INVESTMENT IS A LIFETIME

LEARNING PROCESS (NO SHORT

CUT)

1 You continue to polish your investment tools/strategies from

making mistakes. You would have to find your own strategy.
 Risk, Return
and Historical
Record

5
OUTCOMES

• Calculate various measures of return and risk

• Determine the expected return and risk of portfolios of
combination of risky and risk-free assets
• Evaluate investment performance by Sharpe ratio

3
WHY DO WE HAVE TO KNOW THOSE
HISTORICAL RETURNS

• They serve as a reference point for the return

you may be expecting in the long run

• It helps you determine whether the return you

are looking for is realistic/justified by risk

• Your investment consultant told you that

investing in Hang Seng Index fund can earn
you an average of 10% in the long run, what do
you think? How do you perform the
calculations? 4
 TABLE 5.1 BELOW SHOWS YOU THE
QUARTERLY CASH FLOWS/RATES OF RETURN
OF A MUTUAL FUND

1st 2nd 3rd 4th

Quarter Quarter Quarter Quarter
Assets under management at start of 1 1.2 2 0.8
quarter ($ million)
Holding-period return (%) 10 25 −20 20
Total assets before net inflows 1.1 1.5 1.6 0.96
Net inflow ($ million) 0.1 0.5 −0.8 0.6
Assets under management at end of 1.2 2 0.8 1.56
quarter ($ million)

You are the fund manager showing your fund’s performance to a potential customer.
If you are free to calculate the average quarterly return, what is your number?
5
An ETF: https://www.marketwatch.com/investing/fund/arkk
5.1 RATES OF RETURN (RECAP)
• Holding-Period Return (HPR)
• Rate of return over given investment period

• HPR= [PS − PB + CF] / PB

• PS = Sale price
• PB = Buy price
• CF = Cash flow during holding period
Initial investment: $100
• Four year later, value of investment: $240
6
• HPR =(240-100)/100
 5.1 RATES OF RETURN (RECAP)
• Measuring Investment Returns over Multiple
Periods
• Arithmetic average (use table 5.1, get the results yourselves, answers
next slide)
• Sum of returns in each period divided by number of periods

• Geometric average (use table 5.1, get the results yourselves)

• Single per-period return; gives same cumulative performance as sequence of
actual returns
• Compound period-by-period returns; find per-period rate that compounds to
same final value
• Dollar-weighted average return
7
• Internal rate of return on investment
 AVERAGE QUARTELY RETURN
USING TABLE 5.1 BEFORE Which one is a good predictor?
• Arithmetic average (ignore compounding)
(10+25-20+20)/4 = 8.75%

• Geometric average (time weighted average, ignore periodic fluctuation) *

1.1x1.25x0.8x1.2 = (1+rG)4 , rG =

• Dollar-weighted average (account for varying amount under management)

• Quarter 0 1 2 3 4

Net cash flow ($ million) -1 -0.1 -0.5 0.8 -0.6 + 1.56

Put NPV=0, IRR = 3.379% (use excel function =IRR()

much less than 8.75% or 7.19% 8
Why the IRR is so low?
* Required for published data by mutual funds
 5.2 RISK AND RISK PREMIUMS
• How to tell the risk and the risk premium of an investment? We
can use
Scenario Analysis and Probability Distributions
• Scenario analysis: Possible economic scenarios; specify
likelihood and HPR
• Probability distribution: Possible outcomes with probabilities
• Expected return: Mean value of distribution of HPR
• Variance: Expected value of squared deviation from mean
• Standard deviation: Square root of variance

Note: A risk premium is the return expected in excess of the risk-free rate 9
of return an investment. So it is like a kind of compensation for taking risk.
Money market instruments may have a risk premium like say 0.25%
SPREADSHEET 5.1 SCENARIO ANALYSIS FOR THE STOCK MARKET

Scenario analysis help us do an in-depth examination of all possible outcomes.

Under best scenario (say if automatic self-driving is successful), what will be
the expected cash flows, then price of the stock in say 5 years. What will be
the price under normal (50% growth rate in revenue) and worse scenario (10%
growth rate)? Then you can estimate the current fair price of a stock of car
manufacturer.

