Asset Allocation (10.20.24) Flashcards
Primary determinant of long-run portfolio performance
Asset allocation
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error in gathering and recording data
Anchoring bias
tendency to give disproportionate weight to the first information received or first number envisioned
prudence bias
tendency to temper forecasts so that they do not appear extreme or the tendency to be overly cautious in forecasting
availability bias
tendency to be overly influenced by events that have left a strong impression and/or which it is easy to recall an example
Aggregate Market Value of Equity / V(e)
level of nominal GDP * share of profits in economy * P/E
GDP * S(k) * PE
3 Major Approaches to Economic Forecasting
1) Econometric models
2) Indicators
3) Checklists
Econometrics
Application of statistical methods to model relationships among economic variables
Structural models
Specify functional relationships among variables based on economic theory
Reduced-form models
Statistical credit models that solve for the probability of default over a specific time period, using observable company-specific and market-based variables
Economic indicators
economic statistics provided by government and established private organizations that contain info on an economy’s recent past activity or its current or future position in the business cycle
Diffusion index
reflects the proportion of the index’s components that are moving in a pattern consistent with the overall index
Business cycle
fluctuations in the GDP in relation to long-term trend growth, usually lasting 9-11 years
5 Phases of the Business Cycle
1) Initial Recovery
2) Early Expansion
3) Late Expansion
4) Slowdown
5) Contraction
Initial Recovery (markers)
1) Business confidence rises
2) Stimulative policies are still in place
3) Negative output gap is large
4) Inflation is decelerating
5) Upturn in spending on housing and consumer durables
6) Short-term rates and government bond yields are low
7) Stock market rises as fears of recession dissipate
8) Cyclical, risky assets, and small stocks perform well
Early expansion (markers)
1) Unemployment starts to fall
2) Output gap remains negative
3) Consumers borrow and spend
4) Businesses step up production and investment
5) Profit rises rapidly
6) Demand for housing and consumer durables is strong
7) Short rates move up, as stimulus is withdrawn
8) Longer-maturity bond yields rising slightly
9) Yield curve flattens
10) Stocks trend upward
Late expansion (markers)
1) Output gap closed
2) Economy in danger of overheating
3) Boom mentality prevails
4) Unemployment low, profits are strong, wages and inflation rise, and investment spending increases
5) Debt coverage ratios deteriorate as balance sheets expand and interest rates rise
6) Central bank aims for soft landing
7) Interest rates rise
8) Yield curve continues to flatten
9) Stocks rise, but are volatile
10) Cyclical assets underperform/inflation hedges outperform
Slowdown (markers)
1) Economy slows and peaks, in response to rising interest rates, fewer viable investment projects, and accumulated debt
2) Vulnerable to shocks
3) Business confidence wavers
4) Inflation rises as costs rise
5) Short-term rates are high
6) Yield curve inverts
7) Credit spreads weaken
8) Stock market falls, and flight to quality happens
Contraction (markers)
1) Recessions typically last 12 to 18 months
2) Firms cut production sharply
3) Central bank eases monetary policy
4) Profits drop sharply
5) Tightening credit magnifies downward pressure on the economy
6) Major bankruptcies, incidents of uncovered fraud, exposure of aggressive accounting practices, financial crises
7) Unemployment rises quickly, impairing household financial positions
8) Short-term interest rates drop
9) Yield curve substantially steepens
10) Stock market initially declines but improves at the later stages
11) Credit spreads widen
Two areas that deflation affects negatively
1) Debt-financed instruments
2) The power of central banks
Analogy that represents the asymmetry in power of monetary policy
Expansionary policy is like pushing on a string, whereas restrictive policy is like pulling on a string
Taylor rule
A rule linking a central bank’s target short-term interest rate to the rate of growth of the economy and inflation
neutral real policy rate + expected inflation + (expected growth - trend growth) / 2 + (expected inflation - target inflation) / 2
High Real Rate + high Expected Inflation
High Nominal Rates
Low Real Real + high Expected Inflation
Mid Nominal Rates
High Real Rates + Low Expected Inflation
Mid Nominal rates
Low Real Rates + Low Expected Inflation
Low Nominal rates
National income accounting equation
(X-M) = (S-I) + (T-G)
4 Primary mechanisms by which the current and capital accounts are kept in balance
1) Changes in income (GDP)
2) Relative prices
3) Interest rates and assets prices
4) Exchange rates
3 Approaches to Forecasting
1) formal tools
2) surveys
3) judgement
formal tools
established research methods amenable to precise definition and independent replication of results
surveys
asking a group of experts for their opinions
judgement
qualitative synthesis of information derived from various sources and filtered through the lens of experiences
3 Categories of formal forecasting tools
1) Statistical methods
2) Discounted Cash Flow Models
3) Risk premium models
