Week 7: asset allocation and international investing Flashcards
4 steps to asset allocation:
- define the portfolio opp set
- forecast the inputs for each asset class (Expected return, sd or variance, covariance)
- cal the optimal risky portfolio
- allocate funds between the risky portfolio and the risk free asset based on investor risk tolerance
How to determine the opt portfolio of risky assets
Select the P that has the highest sharpe ratio
What is the sharpe ratio
reward to risk ratio, measure the risk-adjusted return
Portfolio is tangent to
capital allocation line
What is the CAL slope and y intercept
Y intercept: risk-free asset return
slope: sharpe ratio
Separation property
separate the portfolio optimization process into two tasks:
1. find the tangency portfolio (with highest sharpe ratio)
2. find the combo of P and risk-free asset based on investor’s utility
Tangency is the same for:
all investors
Risk averse investors hold:
more risk free and some tangency portfolio
Risk-seeking investors will hold:
Only tangency portfolio and use leverage to increase return
What does the seperation property imply?
- all investors have the same portfolio of risky assets
- combine with risk free to achieve the acceptable overall level of risk for each investor
Problems with MVO
- difficult to determine an investors utility function
- assumes investors only care about mean and variance (risk = variance but investors might have different risk objective)
- the success of MVO depends on the quality of inputs
- Corr arent stable and rises in times of crisis
- MVO assumes normal distribution of returns
- optimization often generates a concentrate portfolio and high allocation to alternative asset classes
Issues with utility fnc
Decision making in risky conditions creates results not consistent with concave utility fnc
Prospect theory
- Changes in wealth affect willingness to take risk -> S shape utility function
- people underweight probable outcomes compared to certain outcomes
- with gains, more risk-averse
- with loss, more risk-seeking
- people are more sensitive to gains/ losses than to level of wealth
Fear of regret
Causes to sell winners soon and hold on losers
Loss aversion
Dont want to realize paper losses
Anchoring
Focus on what stock P should be eg. stock P should be this so don’t want to sell
recency effect
give more weight to current events
confirmation bias
give more weight to info that confirms our own opinions
herding
like to follow the crowd, dont want to miss out
overconfidence bias
success leads to overconfidence
why is avg past returns not a good way to forecast market returns
Only reasonable if the Er for stock market is constant
Does not consider current economic and financial conditions
what is the second method for forecasting market return
use specific variables and run a predictive regression eg. divi yield, PE. interest rate, credit spread, cyclically adjusted PE
What is running regression cons
best model has low Rsquare, not very accurate at predicting the actual value
The market P/E is a weighted avg of
the P/E ratio in the index
A higher multiple means what about investors future expectations and future price
higher P/E means higher expectation for future earning, bidding up the stocks price
trailing P/E
based on past EPS
P0/E0
forward P/E
Based on future forecast
P0/E1
Dividend yield
D/P
percentage of dividend of price
Why do P/E ratios predict future returns
- P/e reflect optimism concerning future growth prospect
- investors overreact to earning news and perceived changes in risk
- stock might be overpriced (high P/E) or underpriced (low P/E)
Dogs of the Dow
Takes the 10 lowest in the Dow index and hold for a year
Why is using historical avg bad for forecasting Sd and corr
because covariance and corr arent stable
what is the obj of MVO
want to obtain the highest possible return given our tolerance for risk
assets that are not perfectly corr improve:
diversification
benefit of global diversification
reducing portfolio risk by combining assets with corr < 1
Why does US have to most corr with the world
Bc they take up the majority
Canada and which country has similar corr
US
Why include foreign stocks in your portfolio
- offer diversification opportunity - lower corr with home market
- investments in developing regions may provide superior returns
- access investment opportunities not available in the domestic market
Include foreign stocks to improve the
efficient frontier (same return for lower risk bc diversification)
In a crisis, what happens to the correlation
corr increases and coverts to 1 -> no diversification benefit
Risks of global investing
- political risk variables (government stability, corruption, military, religious tensions)
- financial risk variables (foreign debt, exchange rate stability, liquidity)
- economic risk variables (GDP, inflation, budget balance)
- currency risk
What is currency risk
a foreign investment is investing in foreign asset and its currency (exposure risk(
2 components of returns and risk for local investors
- return of foreign mark (eg. stock)
- change in foregin currency (e. us dollar)
Local investors benefit if foreign investment :
increases in stock market price
increases in the value of foreign currency (appreciation of foreign, depreciation of home $)
Techniques for international investing
- direct purchase of overseas securities
- ETF (unhedged d ETF carry currency risk and market risk vs hedged WTD eliminate currency risk)
- American Depositary receipts
- country or regional mutual funds
American Depositary receipts
-trading on NYSE for foreign companies (nokia, honda toyota, etc)
- want to be accessible (convenience) to US investors
- fraction of the stock in US $
- still has currency risk bc economic tied
Portfolio risk is simply not the weighted ag of the risk of assets, but
the also the covariance
risk of stock has two components
- systematic (market) risk
- Non-systematic (firm-specific, idiosyncratic) risk
Which components of risk can be eliminated
Non systematic can be eliminated by diversifying
If p (corr) = 1
the securities would be perfectly positively corr and there will be no diversification
If p (corr) = -1
he securities would be perfectly negatively correlated and offer a perfect hedge
If p = 0
the securities are uncorrelated
has diversification benefit
Distribution of returns shape
have fat tails ( higher probability of big losses than estimated by normal distribution
what is the most volatile fixed income?
Zero government coupon bond bc has very high price volatility but zero risk for investor
What is the portfolio management process?
- identify investor’s objective and constraint using IPS
- asset allocation to achieve long term objective and constraint
- security selection
- measure portfolio performance
what is IPS