When you are considering the price for acquiring, say a private firm in retail
industry, you may also apply scenario analysis to determine how the value of
the firm would be affected under different economic situations in order to
determine the fair price. 10

https://seekingalpha.com/article/4399110-3-scenarios-for-teslas-value
https://www.munich-business-school.de/insights/en/2016/tesla-ev-world-2020/
 2024 EXPECTED VALUE PER SHARE FOR TSLA (REFERENCE)

ARK’s 2024
Predicted Price Significance
Scenarios Target

This projection is our base case for

Expected
$7,000 TSLA’s stock price in 2024 based on our
Value
probability matrix.

We believe that there is a 25% probability

Bear Case $1,500 that Tesla could be worth $1,500 per share
or less in 2024.

We believe that there is a 25% probability

Bull Case $15,000 that Tesla could be worth $15,000 per
share or more in 2024.

11
https://ark-invest.com/articles/analyst-research/tesla-price-target/
5.2 RISK AND RISK PREMIUMS
• Apart from using scenario analysis, mean and
standard deviation can be also be estimated by
using time series of return (i.e. historical prices, you
download five-year stock data and calculate the
mean and standard deviations, want a
demonstration?)
• do you know how to do it?
• Which methods should be used? Which method is
better?
• Another method is using probability distribution
(coming slide) 12
 FIGURE 5.1 NORMAL DISTRIBUTION WITH
MEAN RETURN 10% AND STANDARD
DEVIATION 20%

Return with 68.26% Talk to me during

probability within the break or after
range of -10% to class if you don’t
30% know what a normal
distribution is.

13
How many observations are expected to deviate from the mean by three or more SDs?
Ans. 0.26 out of 100 or 26 out of 10000 observations
A brief account on Value at Risk (VaR)
A measure of downside risk, you may want to ask the
worst loss that your investment will suffer with a given
probability, say 5%. Your loss will be worse than this value
(the VaR) only 5% of the time. That is 95% of the time, it
will be better.

Excel: =NORMSINV(0.05) = -1.64485, for VaR of 5%

OR =NORMSINV(0.01)=-2.3263 for VaR of 1%

VaR of 5% : VaR = E(ri)+ (-1.64485) σ, knowing E(ri) and

σ, you can get VaR

e.g. 5% one day VaR of $1 million meaning it is expected

to lose $1 million in 20 days 14

https://www.investopedia.com/terms/v/var.asp
A BRIEF ACCOUNT ON VALUE AT RISK
(VAR)
You were responsible for risk management. Using in house built-in
software, you get 0.1% one day VaR of value $10 million. How
comfortable are you with the number you get?

Meaning? Expect to lose $10million in 1000 days or in about 4 years

Actual outcome: you lose $10 million in a year!

More frequent than expected!

15
5.2 RISK AND RISK PREMIUMS
• VaR calculated before assume normality
• Real return may not be normal
• Deviation from Normality and Value at Risk
(VaR), we need to consider
• Kurtosis: Measure of fatness of tails of probability distribution;
indicates likelihood of extreme outcomes
• Zero for normal distribution

• Higher kurtosis means higher frequency of extreme values

(can you draw the graph?)
16
• Skew: Measure of asymmetry of probability distribution
SKEW

Extreme negative value more frequent than extreme positive value

Pictures from http://www.statisticshowto.com/probability-and-

statistics/skewed-distribution/
17

No calculation required for Kurtosis or skewness.

5.2 RISK AND RISK PREMIUMS
• Risk Premiums and Risk Aversion
• Risk-free rate: Rate of return that can be earned with
certainty, guess a number?
• Risk premium: Expected return in excess of that on
risk-free securities
• Excess return: Rate of return in excess of risk-free rate
• Risk aversion: Reluctance to accept risk

You just bought a stock, how frequent will you track its price movement
18
Can you sleep well if the stock drop 5%/10%/20%?
Will you sell the stock if it dropped 5%/10%/20%/or more?
RISK AVERSION
http://www.investopedia.com/terms/r/riskaverse.asp
Can we quantify one’s degree of aversion?
We look at one’s willingness to trade off risk against
expected return.

Define A, the measure of risk aversion (the price of risk).

