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CFA L1 > Portfolio Management 2 > Flashcards

Portfolio Management 2 Flashcards

1
Q

Portfolio Perspective

A

The portfolio perspective refers to evaluating individual investments by their contribution to the risk and return of an investor’s portfolio.

Modern portfolio theory concludes that the extra risk from holding only a single security is not rewarded with higher expected investment returns.

Conversely, diversification allows an investor to reduce portfolio risk without necessarily reducing the portfolio’s expected return.

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2
Q

Diversification Ratio

A

It is calculated as the ratio of the risk of an equally weighted portfolio of n securities (measured by its standard deviation of returns) to the risk of a single security selected at random from the n securities.

There are no diversif ication bene its and the diversif ication ratio equals one. A lower diversi fication ratio indicates a greater risk-reduction bene it from diversi fication.

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3
Q

Portfolio Management Process

A

Step 1: Planning Step
Step 2: Execution Step
Step 3: Feedback Step

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4
Q

Portfolio Management Process Step 1: Planning

A
  • Analysis of investors risk tolerance, return objectives, time horizon, tax exposure, liquidity needs, income needs and any any unique circumstances or investor preferences.
  • Analysis results in an Investment Policy Statement (IPS)
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5
Q

Investment Policy Statement

A
  • Details the investor’s investment objectives and constraints.
  • Specify an objective benchmark (such as an index return) against which the success of the portfolio management process will be measured.
    -The IPS should be updated at least every few years and any time the investor’s objectives or constraints change signif icantly.
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6
Q

Portfolio Management Process Step 2: Execution

A
  • Analysis of the risk and return characteristics of various asset classes to determine fund allocation
  • Top-Down & Bottom-Up analysis is done
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7
Q

Top-Down Analysis

A

A portfolio manager will examine current economic conditions and forecasts of such macroeconomic variables as GDP growth, in flation, and interest rates, in order to identify the asset classes that are most attractive. The resulting portfolio is typically diversi fied across such asset classes as cash, f ixed-income securities, publicly traded equities, hedge funds, private equity, and real estate, as well as commodities and other real assets.

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8
Q

Bottom-up analysis

A

Once the asset class allocations are determined, portfolio managers may attempt to identify the most attractive securities within the asset class. Security analysts use model valuations for securities to identify those that appear undervalued in what is termed bottom-up security analysis.

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9
Q

Portfolio Management Process Step 3: Feedback

A
  • Over time, investor circumstances will change, risk and return characteristics of asset classes will change, and the actual weights of the assets in the portfolio will change with asset prices.
  • The portfolio manager must monitor these changes and rebalance the portfolio periodically in response, adjusting the allocations to the various asset classes back to their desired percentages.
  • The manager must also measure portfolio
    performance and evaluate it relative to the return on the benchmark portfolio identi fied in the IPS.
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10
Q

Types of Investors

A
  • Individual Investors

-Institutions:
Endowment: fund that is dedicated to providing financial support on an ongoing basis for a speci fic purpose
Foundation: fund established for charitable purposes
- Banks
- Insurance Companies
- Investment Companies
Mutual Funds
- Sovereign Wealth Funds: pools of assets owned by a government

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11
Q

Investor Profiles: Individuals
(Risk Tolerance, Investment Horizon, Liquidity Needs, Income Needs)

A

Risk Tolerance: Depends on Individual
Investment Horizon: Depends on Individual
Liquidity Needs: Depends on Individual
Income Needs: Depends on Individual

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12
Q

Investor Profiles: Banks
(Risk Tolerance, Investment Horizon, Liquidity Needs, Income Needs)

A

Risk Tolerance: Low
Investment Horizon: Short
Liquidity Needs: High
Income Needs: Pay Interest

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13
Q

Investor Profiles: Endowments
(Risk Tolerance, Investment Horizon, Liquidity Needs, Income Needs)

A

Risk Tolerance: High
Investment Horizon: Long
Liquidity Needs: Low
Income Needs: Spending Level

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14
Q

Investor Profiles: Insurance
(Risk Tolerance, Investment Horizon, Liquidity Needs, Income Needs)

A

Risk Tolerance: Low
Investment Horizon: Life - Long, P&C - Short
Liquidity Needs: High
Income Needs: Low

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15
Q

Investor Profiles: Mutual Funds
(Risk Tolerance, Investment Horizon, Liquidity Needs, Income Needs)

A

Risk Tolerance: Depends on fund
Investment Horizon: Depends on fund
Liquidity Needs: High
Income Needs: Depends on Fund

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16
Q

Investor Profiles: Defined benefit pensions
(Risk Tolerance, Investment Horizon, Liquidity Needs, Income Needs)

A

Risk Tolerance: High
Investment Horizon: Long
Liquidity Needs: Low
Income Needs: Depends on Age

