Part Three: The New Investment Technology Flashcards
How can we define financial risk?
Financial risk has generally been defined as the variance or standard deviation of returns. Being long-winded, we use the accompanying exhibit to illustrate what we mean. A security whose returns are not likely to depart much, if at all, from its average (or expected) return is said to carry little or no risk. A security whose returns from year to year are likely to be quite volatile (and for which sharp losses occur in some years) is said to be risky.
How can you reduce risk using the Modern Portfolio Theory
Let’s suppose we have an island economy with only two businesses. The first is a large resort with beaches, tennis courts, and a golf course. The second is a manufacturer of umbrellas. Weather affects the fortunes of both. During sunny seasons, the resort does a booming business and umbrella sales plummet. During rainy seasons, the resort owner does poorly, while the umbrella manufacturer enjoys high profits. (diversify )
Is there a point at which diversification is no longer a magic wand safeguarding returns?
About fifty is also the golden number for global-minded investors. Such investors get more protection for their money, as shown in the preceding chart. Here, the stocks are drawn not simply from the U.S. stock market but from the international markets as well. As expected, the international diversified portfolio tends to be less risky than the one drawn purely from U.S. stocks.
What’s the best diversification of U.S. and developed foreign country stock?
It turns out that the portfolio with the least risk had 18 percent foreign securities and 82 percent U.S. securities. Moreover, adding 18 percent EAFE stocks to a domestic portfolio also tended to increase the portfolio return. International diversification provided the closest thing to a free lunch available in our world securities markets. When higher returns can be achieved with lower risk by adding international stocks, no investor should fail to take notice.
What’s Beta(relating to systematic risk)?
Basically, beta is the numerical description of systematic risk. Despite the mathematical manipulations involved, the basic idea behind the beta measurement is one of putting some precise numbers on the subjective feelings money managers have had for years. The beta calculation is essentially a comparison between the movements of an individual stock (or portfolio) and the movements of the market as a whole.
The calculation begins by assigning a beta of 1 to a broad market index. If a stock has a beta of 2, then on average it swings twice as far as the market. If the market goes up 10 percent, the stock tends to rise 20 percent. If a stock has a beta of 0.5, it tends to go up or down 5 percent when the market rises or declines 10 percent. Professionals call high-beta stocks aggressive investments and label low-beta stocks as defensive.
Now, the important thing to realize is that systematic risk cannot be eliminated by diversification. It is precisely because all stocks move more or less in tandem (a large share of their variability is systematic) that even diversified stock portfolios are risky. Indeed, if you diversified perfectly by buying a share in a total stock market index (which by definition has a beta of 1), you would still have quite variable (risky) returns because the market as a whole fluctuates widely.
What’s unsystematic risk?
Unsystematic risk (also called specific risk) is the variability in stock prices (and, therefore, in returns from stocks) that results from factors peculiar to an individual company. Receipt of a large new contract, the finding of mineral resources, labor difficulties, accounting fraud, the discovery that the corporation’s treasurer has had his hand in the company till—all can make a stock’s price move independently of the market. The risk associated with such variability is precisely the kind that diversification can reduce.
What does the following graph represent?(check on notion)
The chart illustrates the important relationship between diversification and total risk. Suppose we randomly select securities for our portfolio that on average are just as volatile as the market (the average betas for the securities in our portfolio will be equal to 1). The chart shows that as we add more securities, the total risk of our portfolio declines, especially at the start.
When thirty securities are selected for our portfolio, a good deal of the unsystematic risk is eliminated, and additional diversification yields little further risk reduction. By the time sixty well-diversified securities are in the portfolio, the unsystematic risk is substantially eliminated and our portfolio (with a beta of 1) will tend to move up and down essentially in tandem with the market.
What’s the Capital-Asset Pricing Model(CAPM)?
The new theory says that the total risk of each individual security is irrelevant. It is only the systematic component that counts as far as extra rewards go.
