return than risk-free

bonds
Stock returns are random; hence we cannot anticipate whether

stocks will outperform riskless bonds in any given future period

There are no taxes or transaction costs to between stocks and bonds

returns of either 20% or -5% with equal probability. Further,

risk-free bonds yield a constant periodic rate of 5%

44/48

Ramana Sonti

Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

The puzzle

Year
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

45/48

Stock
20%
-5%
20%
-5%
20%
-5%
20%
-5%
20%
-5%
20%
-5%
20%
-5%
20%
-5%
20%
-5%
20%
-5%
Results:

Bond
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%

Returns
Balanced
Switching
12.5%
20.0%
0.0%
-5.0%
12.5%
20.0%
0.0%
-5.0%
12.5%
20.0%
0.0%
-5.0%
12.5%
20.0%
0.0%
-5.0%
12.5%
20.0%
0.0%
-5.0%
12.5%
5.0%
0.0%
5.0%
12.5%
5.0%
0.0%
5.0%
12.5%
5.0%
0.0%
5.0%
12.5%
5.0%
0.0%
5.0%
12.5%
5.0%
0.0%
5.0%
6.25%
6.25%

Wealth
Balanced
Switching
1.125
1.200
1.125
1.140
1.266
1.368
1.266
1.300
1.424
1.560
1.424
1.482
1.602
1.778
1.602
1.689
1.802
2.027
1.802
1.925
2.027
2.022
2.027
2.123
2.281
2.229
2.281
2.340
2.566
2.457
2.566
2.580
2.887
2.709
2.887
2.845
3.247
2.987
3.247
3.136
3.247
3.136

Exposure
Balanced
Switching
0.500
1.000
0.563
1.200
0.563
1.140
0.633
1.368
0.633
1.300
0.712
1.560
0.712
1.482
0.801
1.778
0.801
1.689
0.901
2.027
0.901
1.925
1.014
0.000
1.014
0.000
1.140
0.000
1.140
0.000
1.283
0.000
1.283
0.000
1.443
0.000
1.443
0.000
1.624
0.000
0.9551
0.8234

Ramana Sonti

Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

The puzzle

1988-2007
Year
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
46/48

Stock
17.6%
28.4%
-6.1%
33.6%
9.1%
11.6%
-0.8%
35.7%
21.2%
30.3%
22.3%
25.3%
-11.0%
-11.3%
-20.8%
33.1%
13.0%
7.3%
16.2%
7.3%

Bond
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%

Balanced
11.3%
16.7%
-0.5%
19.3%
7.0%
8.3%
2.1%
20.3%
13.1%
17.7%
13.6%
15.1%
-3.0%
-3.1%
-7.9%
19.1%
9.0%
6.2%
10.6%
6.1%

Returns
Switch 1
17.6%
28.4%
-6.1%
33.6%
9.1%
11.6%
-0.8%
35.7%
21.2%
30.3%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%

Switch 2
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
22.3%
25.3%
-11.0%
-11.3%
-20.8%
33.1%
13.0%
7.3%
16.2%
7.3%

Balanced
1.113
1.299
1.292
1.541
1.650
1.787
1.824
2.195
2.483
2.921
3.320
3.822
3.706
3.590
3.306
3.936
4.291
4.555
5.039
5.348

Wealth
Switch 1
1.176
1.510
1.418
1.895
2.067
2.306
2.289
3.105
3.762
4.903
5.149
5.406
5.676
5.960
6.258
6.571
6.900
7.244
7.607
7.987

Switch 2
1.050
1.103
1.158
1.216
1.276
1.340
1.407
1.477
1.551
1.629
1.992
2.495
2.219
1.969
1.559
2.076
2.345
2.517
2.926
3.139
Ramana Sonti

Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

Evaluation

Simulation results: Historical returns 1988-2007

Of course, the above results are specific to this 20 year period
How do we make general inferences?
One idea is bootstrapping
Step 1: Generate a sample of 20 yearly returns by picking from the

basket of historical returns randomly with replacement

Step 2: Calculate expected returns, standard deviations, and ending

wealths for each of the investment strategies

Repeat Step 1 and Step 2 a large number of times, e.g. 10,000
Calculate average values of expected return, standard deviation and

ending wealth over all trials

Results with 100,000 trials

Ending wealth (\$)

Expected return (%)
Standard deviation (%)

47/48

Balanced
5.66
9.06
7.97

Switch 1
5.58
9.05
11.97

Switch 2
5.58
9.06
11.97

Ramana Sonti

Using the CAPM

Black-Litterman Approach

Time diversification

Half or half

Evaluation

Lessons for market timers

The only way a switching strategy can be justified is if you believe

you can time the market to generate an expected return more than
the balanced strategy. How much more?
The Sharpe ratio is a good way to compare the balanced and
switching strategies, since it represents a reward-to-risk ratio
Sharpe ratio =

E (r )rf

Question: If you believe you are a market timer, what extra return

should you generate for both strategies balanced and switching to

have the same Sharpe ratio?
In other words, what is the in 0.09060.05
=
0.0797
We can solve to give = 2.04%.

0.09060.05+
?
0.1197

This means your timing skill will have to result in a 2% extra annual