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17
Q

Defined contribution pension plan

A
  • Retirement plan in which the firm contributes a sum each period to the employee’s retirement account.
  • The f irm’s contribution can be based on any number of factors, including years of service, the employee’s age, compensation, pro fitability, or even a percentage of the employee’s contribution.
  • In any event, the firm makes no promise to the employee regarding the future value of the plan assets. The investment decisions are left to the employee, who assumes all of the investment risk.
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18
Q

Types of Pensions

A
  • De fined contribution pension plan
  • Def ined bene it pension plan
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19
Q
  • Defined beneit pension plan
A
  • The firm promises to make periodic payments to employees after retirement.
  • The bene fit is usually based on the employee’s years of service and the employee’s compensation at, or near, retirement.
  • Because the employee’s future bene fit is de fined, the employer assumes the investment risk.
  • The employer makes contributions to a fund established to provide the promised future bene its.
  • Poor investment performance will increase the amount of required employer contributions to the fund.
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20
Q

Portfolio diversi fication has been shown to be relatively ineffective during _______ and is most effective when _______

A

severe market turmoil
securities have low correlation, markets operate normally

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21
Q

Buy-side & Sell-side Firms

A

Asset management f irms include both independent managers and divisions of larger financial services companies. They are referred to as buy-side f irms, in contrast with sell-side f irms such as broker- dealers and investment banks.

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22
Q

Full-service asset managers

A

are those that offer a variety of investment styles and asset classes.

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23
Q

Specialist asset managers

A

may focus on a particular investment style or a particular asset class.

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24
Q

multi-boutique firm

A

is a holding company that includes a number of different specialist asset managers.

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25
Q

Active management

A
  • attempts to outperform a chosen benchmark through manager skill, for example by using fundamental or technical analysis.
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26
Q

Passive management

A

attempts to replicate the performance of a chosen benchmark index.

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27
Q

Smart Beta

A

approach that focuses on exposure to a particular market risk factor.

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28
Q

Tradition asset managers

A

Traditional asset managers focus on equities and fixed-income securities.

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29
Q

Alternative asset managers

A

Alternative asset managers focus on asset classes such as private equity, hedge funds, real estate, or commodities.

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30
Q

Notable Trends in asset management

A
  1. The market share for passive management has been growing over time. Reason: low fees, efficient markets
  2. The amount of data available to asset managers has grown exponentially in recent years. Result: Greater technological adaptations
  3. Robo-advisors: are a technology that can offer investors advice and recommendations based on their investment requirements and constraints, using a computer algorithm.
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31
Q

Mutual Funds

A

Mutual funds are one form of pooled investments (i.e., a single portfolio that contains investment funds from multiple investors). Each investor owns shares representing ownership of a portion of the overall portfolio.

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32
Q

Net Asset Value

A

The total net value of the assets in the fund (pool) divided by the number of such shares issued is referred to as the net asset value (NAV) of each share.

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33
Q

Open-End Funds

A
  • Investors can buy newly issued shares at the NAV.
  • Newly invested cash is invested by the mutual fund managers in additional portfolio securities.
  • Investors can redeem their shares at NAV as well.
  • All mutual funds charge a fee for the ongoing management of the portfolio assets, which is expressed as a percentage of the net asset value of the fund.
  • Maybe No-Load or Load funds
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34
Q

No-Load Funds

A

do not charge additional fees for purchasing shares (up-front fees) or for redeeming shares (redemption fees).

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35
Q

Load Funds

A

charge either up-front fees, redemption fees, or both.

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36
Q

Close-end funds

A
  • Professionally managed pools of investor money that do not take new investments into the fund or redeem investor shares.
  • The shares of a closed-end fund trade like equity shares (on exchanges or over-the-counter).
  • As with open-end funds, the portfolio management f irm charges ongoing management fees.
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37
Q

Types of Mutual Funds

A
  • Money Market Funds
  • Bond Mutual Funds
  • Stock Mutual Funds
  • Index funds
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38
Q

Money Market Funds

A
  • Money Market Funds: invest in short-term debt securities and provide interest income with very low risk of changes in share value.
  • Fund NAVs are typically set to one currency unit, but there have been instances over recent years in which the NAV of some funds declined when the securities they held dropped dramatically in value.
  • Funds are differentiated by the types of money market securities they purchase and their average maturities.
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39
Q

Bond Mutual Funds

A
  • Invest in ixed-income securities. They are differentiated by bond maturities, credit ratings, issuers, and types.
  • Examples include government bond funds, tax-exempt bond funds, high-yield (lower rated corporate) bond funds, and global bond funds.
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40
Q

Other types of Pooled Investments

A
  • Exchange-traded funds (ETFs)
  • Separately managed accounts
  • Hedge Funds
  • Private Equity
  • Venture Capital
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41
Q

Exchange-traded funds (ETFs)

A
  • similar to closed-end funds in that purchases and sales are made in the market rather than with the fund itself.
  • ETFs are most often invested to match a particular index (passively managed).
  • Special redemption provisions for ETFs are designed to keep their market prices very close to their NAVs as there may be fluctuations
  • can be sold short, purchased on margin, and traded at intraday prices
  • Investors in ETFs must pay brokerage commissions when they trade, and there is a spread between the bid price at which market makers will buy shares and the ask price at which market makers will sell shares.
  • With most ETFs, investors receive any dividend income on portfolio stocks in cash
  • may produce less capital gains liability compared to open-end index funds.
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42
Q

Separately managed account

A

a portfolio that is owned by a single investor and managed according to that investor’s needs and preferences. No shares are issued, as the single investor owns the entire account.