An investor investing her entire wealth in portfolio Q:
A= [E(rQ) – rf ]/σ2Q ,

the ratio of portfolio risk premium to its variance (the

price of risk)
A is a number, say, 2, 3.5, 4.2, etc.

You would demand a higher risk premium if you are more 19

risk averse (hold less risky asset)

5.2 RISK AND RISK PREMIUMS
• The Sharpe (Reward-to-Volatility) Ratio

• [E(rp) – rf ]/σp

• Ratio of portfolio risk premium to standard deviation

• We can use Sharpe ratio for Mean-Variance Analysis (i.e.
analyzing the return and risk)
• i.e. Rank portfolios by Sharpe ratios

If you form portfolio of Hang Seng Composite LargeCap Index, MidCap Index
and SmallCap Index. Which portfolio would have highest risk premium and
lowest risk?
That is , which one should have highest Sharpe ratio? If you are interested in the
subject, check it out.
20
Note: http://www.hsi.com.hk/HSI-Net/HSI-Net
EXAMPLE
A risk-averse investor with a risk aversion of A = 3. Treasury
bills are paying a 1% rate of return. The investor should invest
entirely in a risky portfolio with a standard deviation of 20%
only if the risky portfolio's expected return is at least greater
than or equal to 13%

  =  = > E(Rp) = 13%

What does it mean if A has a larger value, e.g. A=4?

If you are more risk-averse, you will demand a higher return for
the same risk.

A=4 => E(Rp) = 17%

21
RISK AVERSION

22

http://analystnotes.com/graph/portfolio/SS12SBsubc1.gif
 5.3 THE HISTORICAL RECORD
• World and U.S. Risky Stock and Bond Portfolios
• U.S. large stocks: Standard & Poor's 500 largest cap
• U.S. small stocks: Smallest 20% on NYSE, NASDAQ,
and Amex
• U.S. Treasury bonds: Barclay's Long-Term Treasury Bond
Index

Why do we want to look at the historical data?

23
FIGURE 5.4 RATES OF RETURN ON US
STOCKS, BONDS, AND BILLS

Which investment should have

a higher risk premium?

24
 Fig 5.5 for text

What is the risk premium

for US small stock?

25

Do you still remember what rate of return investors asked in reddit?

Around 8-10% a year
5.4 INFLATION AND REAL RATES OF RETURN,
YOU MAY REFER TO SECTION 5.2 IF YOU READ THE TEXT
• Equilibrium Nominal Rate of Interest
• Fisher Equation (Irving Fisher 1930)
• R = r + E(i)
• E(i): Current expected inflation
• R: Nominal interest rate
• r: Real interest rate
Note: Real rate measure the growth rate of purchasing
power
Remember what I introduce in lesson 1 about expected inflation (we
are seeing increasing commodity prices) and how to contain it?
26
https://www.bloomberg.com/markets/commodities pick one you are interested
https://www.bloomberg.com/quote/C%201:COM click 1 year (1Y)
5.4 INFLATION AND REAL RATES OF
RETURN, YOU MAY REFER TO SECTION 5.2 IF YOU READ THE TEXT
• U.S. History of Interest Rates, Inflation, and
Real Interest Rates
• Since the 1950s, nominal rates have increased
roughly in tandem with inflation
• Look at the blue- and red-lines on the graph (next
slide)
• 1930s/1940s: Volatile inflation affects real rates of
return
27
FIGURE 5.5 INTEREST RATES,
INFLATION, AND REAL INTEREST RATES
1926-2010

28
CAN WE CAPITALIZE THE HIGH INTEREST RATE
BECAUSE OF HIGH EXPECTATION ON INFLATION?

Think about bond investment directly.