In a big fat nutshell, the proof of the capital-asset pricing model (henceforth to be known as CAPM) can be stated as follows: If investors did get an extra return (a risk premium) for bearing unsystematic risk, it would turn out that diversified portfolios made up of stocks with large amounts of unsystematic risk would give larger returns than equally risky portfolios of stocks with less unsystematic risk. Investors would snap at the chance to have these higher returns, bidding up the prices of stocks with large unsystematic risk and selling stocks with equivalent betas but lower unsystematic risk. This process would continue until the prospective returns of stocks with the same betas were equalized and no risk premium could be obtained for bearing unsystematic risk. Any other result would be inconsistent with the existence of an efficient market.
Is there a relationship between Beta and returns?
The remarkable result, shown in the chart below(in notion), is that there was essentially no relationship between the return of these decile portfolios and their beta measures. I found a similar result for the relationship between return and beta for mutual funds. There was no relationship between returns for stocks or portfolios and their beta risk measures.
How can we understand Arbitrage Pricing Theory and why Beta may be inefficient?
To understand the logic of APT, one must remember the correct insight underlying the CAPM: The only risk that investors should be compensated for bearing is the risk that cannot be diversified away. Only systematic risk will command a risk premium. But the systematic elements of risk in particular stocks and portfolios may be too complicated to be captured by beta—the tendency of the stocks to move more or less than the market. This is especially so because any particular stock index is an imperfect representative of the general market. Hence, beta may fail to capture a number of important systematic elements of risk.
What are other important systematic risk elements?
Changes in national income. Also changes in national income mirror changes in the personal income of individuals, and the systematic relationship between security returns and salary income can be expected to have significant effect on individual behavior.
Changes in interest rates also systematically affect the returns from individual stocks and are important nondiversifiable risk elements. To the extent that stocks tend to suffer as interest rates go up, equities are a risky investment, and those stocks that are particularly vulnerable to increases in the general level of interest rates are especially risky. Thus, some stocks and fixed-income investments tend to move in parallel, and these stocks will not be helpful in reducing the risk of a bond portfolio. Because fixed-income securities are a major part of the portfolios of many institutional investors, this systematic risk factor is particularly important for some of the largest investors in the market.
Changes in the rate of inflation will similarly tend to have a systematic influence on the returns from common stocks. This is so for at least two reasons. First, an increase in the rate of inflation tends to increase interest rates and thus tends to lower the prices of some equities, as just discussed. Second, the increase in inflation may squeeze profit margins for certain groups of companies—public utilities, for example, which often find that rate increases lag behind increases in costs.
On the other hand, inflation may benefit the prices of common stocks in the natural resource industries. Thus, again there are important systematic relationships between stock returns and economic variables that may not be captured adequately by a simple beta measure of risk.
What’s the Arbitrage Pricing Theory?
Arbitrage pricing theory is a general theory of asset pricing that holds that the expected return of a financial asset can be modeled as a linear function of various factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient.
What’s The Fama-French Three-Factor Model
A factor model to account for risk using two more factors in addition to beta.
Fama-French argue that smaller firms are relatively risky. One explanation might be that they will have more difficulty sustaining themselves during recessionary periods and thus may have more systematic risk relative to fluctuations in GDP. Fama-French also argue that stocks with low market prices relative to their book values may be in some degree of “financial distress.” These views are hotly debated, and not everyone agrees that the Fama-French factors measure risk.
Beta: from the Capital-Asset Pricing Model
Size: measured by total equity market capitalization
Value: measured by the ratio of market to book value
Is there one perfect system to measure risk and potential stock value?
No: Neither technical analysis, which analyzes the past price movements of stocks, nor fundamental analysis, which analyzes more basic information about the prospects for individual companies and the economy, seems to yield consistent benefits. It appears that the only way to obtain higher long-run investment returns is to accept greater risks.
What should be considered with risk measurement systems?
We must be careful not to accept beta or any other measure as an easy way to assess risk and to predict future returns with any certainty. You should know about the best of the modern techniques of the new investment technology—they can be useful aids. But there is never going to be a handsome genie who will appear and solve all our investment problems. And even if he did, we would probably foul it up