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43
Q

Hedge Funds

A

pools of investor funds that are not regulated to the extent that mutual funds are. Hedge funds are limited in the number of investors who can invest in the fund and are often sold only to qualif ied investors who have a minimum amount of overall portfolio wealth. Minimum investments can be quite high, often between $250,000 and $1 million.

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44
Q

Private Equity & Venture Capital

A

invest in portfolios of companies, often with the intention to sell them later in public offerings. Managers of funds may take active roles in managing the companies in which they invest.

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45
Q

Investment Policy Statement

A

A written statement with the investors goals in terms of risk and return

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46
Q

Components of an IPS

A
  • Description of Client (circumstances, objectives)
  • Statement of the Purposes of IPS
  • Statement of Duties & Responsibilities of investment manager, custodian of assets & the client
  • Procedure to update IPS and to respond to various possible situations
  • Investment Objectives
  • Investment Constraints
  • Investment Guidelines (policy execution, asset types permitted, leverage)
  • Evaluation of Performance
  • Appendices (strategic baseline asset allocation, permitted deviations, rebalancing)
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47
Q

Risk Objectives

A

Absolute Risk Objectives
Relative Risk Objectives

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48
Q

Absolute Risk Objectives

A

Examples:
- have no decrease in portfolio value during any 12-month period
- not decrease in value by more than 2% at any point over any 12-month period
(Both potentially made up of government securities offering guaranteeing returns)
- No greater than a 5% probability of returns below -5% in any 12-month period.
- No greater than a 4% probability of a loss of more than $20,000 over any 12- month period.
- An overall return of at least 6% per annum,
- A return of 3% more than the annual in flation rate each year.

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49
Q

Relative risk objectives

A
  • relate to a specif ic benchmark and can also be strict
  • Returns will not be less than 12-month euro LIBOR over any 12-month period
  • No greater than a 5% probability of returns more than 4% below the return on the MSCI World Index over any 12- month period.
  • Exceed the return on the S&P 500 Index by 2% per annum.
    -For a bank, the return objective may be relative to the bank’s cost of funds (deposit rate).
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50
Q

Ability to bear risk

A
  • depends on financial circumstances
  • Longer investment horizons (20 years rather than 2 years), greater assets versus liabilities (more wealth), more insurance against unexpected occurrences, and a secure job all suggest a greater ability to bear investment risk in terms of uncertainty about periodic investment performance.
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51
Q

Willingness to bear risk

A
  • based primarily on the investor’s attitudes and beliefs about investments (various asset types).
  • subjective and is sometimes done with a short questionnaire that attempts to categorize the investor’s risk aversion or risk tolerance.
  • if ability and willingness match = easy to select level of risk
  • mismatch: willingness > ability, low ability will take precedence in advisers assessment
  • mismatch: willingness < ability, willingness takes precedence, adviser to educate (not push to change opinion)
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52
Q

Investment Constraints

A

include the investor’s liquidity needs, time horizon, tax considerations, legal and regulatory constraints, and unique needs and preferences.

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53
Q

Liquidity

A
  • ability to convert assets into cash in a short period of time at fair price.
  • portfolios must hold a significant proportion of liquid or maturing securities in order to be prepared for needs of investor
  • Illiquid investments in hedge funds and private equity funds, which typically are not traded and have restrictions on redemptions, are not suitable for an investor who may unexpectedly need access to the funds.
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54
Q

Time Horizon

A
  • generally, the longer an investor’s time horizon, the more risk and less liquidity the investor can accept in the portfolio.
  • Longer: Equities
  • Shorter: Certificate of Deposit, G-Bonds
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55
Q

Tax Situation

A
  • Based on individual’s overall tax rate
  • Fully Taxable: prefer tax-free bonds or equities that are expected to produce capital gains as they are taxed at lower rates
  • Focus on expected after-tax returns over time in relation to risk should correctly account for differences in tax treatments as well as investors overall tax rates
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56
Q

Legal & Regulatory

A
  • Financial Market Regulations + legal & regulatory constraints (may apply)
  • Ex: Trusts/Qualified investment accounts may be restricted in investing in certain assets
57
Q

