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Portfolio Management

Lecture 1: A simple model of portfolio

management

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Investment objective, risk

tolerance & strategy

(Class 3,4,5) (Class 8, 9, 10)

(Class 6&7) (Class 11 & 12)

Performance measurement

& evaluation (class 13& 14)

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› Risk is probably the most ambiguous element of

modern portfolio theory and asset choice.

› People tend to confuse their risk expectations with

their risk attitude.

› Risk attitude can be modelled using utility functions.

› Risk tolerance is the willingness of people to bear risk

in excange for return (risk premium)

The efficient frontier

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Utility function

Return

Opportunity set of investment

Alternatives that present

Rational choices for risk

Averse investors

Risk

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› U(W) utility function representing the utility of wealth W

system

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› In the past, the following was used in counting soccer

scores in a tournament:

Win 2

Tie 1

Loss 0

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› A common way of counting soccer scores in a

tournament is by using the following system:

Win 3

Tie 1

Loss 0

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› Consider two equally strong teams, that use a

different strategy:

1. The first team plays a risky strategy involving an

offensive playing style

2. This team plays a conservative strategy involving a

defensive playing style.

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› Suppose that team 1 has a 50% probability of winning and a 50%

probability of losing

› Suppose that team 2 has a 10% probability of winning, an 80%

probability of an equal outcome, and a 10% probability of

loosing.

› Team 1: has 5*3 = 15 points (old score: 10)

› Team 2: has 1*3 + 8*1 = 11 points (old score: 10)

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σ 2

f = E[ R] −

T

where T represents the risk tolerance, R is the

return on a portfolio and σ is its standard deviation

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› We like to choose a portfolio of stocks and riskless bonds

that maximizes our utility.

› Rs is the return on stocks, Rf is the return on bonds, and σs

is the standard deviation of stock returns.

› Let x be the fraction of assets in stocks.

› We want to choose x in such a way that we maximize our

utility f:

x 2σ 2

max f = ( xRs + (1 − x ) R f ) −

s s

T

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For example:

= ( Rs − R f ) − x σ 2 = 0

df 2

s s Rs 12%

dx T

T Rs − R f Rf 8%

xs =

2 σ2 s Sigma 20%

T=1

x=5

0%

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Allocation to risky assets

1.2

0.8

Risky asset

0.6

0.4

0.2

0

0 0.5 1 1.5 2 2.5

Risky tolerance

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› Design questionairres and interview individuals

(expected)

› Implicitly derive it from portfolio data (realized)

› We need to know the

1. Risk of the risky assets

2. The risk premium

3. The allocation to risky assets

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› Following the implicit method

› According to Dimson et al, the equity risk premium is

somewhere between 3.5% and 5.25%.

› Risk estimates for the stock market index are between

18% and 25%.

For a fully invested investor

σ2

=T

s

2 xs

Alloca

Rs − R f

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Rational:

› Risk tolerance (or inversely risk aversion)

› Risk premium

› Riskiness of the asset

Psychological:

› Perception of risk

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Risk premium

› 1990-1999: US investor achieved total return of 14.2%

per annum

› 1926-2000: US investor achieved an equity risk

premium of 7.3%

› UK, 1919-1999: UK investor achieved an equity risk

premium of 6.4%

• survivorship bias

• only 2 markets from the 36.

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› Risk premium:

• Lowest: 2.2% (gmt) or 4.4% (arm) for Belgium

• Highest 6.8% (gmt) or 8.3% (arm) for Australia

› So estimates range from 16.5% to 35.5% for the

standard deviation

0.00

10.00

20.00

30.00

40.00

50.00

60.00

70.00

3-1-2000

3-4-2000

3-7-2000

3-10-2000

3-1-2001

3-4-2001

3-7-2001

3-10-2001

3-1-2002

3-4-2002

3-7-2002

3-10-2002

3-1-2003

3-4-2003

3-7-2003

3-10-2003

VAEX

3-1-2004

3-4-2004

3-7-2004

3-10-2004

3-1-2005

3-4-2005

3-7-2005

3-10-2005

3-1-2006

3-4-2006

3-7-2006

Expected risk: implied volatility

3-10-2006

3-1-2007

3-4-2007

3-7-2007

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Different beliefs

› Even persons with the same risk tolerance could hold

very different portfolios if their expectations are

different.

T 1 1 1 1

Rs-Rf 4% 8% 2% 4%

Sigma 15% 20% 25% 25%

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risk tolerance

Rs-Rf 4% 4% distinguish between

Sigma 15% 30% these two concepts?

Risky asset 22% 22% Is risk tolerance

affected by previous

high volatility on the

stock market?

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Strategy

› Brinson & Fachler: study of pension fund

performance measurement

› What factors impact the realized performance?

› Top down model

1. Strategic asset allocation

2. Tactical asset allocation

3. Security selection (stock picking)

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› The long-term asset allocation choosen by an investor in

terms of

• the allocation over stocks, bonds, real estate

• different geographical regions

› Reflects the main risk-profile of the investor

• This is the asset allocation that is recommended by

banks to their customers after filling in the risk-

questionaire

• Pension funds use an ALM study to find out what asset

allocation serves their long-term goals.

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› Reflects the actual current asset allocation

› Differs from the strategical asset allocation because

• Asset classes perform differently (so you have to

rebalance to maintain the strategic asset

allocation)

• Reflect the market view of the investor (US stocks

will recover in the next period, so we increase the

weight to profit from this.

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1. The benchmark portfolio;

2. The stock-selected portfolio;

3. The timing portfolio;

4. The actual portfolio.

› Portfolio 1 is the overall benchmark portfolio, which

is derived directly from the general investment

plan.

› Portfolios 2 and 3 are the outcomes of a ‘what if

analysis’ that measure the impact of decisions in

isolation from other decisions.

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Measurement:

R(I) = ∑ w ip R ip R(III) = ∑ w ia R ip

i i

i i

Source Calculation

Timing R(III) -R(I) Σ (wip - wia) Rip

Selection R(II) -R(I) Σ (Ria - Rip) wip

Interaction R(I)-R(II)-R(III) + R(IV) Σ wip (Rip - Ria) +wia (Ria-Rip)

Total contribution R(IV) -R(I) Ra- Rp

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Example

An investor utilizes a strategic asset allocation of

• 50% bonds

• 20% domestic stocks

•30% foreign stocks

benchmark portfolio

Bond 30% 8% 7%

Domestic stocks 20% 12% 15%

Foreign stocks 50% 24%* 22%*

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Outcome:

Portfolio Return

I 13.6% Timing 3.2%

II 13.1% Selection -0.5%

III 16.8% Interaction -0.2%

IV 16.1% Total contribution 2.5%

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Lessons to be learned

› Strategic asset allocation / the allocation to choose the

level of risk is the most important decision in the

investment portfolio and explains more than 90% of

differences in return between portfolios.

› Tactical asset allocation and stock selection contribute

little to total outperformance.

› Decision to choose level of risk depends on a number

of subjective variables, such as risk tolerance,

expected return, and risk.

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