29
5.5 ASSET ALLOCATION ACROSS
PORTFOLIOS
A simple way to control risk, we start with
1. Asset Allocation
• Portfolio choice among broad investment classes (stocks,
bonds, bills, commodities, real estate, rolex, bitcoin,
etc.). A little sidetrack, if it is wartime, what would you
want to get?
2. Complete Portfolio
• Entire portfolio, including risky and risk-free assets
3. Capital Allocation
• Choice between risky and risk-free assets
30
5.5 ASSET ALLOCATION ACROSS
PORTFOLIOS
• The Risk-Free Asset
• Treasury bonds (still affected by inflation)
• Price-indexed government bonds, TIPS (like ibond
in H.K.), less affected by inflation
• Money market instruments effectively risk-free
• Risk of CDs and commercial paper is very small
compared to most assets

31
5.5 ASSET ALLOCATION ACROSS
PORTFOLIOS
• How much you are going to allocate in risky assets depends
on your preference.
• Your complete portfolio expected return and risk will be:
E(rC) = yE(rp) + (1 − y)rf
σC = yσp + (1 − y) σrf
p: risky portfolio
y: proportion of investment budget in risky portfolio
rf: rate of return on risk-free asset
E(rp): expected rate of return of risky portfolio
σp, σc : standard deviation of risky, complete portfolio return
E(rC): expected return on complete portfolio 32
NOTE ON RISK PORTFOLIO P

P can be formed buy simply investing in stocks or

bonds or a combination of stocks and bonds

e.g. 40% in stocks with expected return 16% and

60% in bonds with expected return 4%

What is the expected return of P?

E(rp) = 0.4x0.16 + 0.6x0.04

33
FIGURE 5.6 INVESTMENT OPPORTUNITY SET
You are given a risk-free asset (rf =7%) and a risky portfolio,
E(rp)=15%, what are your choices? What are the expected return
and standard deviation if you allocate 80% in risky portfolio?

34

Sharpe ratio
5.5 ASSET ALLOCATION ACROSS
PORTFOLIOS

• Capital Allocation Line (CAL)

• Plot of risk-return combinations available by varying
allocation between risky and risk-free
• Risk Aversion and Capital Allocation
• y: Preferred capital allocation, can be found below:

Think about this, when the price of risk of a risky portfolio matches
your degree of aversion, what would you do?
35
Invest all your money in that portfolio, so y = 1
EXAMPLE OF LEVERED COMPLETE
PORTFOLIO

You have $300,000 and borrow $150,000, and all

invest in risky asset with expected return 20% and
standard deviation of 25%. Calculate the expected
return and risk of your complete portfolio.

y= 450,000/300,000=1.5
1-y = -0.5 (a short position in risk-free asset ,i.e.
you borrow at, say risk free rate of 4%)

E(rc) = (-0.5)(0.04) + (1.5)(0.2) =

σc = 1.5 x 0.25 =
36
5.6 PASSIVE STRATEGIES AND THE
CAPITAL MARKET LINE
• Passive Strategy
• Investment policy that avoids security analysis (you
believe securities are fairly priced)
• Capital Market Line (CML)
• Capital allocation line using market-index portfolio
as risky asset
• Line joining risk free T-bills and the market index
(say S&P500 or Hang Seng Index)
37
WARREN BUFFETT: VANGUARD’S BEST SALESMAN
(FROM FT.COM AUGUST 31, 2014)
Jack Bogle, the founder of Vanguard, has called Warren
Buffett the mutual fund group’s best salesman after the
billionaire investor recommended Vanguard’s funds to
his wife in his will.
Mr Buffett said his advice for the cash left to his wife was
that 10 per cent should go to short-term government
bonds and 90 per cent into a very low-cost S&P 500
index fund…………….

Does it look like what we just mentioned?

38
TABLE 5.4 EXCESS RETURN STATISTICS FOR
S&P 500 READ THE TEXT FOR UPDATED DATA TO 2013

Excess Return (%)

Average Std Dev. Sharpe Ratio
1926-2010 8.00 20.70 .39
1926-1955 11.67 25.40 .46
1956-1985 5.01 17.58 .28
1986-2010 7.19 17.83 .40

If a wealth management consultant told you that he can help you earn
a return of 12% a year with Sharpe ratio of 0.6 by investing in
US stocks, do you buy it? 39
5.6 Passive Strategies and the Capital Market Line

• Cost and Benefits of Passive Investing

• Passive investing is inexpensive and simple
• Expense ratio* of active mutual fund averages about
1%, of index fund about 0.2% or below
• Expense ratio of hedge fund averages 1%-2%, plus
10% of returns above risk-free rate
• Active management offers potential for higher
returns
* A measure of the cost to operate a mutual fund.
40
EXERCISES

• Check the outcomes

• Try some chapter end exercises at home

41