Unique Circumstances

A
  • Each investor may have speci fic preferences or restrictions on which securities and assets may be purchased for the account.
  • non financial considerations ie. responsible investing: ethical preferences (Ex: no tobacco)
  • investor preferences may be based on diversification needs - investor’s income may depend heavily on the prospects for one company or industry.
58
Q

Strategic Asset Allocation

A

After creating an IPS, a strategic asset allocation is developed which speci fifes the percentage allocations to the included asset classes.
- correlations of returns within an asset class should be relatively high (ie should be similar)
- low correlations of returns between asset classes that leads to risk reduction through portfolio diversi fication.
- Traditional: equities, bonds, cash, and real estate
- Alternative Investments: Hedge Funds, PE Funds, Artwork, IP rights
- Equities: Small/large/foreign/domestic
- Bonds: Domestic/Gov/Corporate etc
- Once the universe of asset classes has been speci fied, the investment manager will collect data on the returns, standard deviation of returns, and correlations of returns with those of other asset classes for each asset class.

59
Q

Principles of Portfolio Constrcution

A

-Once the portfolio manager has identif ied the investable asset classes for the portfolio and the risk, return, and correlation characteristics of each asset class, an eff icient frontier, analogous to one constructed from individual securities, can be constructed using a computer program.
-By combining the return and risk objectives from the IPS with the actual risk and return properties of the many portfolios along the eff icient frontier, the manager can identify that portfolio which best meets the risk and return requirements of the investor.
-The asset allocation for the ef ficient portfolio selected is then the strategic asset allocation for the portfolio.

60
Q

Tactical Asset Allocation

A

A manager who varies from strategic asset allocation weights in order to take advantage of perceived short-term opportunities is adding tactical asset allocation to the portfolio strategy.
the success of tactical asset allocation will depend both on the existence of short-term opportunities in speci fic asset classes and on the manager’s ability to identify them.

61
Q

Security Selection

A

refers to deviations from index weights on individual securities within an asset class.
the success of security selection will depend on the manager’s skill and the opportunities (mispricings or ineff iciencies) within a particular asset class.

62
Q

Risk Budgeting

A

sets an overall risk limit for the portfolio and budgets (allocates) a portion of the permitted risk to the systematic risk of the strategic asset allocation, the risk from tactical asset allocation, and the risk from security selection.

63
Q

Issues of active portfolio management

A
  1. Multiple managers actively managing to the same benchmark for the same asset class (have signi ficant benchmark overlap). In this case, one manager may overweight an index stock while another may underweight the same stock. Taken together, there is no net active management risk, although each manager has reported active management risk. Overall, the risk budget is underutilized as there is less net active management than gross active management.
  2. When all managers are actively managing portfolios relative to an index, trading may be excessive overall. This extra trading could have negative tax consequences, speci fically potentially higher capital gains taxes, compared to an overall eff icient tax strategy.
64
Q

Core-satellite Approach

A

invests the majority, or core, portion of the portfolio in passively managed indexes and invests a smaller, or satellite, portion in active strategies. This approach reduces the likelihood of excessive trading and offsetting active positions.

65
Q

Approaches to ESG Investing Schedule

A
  • Negative screening: excluding specif ic companies or industries based on ESG factors.
  • Positive screening: investing in companies that have positive ESG practices.
  • Thematic investing: selecting sectors or companies to promote speci fic ESG- related goals.
  • Impact investing: selecting investments both to provide a return and to promote positive ESG practices.
  • Engagement/active ownership: using share ownership as a platform to promote improved ESG practices at a company.
  • ESG integration: considering ESG factors throughout the asset allocation and security selection process.
66
Q

Investment Objectives include:

A

investor’s return requirements and risk tolerance.

67
Q

Investment Constraints include:

A

investor’s time horizon, liquidity needs, tax considerations, legal and regulatory requirements, and unique needs and preferences.

68
Q

Investment Guidelines include:

A

Policies regarding permitted asset types and the amount of leverage

69
Q

In determining the appropriate asset allocation for a client’s investment account, the manager should:

A

consider the investor’s risk tolerance and future needs, and also forecasts of market conditions.

70
Q

Cognitive Errors

A
  • Primarily due to faulty reasoning or irrationality.
  • They can arise from not understanding statistical analysis, information processing errors, illogical reasoning, or memory errors.
  • Such errors can possibly be reduced by increased awareness, better training, or more information.
  • can be divided into belief perseverance biases that ref lect an irrational reluctance to change prior conclusions and decisions, and processing errors where the information analysis is f lawed.
71
Q

Emotional Biases

A
  • Not related to conscious thought.
  • Rather, they stem from feelings, impulses, or intuition.
  • As such, they are diff icult to overcome and may have to be accommodated.
72
Q

Belief Perservance

A

Biases that reflect an irrational reluctance to change prior conclusions and decisions
- Cognitive Dissonance
- Conservatism Bias
- Confirmation Bias
- Representative Bias (Base rate neglect, sample-size neglect)
- Illusion of Control bias
- Hindsight Bias

