Investment principles and risk

Our audiovisual presentation provides an introduction to the ...

Shortened demo course. See details at foot of page.

...ss risk adjusted returns and the basics of behavioural finance.

Modern portfolio theory builds on the concept of diversification and provides mathematical justification. This theoretical work confirmed that if returns on assets are not perfectly correlated, then the greater the diversification of a portfolio, the l...

Shortened demo course. See details at foot of page.

...s. The implication of this is that a rational investor would not invest in a portfolio if there were an alternative that offered the same return for lower risk.

What is the basis of Markowitz‘s Modern Portfolio Theory?

Answer : Purchase course for answer

The most commonly used measure of risk is standard deviation. The standard deviation of returns measures how widely the actual return of an investment varies around the mean or expected return, year on year.

Where an investment has year on year returns that are close to its expected return, it is said to have a low standard deviation

Where returns vary widely, the overall expected returns may be the same as the investment with a low standard deviation, but it will be higher risk (returns fluctuate to greater extremes). It has a higher deviation of e...

Shortened demo course. See details at foot of page.

...stment theory assumes a normal distribution as described above and standard deviation is generally accepted as a suitable measure of risk. However, recent research has discovered that financial data is not always symmetrically spread around the mean. It can be skewed, which means it forms a lopsided graph with a long tail on one side, or it can exhibit fat tails (called 'excess kurtosis'). This would indicate that there is a higher probability of unlikely events.

What does standard deviation measure?

Answer : Purchase course for answer

On the basis of Modern Portfolio Theory, all investors are risk averse; therefore, all portfolios should be made up of low risk assets. In reality, however, the return provided by these low risk assets may not meet the investor’s requirements. It may instead be necessary to include higher risk assets that offer the potential for higher returns, then reduce the overall risk in one of two ways:

By diversifying the portfolio holdings

           or

By hedging out risk

Diversification

It is generally accepted that diversification of a portfolio - i.e. holding a number of securities rather than just one - will reduce risk. This is because the downside risk of one security can be offset by the upside potential of another investment. Of course, this trade-off is not going to occur if all securities held within the portfolio are perfectly correlated with each other, so that they move in the same direction and by the same extent in percentage terms with the market. Effective diversification therefore takes place when securities move in opposite directions to each other. This will reduce non-systematic risk but not systematic risk.

Diversification can be achieved in a number of ways:

By investing across the main asset classes

Within any one asset class

Across different sectors or industries

Across different geographical areas

In different currencies

The degree of diversification will largely depend upon the extent to which investment returns are correlated.

Positive Correlation - Returns from securities move up and down together. They are affected by the same factors in the market, e.g. exports, inflation, exchange rates, etc.

Negative Correlation - The returns from some securities move in opposite directions to those from others. As a simple example, a firm making deck chairs will benefit from increased sales during prolonged spells of warm and dry weather. On the other hand, makers of umbrellas will benefit from increased sales where there are periods of wet weather. This is likely to produce the most effective diversification if it can be achieved.

No Correlation - Returns from some companies are not related to others in any way. For example an English firm making furniture for the domestic market will not be correlated with a South African gold mining firm.

Example of a correlation matrix  

UK

Japan

China

Germany

US

UK

1.00

0.26

0.11

0.81

0.55

Japan

0.26

1.00

0.27

0.21

0.11

China

0.11

0.27

1.00

0.05

0.05

Germany

0.81

0.21

0.05

1.00

0.56

US

0.55

0.11

0.05

0.56

1.00

The table above demonstrates the degree of correlation that could occur between different countries.

A correlation of 1 indicates a perfect relationship between the selected indices (positive correlation)

A correlation of -1 indicates an opposite or inverse relationship (negative correlation)

A correlation of 0 indicates that the relationship between the selected indices is completely independent (no correlation)

Hedging

An investment portfolio manager can reduce risk within their portfolio of securities by using investments such as derivatives (e.g. futures and options), to take a counter position to the direction in which they feel that their portfolio (and by implication the market) is going to move. This strategy is commonly referred to as 'hedging'.

The use of derivatives is covered in greater detail in chapter 8.

Which two methods can be used to reduce risk in a portfolio?

Answer : Purchase course for answer

Modern Portfolio Theory can be used to create what is known as an efficient frontier, which is one that has the highest chance of providing the required returns, whilst exposing the investor to the lowest risk by combining different securities.

The efficient frontier plots the risk-reward profiles of various portfolios and shows the best return that can be expected for a given level of risk, or the lowest level of risk needed to achieve a given expected...

Shortened demo course. See details at foot of page.

...ed away than indicated by the model

It does not take into account transaction costs and investors may not wish to change their investments as often as the model recommends

It assumes that the underlying portfolios are made up from index funds with the same characteristics as the input data; this would not be the case for an actively managed portfolio

What information is required to create the efficient frontier curve?