73
Q

Cognitive Dissonance

A
  • Refers to a situation where an individual holds con flicting beliefs or receives information that causes a current belief to be questioned.
  • Cognitive dissonance causes stress that individuals seek to reduce.
  • They may do so by letting go of prior beliefs in favor of the conf licting belief.
  • On the other hand, they might discount the conf licting information or viewpoints by questioning their truth, source, applicability, or signi ficance.
  • To the extent that it is easier to do the latter than the former, bias in favor of currently held beliefs is the result.
74
Q

Conservatism Bias

A
  • Occurs when market participants rationally form an initial view but then fail to change that view as new information becomes available.
  • That is, they overweight their prior probabilities and do not adjust them appropriately as new information becomes available.
  • Individuals displaying this bias tend to maintain prior forecasts and securities allocations, ignoring or failing to recognize the signi ficance of new information.
  • Individuals may react slowly to new data or ignore information that is complex to process.
  • may result in market participants holding investments too long because they are unwilling or slow to update a view or forecast.
75
Q

Confirmation Bias

A
  • Occurs when market participants focus on or seek information that supports prior beliefs, while avoiding or diminishing the
    importance of con flicting information or viewpoints. They may distort new information in a way that remains consistent with their prior beliefs.
    – Consider positive information but ignore negative information.
    – Set up a decision process or data screen incorrectly to support a preferred belief.
    – Become overconf ident about the correctness of a presently held belief.
  • Market participants can reduce conf irmation bias by seeking out contrary views and information
76
Q

Representativeness Bias

A
  • Occurs when certain characteristics are used to put an investment in a category and the individual concludes that it will have the characteristics of investments in that category.
  • Individuals systematically make the error of believing that two things that are similar in some respects are more similar in other respects than they actually are.
  • Two types: Base-rate neglect and sample-size neglect
  • Rentativeness bias may lead market participants to attach too much importance to a few characteristics based on a small sample size or make decisions based on simple rules and classi fications rather than conducting a more-thorough and complex analysis.
77
Q

Base-rate neglect

A
  • Refers to analyzing an individual member of a population without adequately considering the probability of a characteristic in that population (the base rate).
  • using one characteristic as representative of a population, ignoring other factors that might even be more significant
78
Q

Sample Size neglect

A

refers to making a classif ication based on a small and potentially unrealistic data sample. The error is believing the population re flects the characteristics of the small sample.

79
Q

Illusion of Control Bias

A

Exists when market participants believe they can control or affect outcomes when they cannot.
- Associated with emotional biases: illusion of knowledge, self-attribution, and overcon fidence
- may cause market participants to overweight securities for which they believe they have control over outcomes, such as a company they work for or are otherwise associated with. This can result in their portfolios being inadequately diversif ied.

80
Q

Hindsight Bias

A
  • Selective memory of past events, actions, or what was knowable in the past, resulting in an individual’s tendency to see things as more predictable than they really are.
  • People tend to remember their correct predictions and forget their incorrect ones.
  • They also overestimate what could have been known.
  • This behavior results from individuals being able to observe outcomes that did occur but not the outcomes that did not materialize.
  • AKA I-knew-it-all-along phenomenon.
  • Hindsight bias can lead to overconf idence in ability to predict outcomes. It may also cause investors to cast aside valid analysis techniques that did not turn out to be correct in favor of poor techniques that turned out well by chance.
81
Q

Information Processing Biases

A
  • Anchoring & Adjustment Bias
  • Mental Accounting Bias
  • Framing Bias
  • Availability Bias
82
Q

Anchoring & Adjustment Bias

A
  • Refers to basing expectations on a prior number and overweighting its importance, making adjustments in relation to that number as new information arrives.
  • Anchoring leads to underestimating the implications of new information.
  • New data should be considered objectively without regard to any initial anchor point.
83
Q

Mental Accounting Bias

A
  • Refers to viewing money in different accounts or from different sources differently when making investment decisions.
  • This conf licts with the idea that security decisions should be made in the context of the investor’s overall portfolio of assets based on their financial goals and risk tolerance.
    The result is not optimal portfolio given the investor’s circumstances, goals, and risk tolerance.
  • It can cause an investor to hold positions that offset each other, rather than considering investments in the context of their correlation of returns.
  • One common form of mental accounting bias is a tendency to view income differently from capital appreciation. This may cause an investor to hold a mix of income-producing and non-income-producing securities that does not match the investor’s circumstances.
84
Q

Framing Bias

A
  • occurs when decisions are affected by the way in which the question or data is “framed.” In other words, the way a question is phrased can in fluence the answer given.
  • Failing to properly assess risk tolerance may identify investors as more or less risk averse than they actually are, resulting in portfolios that are inconsistent with the investors’ needs.
85
Q

Availability Bias

A
  • Refers to putting undue emphasis on information that is readily available, easy to recall, or based narrowly on personal experience or knowledge. Availability bias occurs when individuals judge the probability of an event occurring by the ease with which examples and instances come to mind.
  • More-recent events are typically easier to recall than events further in the past, which leads to the bias of attaching too much signi ficance to events that have occurred recently and too little to events that occurred further in the past.
  • People also tend to assume that if something is easily remembered, it must occur with a higher probability.
    may lead market participants to choose a manager or investment based on advertising or recalling they have heard the name. They may limit their universe of potential investments to familiar firms, resulting in inappropriate asset allocations and lack of diversi fication. They may also overreact to recent market conditions while ignoring data on historical market performance, or they may place too much emphasis on events that receive a large amount of media attention.
86
Q

Emotional Biases

A
  • Loss Aversion Bias
  • Overconfidence Bias (illusion of knowledge, self-attribution bias, certainty overconfidence)
  • Self Control Bias
  • Status Quo Bias
  • Endowment Bias
  • Regret-Aversion Bias
87
Q

Loss Aversion Bias

A
  • arises from feeling more pain from a loss than pleasure from an equal gain.
  • Consequences: trading too much by selling for small gains, which increases transaction costs and decreases returns, or incurring too much risk by continuing to hold assets that have deteriorated in quality and lost value.
    If an initial decline in value occurs, loss-averse investors may take excessive risk in the hope of recovering (investment managers may be particularly susceptible to this behavior). A loss-averse investor might view a position inappropriately as a gain or a loss based on the framing of the reference point.
88
Q

Overconfidence Bias

A
  • Occurs when market participants overestimate their own intuitive ability or reasoning.
  • It can show up as illusion of knowledge when they think they do a better job of predicting than they actually do.
  • Combined with self- attribution bias, individuals may give themselves personal credit when things go right (self-enhancing) but blame others or circumstances when things go wrong (self-protecting).
  • Prediction overcon fidence leads individuals to underestimate uncertainty and the standard deviation of their predictions
  • Certainty overcon fidence occurs when they overstate the probability they will be right.
  • While overconf idence is both cognitive and emotional, it is more emotional in nature because it is dif ficult for most individuals to correct and is rooted in the desire to feel good.
  • Overconf idence bias may cause market participants to underestimate risk, overestimate return, and fail to diversify suff iciently.
89
Q

Self-Control Bias

A
  • Occurs when individuals lack self-discipline and favor short- term satisfaction over long-term goals.
  • They may favor small payoffs now at the expense of larger payoffs in the future, which is known as hyperbolic discounting.
  • Self-control bias may result in insuf icient savings to fund retirement needs, which in turn may cause an investor to take excessive risk to try to compensate for insuf icient savings accumulation.
  • It may also result in overemphasis on income-producing assets to meet short-term needs.
  • Self-control bias might be mitigated by establishing an appropriate investment plan (asset allocation) and a budget to achieve suff icient savings. Both should be reviewed on a regular basis.
90
Q

Status Quo Bias

A
  • Occurs when comfort with an existing situation causes an individual to be resistant to change.
  • If investment choices include the option to maintain existing investments or allocations, or if a choice will happen unless the participant opts out, status quo choices become more likely.
  • Consequences of status quo bias may include holding portfolios with inappropriate risk and not considering other, better investment alternatives.
91
Q

Endowment Bias

A
  • Occurs when an asset is felt to be special and more valuable simply because it is already owned.
  • Endowment bias is common with inherited assets and might be detected or mitigated by asking a question such as “Would you make this same investment with new money today?”
  • Market participants who exhibit endowment bias may be failing to sell assets that are no longer appropriate for their investment needs, or they hold assets with which they are familiar because they provide some intangible sense of comfort.
92
Q

Regret-aversion Bias

A
  • Occurs when market participants do nothing out of excessive fear that actions could be wrong. They attach undue weight to errors of commission (doing something that turns out wrong) and not enough weight to errors of omission (not doing something that would have turned out right). Their sense of regret and pain is stronger for acts of commission. This is quite similar to status quo bias.
  • Herding behavior is a form of regret aversion where participants go with the consensus or popular opinion. Essentially, participants tell themselves they are
    not to blame if others are wrong too.
  • Consequences of regret-aversion bias may include excess conservatism in the portfolio because it is easy to see that riskier assets do at times underperform. Therefore, an investor might not buy riskier assets so as not to experience regret when they decline.
93
Q

Describe how behavioral biases of investors can lead to market characteristics that may not be explained by traditional finance.

A
  • Overconf idence may lead to overtrading, underestimation of risk, and lack of diversif ication.
  • Persistently good results combined with self-attribution bias can fuel overconf idence, as can hindsight bias (as investors give themselves credit for choosing pro fitable stocks in a bull market).
  • Conf irmation bias may lead investors to ignore or misinterpret new information suggesting that valuations will not continue to rise, or to misinterpret initial decreases in asset values as simply another buying opportunity.
  • Anchoring may cause investors to believe recent highs are rational prices even after prices begin their eventual decline.
  • Fear of regret may keep even very skeptical investors in the market.
94
Q

Halo Effect

A

a version of representativeness in which a company’s good characteristics, such as fast growth and a rising stock price, are extended into a conclusion that it is a good stock to own, leading to overvaluation of growth stocks.