Answer : Purchase course for answer

Modern portfolio theory suggests that there are two types of risk that will affect an investor's portfolio:

Systematic risk

Non-systematic risk

Systematic risk

This is also known as market risk or undiversifiable risk and is the risk that affects markets as a whole and cannot be avoided. It is the risk that markets will fluctuate in response to news and events such as:

Changes to interest rates, inflation or other economic data

Changes to Government fiscal policy such as increases or decreases in taxa...

Shortened demo course. See details at foot of page.

...rises.  However, various academic studies have suggested that 15–20 securities would be sufficient to eliminate most of the investment specific risk. As shown in the diagram below, the rate of risk reduction diminishes when this number of securities is exceeded. This is because there is an element of market risk that cannot be diversified away.

Note - Non-systematic risk can also be referred to as unsystematic risk.

Explain the two types of risk present in a portfolio

Answer : Purchase course for answer

The Capital Asset Pricing Model (CAPM) was a development of Modern Portfolio Theory introduced in the 1960s. It provides a model to estimate whether the expected returns from a portfolio are sufficient in relation to the amount of risk being taken. It is a linear model linking risk and returns. Effectively, CAPM states that the total risk of a security is a combination of systematic and non-systematic risk.

As outlined above, non-systematic risk can be eliminated through diversification of the portfolio. The investor therefore faces only systematic risk, the extent to which a security is correlated to the market as a whole. CAPM identifies a measure of this risk known as “beta”. It establishes a linear relationship between beta and returns.

Beta (β)

The sensitivity of each investment to the movement of the market is calculated and known as its beta . By definition the market has a beta of 1 and the beta of an individual security reflects the extent to which its return moves up or down with the market.

A security with a beta equal to 1 (β=1) is expected to move up and down in line with the market. If the market moves by 10% the security will also move by 10%

If a security has a beta of less than 1 but more than 0, this indicates that the security is more stable than the market and will move less than the market though in the same direction. The amount of difference will depend on the value of the beta. For example, if β=0.5 when the ...

Shortened demo course. See details at foot of page.

...nd inflation are minimised.

The market portfolio – in theory, CAPM market portfolio includes all risky investments worldwide, while in practice this is usually replaced by a market index of shares such as the FTSE All Share or the FTSE 100. Depending on which index is used, the betas will be significantly different. This has brought into question whether these portfolios represent a true market portfolio, since if the true market portfolio is not used the correct beta for the security cannot be established.

The suitability of beta – in order for CAPM to be effective, the beta of a security must be stable or predictable. Betas are calculated based on historical data and do not appear to be stable over time, which may suggest that they are not reliable for estimating future risk.

CAPM is based on the theory that there is a direct relationship between the excess return of a security over the risk free rate and its beta; however, research has failed to substantiate this link, although there is support over longer periods of time. Some studies have implied that securities with low betas provide a higher return than predicted by the model, whereas those with higher betas provide lower than predicted returns.

Although the model is flawed, it does still provide a useful tool in its ability to provide relative data, which helps us to understand expected returns and their relationship to risk.

What is the CAPM intended to show?

Answer : Purchase course for answer

The CAPM uses a simple relationship between risk and return, and hence is often referred to as a single-factor model. One of the main drawbacks to this approach is that in reality there are many factors that will impact on the potential returns.

A multi-factor model uses multiple factors in its computations to explain market phenomena and/or equilibrium of asset prices. It will do this by comparing two or more factors to analyse relationships bet...

Shortened demo course. See details at foot of page.

...designed by Stephen Ross and described in more detail in the next section.

Although there are differences between different multi-factor models, they all share two basic concepts:

That investors require higher returns for taking risk

They also appear to be predominately concerned with the risk that cannot be eliminated by diversification

What is the difference between CAPM and a multi-factor model?

Answer : Purchase course for answer

Arbitrage pricing theory was created in 1976 by Stephen Ross, and the theory predicts a relationship between returns of a portfolio and the returns of a single asset through a linear combination of many independent macro-economic issues. It is an asset pricing model based on the idea that an asset’s returns can be predicted using the relationship between the asset and many common risk factors, where sensitivity to changes in each factor is represented by a factor-specific beta. The model-derived return can then be used to correctly price the ...

Shortened demo course. See details at foot of page.

...mium on bonds

Unanticipated changes in the return of long-term government bonds over treasury bills (shifts in the yield curve)

The inclusion of multiple factors does mean that more betas need to be calculated and does not guarantee that all relevant factors have been identified. The added complexity means that this model is less widely used than CAPM; however, it does still form the basis for many of the commercial risk systems employed by asset managers.

What is Arbitrage Pricing Theory (APT)?

Answer : Purchase course for answer

When considering the performance of a portfolio, it is important to take into account the returns made against the level of risk taken to achieve those returns. We have previously considered two ways in which risk can be measured:

The volatility of returns measured by the standard deviation of returns

Systematic or market risk measured by beta (β)

Risk adjusted returns can be measured using the Sharpe ratio , alpha and the information ratio .

Sharpe ratio

The Sharpe ratio alters the rate of return to take into account the risk associated with an investment or fund. The Sharpe ratio measures the excess returns for every unit of risk where risk is measured by standard deviation.

The ratio is:

(Return on investment – risk free return)/Standard deviation of the return on the investment

The difference between the return achieved on the investment and the risk free rate of return is the excess return achieved for taking some risk

Risk is measured by the standard deviation of returns

Example

Portfolio A provides an annual return of 10% compared to a 4% annual return from a risk-free investment. The standard deviation of the portfolio is 8%.

The Sharpe ratio is (10% - 4%) / 8% = 0.75

This implies that the portfolio earned a 0.75% return above the risk-free rate for each unit of risk taken.

The Sharpe ratio tells us whether a portfolio’s returns are due to the skill of the fund manager or as a result of taking excess risk. It is useful because, although one portfolio or fund may have performed better than its peers,...

Shortened demo course. See details at foot of page.

...nd thus is a useful risk-adjusted measure of actively managed funds or portfolio performance.

It is calculated by deducting the returns of a fund's benchmark from the funds overall performance and dividing the result by its Tracking Error (which is a measure of the volatility of those excess returns/ standard deviation). This provides a value, per unit of extra risk assumed, that the manager’s decisions have added to that which the market could have delivered anyway.

The formula is as follows:

Information ratio = (R p – R b) / Tracking error

Where:

R p is the portfolio return

R b is the benchmark return 

Example

The following shows how to calculate the information ratio of two different funds.

Fund A

Fund B

Actual return

12%

11%

Benchmark return

10%

10%

Tracking error

8%

3%

Information ratio

(12 – 10)/8

= 2/8

= 0.25

(11 – 10)/3

= 1/3

= 0.33

Although Fund A has a higher return than Fund B, when adjusted for the risk taken against the benchmark to achieve these returns, the information ratio tells us that B has generated a higher risk adjusted return.

The higher the positive information ratio, the higher the value added by the manager through active management, based on the amount of risk taken relative to the benchmark. A negative information ratio means that the investor would have achieved a better return by matching the index using a tracker or index fund.

Describe the Sharpe ratio and the Information ratio.

Answer : Purchase course for answer

The efficient market hypothesis (EMH) was developed by Eugene Fama in the 1960s and maintains an assumption that all information relating to the performance of assets is in the public domain and therefore it is not possible to outperform the market.

This assumes an efficient market where all buyers and sellers have access to the same information and that this information is readily available so that an investment manager would not be able to outperform a tracker fund, as prices would reflect all information and be traded at a price realistic to their actual value and level of risk at all times.

As we know, this is not always the case as information is not as open as this hypothesis supposes. There are times when certain individuals or firms may have information ahead of everyone else, thus leading to a less efficient market and the ability to buy assets under value and sell over value depending on the circumstances.

In this way, it would be possible to outperform the market and make additio...

Shortened demo course. See details at foot of page.

...th some markets being more efficient than others. In less efficient markets, more knowledgeable investors can outperform less knowledgeable ones.

Government bonds are considered extremely efficient

Most researchers consider large capitalized stocks to be very efficient, whilst smaller capitalized stocks are less so

Venture capital that does not have a liquid market is considered less efficient because different participants may have varying amounts - and different quality - of information

The efficient market debate plays a key role in the decision between active or passive investment. If EMH is correct, it makes sense to invest in trackers or index funds that mirror the overall performance of the market rather than stock picking. On the other hand, where markets are not efficient there are opportunities for knowledgeable and skilful investors to outperform the market.

Under the Efficient Market Hypothesis (EMH), what does weak form efficiency suggest?

Answer : Purchase course for answer

Much of traditional financial theory is based on the assumption that individuals act rationally and consider all available information when making investment decisions. In practice, however, this is not always the case and psychological factors and behavioural biases can affect investors and lead them to make incorrect investment decisions.

Behavioural finance is an area of research that explores how emotional and psychological factors affect investment decisions and attempts to explain market anomalies and other market activity that cannot be explained by the traditional financial models.

It highlights the inefficiencies caused by the irrational way in which investors react to new information, as causes of market trend...

Shortened demo course. See details at foot of page.

...s are now challenging existing efficient market models in terms of explaining market anomalies. However, they do not appear to be able to predict the effect of the market of human behaviour.

There is little doubt that emotion and psychological factors have an effect on investment decisions and can affect markets significantly. However, some believe that they are not useful in forecasting the markets as many factors of human behaviour cannot be quantified.

Critics who tend to be supporters of existing efficient market models believe that behavioural finance is just a collection of explanations of anomalies rather than a true branch of finance and that these anomalies will eventually be priced out of the market.

 

Your results and the estimated s...

Shortened demo course. See details at foot of page.

...ate.

Estimated study time 3.8 hours