95
Q

Home Bias

A
  • Investors tend to invest heavily in firms in their domestic country in a global portfolio, or more heavily in firms operating in their region of a country, is considered anomalous in that rationality suggests greater diversi fication.
  • may result from a belief that they have better access to information or simply an emotional desire to invest in companies “closer to home.”
  • Similarly, investors may underestimate the risk or overestimate the future returns of f irms whose products they use or firms for which they are exposed to a great amount of positive marketing messages.
96
Q

Risk Governance

A
  • Refers to senior management’s determination of the risk tolerance of the organization, the elements of its optimal risk exposure strategy, and the framework for oversight of the risk management function.
  • Risk governance seeks to manage risk in a way that supports the overall goals of the organization so it can achieve the best business outcome consistent with the organization’s overall risk tolerance.
  • Risk governance provides organization-wide guidance on the risks that should be pursued in an eff icient manner, risks that should be subject to limits, and risks that should be reduced or avoided.
  • A risk management committee can provide a way for various parts of the organization to bring up issues of risk measurement, integration of risks, and the best ways to mitigate undesirable risks.
97
Q

Risk Tolerance

A
  • Involves setting the overall risk exposure the organization will take by identifying the risks the firm can effectively take and the risks that the organization should reduce or avoid. - Factors: expertise in its lines of business, its skill at responding to negative outside events, its regulatory environment, and its financial strength and ability to withstand losses.
  • When analyzing risk tolerance, management should examine risks that may exist within the organization as well as those that may arise from outside.
  • The various risks the firm is exposed to must each be considered and weighted against the expected benef its of bearing those risks and how these f it the overall goals of the organization.
98
Q

Risk Budgeting

A
  • The process of allocating firm resources to assets by considering their various risk characteristics and how they combine to meet the organization’s risk tolerance.
  • The goal is to allocate the overall amount of acceptable risk to the mix of assets or investments that have the greatest expected returns over time.
  • The risk budget may be a single metric, such as portfolio beta, value at risk, portfolio duration, or returns variance.
  • A risk budget may be constructed based on categories of investments, such as domestic equities, domestic debt securities, international equities, and international debt securities.
  • Another way to allocate a risk budget is to identify specif ic risk factors that comprise the overall risk of the portfolio or organization. In this case, specif ic risk factors that affect asset classes to varying degrees, such as interest rate risk, equity market risk, and foreign exchange rate risk, are estimated and aggregated to determine whether they match the overall risk tolerance of the organization.
99
Q

Financial Risks

A
  • Those that arise from exposure to financial markets.
100
Q

Credit risk

A

This is the uncertainty about whether the counterparty to a transaction will fulf ill its contractual obligations.

101
Q

Liquidity Risk

A

This is the risk of loss when selling an asset at a time when market conditions make the sales price less than the underlying fair value of the asset.

102
Q

Market Risk

A

This is the uncertainty about market prices of assets (stocks, commodities, and currencies) and interest rates.

103
Q

Non-Financial Risks

A
  • Arise from the operations of the organization and from sources external to the organization.
  • Operational Risk
  • Solvency Risk
  • Regulatory Risk
  • Government or Political Risk (inc Tax Risk)
  • Legal Risk
  • Model Risk
  • Tail Risk
  • Accounting Risk
104
Q

Operational Risk

A

This is the risk that human error, faulty organizational processes, inadequate security, or business interruptions will result in losses.
- An example of an operational risk is cyber risk, which refers to disruptions of an organization’s information technology.

105
Q

Solvency risk.

A

This is the risk that the organization will be unable to continue to operate because it has run out of cash.

106
Q

Regulatory risk. .

A

This is the risk that the regulatory environment will change, imposing costs on the firm or restricting its activities

107
Q

Governmental or political risk

A

(including tax risk). This is the risk that political actions outside a specific regulatory framework, such as increases in tax rates, will impose significant costs on an organization.

108
Q

Legal risk.

A

This is the uncertainty about the organization’s exposure to future legal action.

109
Q

Model risk.

A

This is the risk that asset valuations based on the organization’s analytical models are incorrect.

110
Q

Tail risk.

A

This is the risk that extreme events (those in the tails of the distribution of outcomes) are more likely than the organization’s analysis indicates, especially from incorrectly concluding that the distribution of outcomes is normal.

111
Q

Accounting risk.

A

This is the risk that the organization’s accounting policies and estimates are judged to be incorrect.

112
Q

Mortality Risk

A

risk of death prior to providing for their families’ future needs
most often addressed with life insurance

113
Q

longevity risk

A

risk of living longer than anticipated so that assets run out
longevity risk can be reduced by purchasing a lifetime annuity.

114
Q

Measures of Risks for Specific Asset Types

A
  • Standard Deviation
  • Beta
  • Duration
115
Q

Standard Deviation

A

Standard deviation is a measure of the volatility of asset prices and interest rates. Standard deviation may not be the appropriate measure of risk for non- normal probability distributions, especially those with negative skew or positive excess kurtosis (fat tails).

116
Q

Beta

A

Beta measures the market risk of equity securities and portfolios of equity securities.
This measure considers the risk reduction bene its of diversi fication and is appropriate for securities held in a well-diversif ied portfolio, whereas standard deviation is a measure of risk on a stand-alone basis.

117
Q

Duration

A

Duration is a measure of the price sensitivity of debt securities to changes in interest rates.

118
Q

Derivatives Risks

A

AKA the Greeks
- Delta
- Gamma
- Vega
- Rho

119
Q

Delta

A

This is the sensitivity of derivatives values to the price of the underlying
asset.

120
Q

Gamma

A

This is the sensitivity of delta to changes in the price of the underlying asset.

121
Q

Vega

A

This is the sensitivity of derivatives values to the volatility of the price of the underlying asset.

122
Q

Rho

A

This is the sensitivity of derivatives values to changes in the risk-free rate.

123
Q

Tail Risk

A

is the uncertainty about the probability of extreme (negative) outcomes. Commonly used measures of tail risk (sometimes referred to as downside risk) include Value at Risk and Conditional VaR.

124
Q

Value at risk (VaR)

A
  • is the minimum loss over a period that will occur with a speci fic probability.
  • VaR has become accepted as a risk measure for banks and is used in establishing minimum capital requirements.
  • There are various methods of calculating VaR, and both the inputs and models used will affect the calculated value, perhaps signi ficantly. As is always the case with estimates of risk, incorrect inputs or inappropriate distribution assumptions will lead to misleading results. Given these limitations, VaR should be used in conjunction with other risk measures.
125
Q

Conditional VaR (CVaR)

A

is the expected value of a loss, given that the loss exceeds a minimum amount.
It is calculated as the probability-weighted average loss for all losses expected to be at least $1 million. CVaR is similar to the measure of loss given default that is used in estimating risk for debt securities.

126
Q

Stress Testing

A

examines the effects of a specif ic (usually extreme) change in a key variable such as an interest rate or exchange rate.

127
Q

Scenario Analysis

A

refers to a similar what-if analysis of expected loss but incorporates changes in multiple inputs. A given scenario might combine an interest rate change with a signi ficant change in oil prices or exchange rates.

128
Q

Risk Management

A

Risk management does not seek to eliminate all risks. The goal is to retain the optimal mix of risks for the organization.
This may mean taking on more of some risks, decreasing others, and eliminating some altogether.
Once the risk management team has estimated various risks, management may decide to prevent or avoid a risk, accept a risk, transfer a risk, or shift a risk.

129
Q

Diversification

A

For risks that management has decided to bear, the organization will seek to bear them ef iciently. Diversif ication may offer a way to more eff iciently bear a specif ic risk.

130
Q

Self Insurance

A
  • Used to describe a situation where an organization has decided to bear a risk.
  • Note, however, that this simply means that it will bear any associated losses from this risk factor.
  • It is possible that this represents inaction rather than the result of analysis and strategic decision-making.
    In some cases, the f irm will establish a reserve account to cover losses as a way of mitigating the impact of losses on the organization.
131
Q

Risk Transfer

A

For a risk an organization has decided not to bear, risk transfer or risk shifting can be employed. With a risk transfer, another party takes on the risk. Insurance is a type of risk transfer.

132
Q

Fidelity Bonds

A

Insurers also issue fidelity bonds, which will pay for losses that result from employee theft or misconduct.

133
Q

Surety Bond

A

With a surety bond, an insurance company has agreed to make a payment if a third party fails to perform under the terms of a contract or agreement with the organization.

134
Q

Risk Shifting

A

a way to change the distribution of possible outcomes and is accomplished primarily with derivative contracts.

135
Q

An investor has the most control over her portfolio’s

A

risk

136
Q

Risk Management Framework

A

A risk management framework includes the procedures, analytical tools, and infrastructure to conduct the risk governance process. It includes all of the items listed with the exception of establishing position limits, which is an example of the operational implementation of a system of risk management.

137
Q

Effective risk management would most likely attempt to:

A

maximize expected return for a given level of risk.
Risk management requires establishment of a risk tolerance (maximum acceptable level of risk) for the organization and will attempt to maximize expected returns for that level of risk.

138
Q

Risk budgeting can best be described as:

A

selecting assets by their risk characteristics up to the maximum allowable amount of risk. The maximum amount of risk to be taken is established through risk governance.

CFA L1 (16 decks)

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