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Draft lecture – FIN 352 Professor Dow CSU-Northridge March 2012

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If markets are generally efficient, then… Looking for undervalued assets is not a useful investing strategy. Does it matter what you do? MPT looks at the investing implications of market efficiency. Assets are evaluated in terms of risk and expected return rather than price or intrinsic value. The hard part is how to measure risk.

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An individual chooses what portfolio to have. Portfolios are judged based on expected return and risk (as measured by standard deviation). The risk of a single asset is the risk it adds to the portfolio.

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Market Efficiency Previous Lecture Portfolio Selection We’ll learn the basic principles and calculations Skip the more advanced calculations (see the book) What is the bottom line for portfolio selection?

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Market Price of Risk Quantifying the Risk-Return Tradeoff Theory of Expected Returns ▪ CAPM (we’ll only cover the basics) ▪ Issues related to measuring uncertainty How to Evaluate Investor Performance

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Markets are not necessarily efficient. Uncertainty is not measured correctly. Overly technical. What is the alternative?

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Statistics Review Expected Return Standard Deviation Covariance and Correlation Normal Distribution ▪ Tail Probabilities

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The portfolio return equals the weighted average of the individual asset returns. R P = w 1 R 1 + w 2 R 2 60% of your wealth is in stocks, 40% in bonds. Stocks earned 7%, bonds earned 5%. (0.6)(7%)+(0.4)5% = 6.2%

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The expected return to the portfolio is the weighted average of the expected returns to the individual assets. E(R P ) = w 1 E(R 1 ) + w 2 E(R 2 ) 60% of your wealth is in stocks, 40% in bonds. Stocks are expected to earned 12%, bonds are expected to earned 2%. (0.6)(12%)+(0.4)2% = 8%

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Is the portfolio standard deviation the average of the individual standard deviations NO! Some of the changes will cancel out across securities. This is diversification – combining different assets reduces risk.

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The correlation coefficient, Rho ( ), measures how movements in returns are related. > 0 Returns tend to move in the same direction. < 0 Returns tend to move in opposite directions. = 0 Movements in returns are unrelated.

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The correlation coefficient, Rho ( ), determines the amount of diversification = 1 Returns always move in same direction; no diversification = -1 Returns always move in opposite direction; can eliminate risk completely. 0 < < 1 Returns sometimes move in different directions; some diversification

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Negative correlations would be ideal. Generally, security returns have positive correlations. Why? Correlations not equal to 1 so still opportunities for diversification.

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How much depends on which assets. Can’t diversify away all risk. Non-diversifiable, systematic or market risk Reflects changes in the economy or in the willingness of investors to bear risk.

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Higher-risk assets offered higher return on average in the past. Mixing assets classes will provide better diversification. Lower risk for the same expected return. Holding more of the relatively high-risk assets will increase portfolio risk (and expected return).

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Fancy Version (discussed in book – optional, not required for class) The Efficient Frontier Market portfolio provides maximum diversification and is the best portfolio of risky assets. You should hold the market portfolio and a risk- free asset; the share of each depending on your risk tolerance.

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Our basic investment strategy up to now: Be diversified Choose the mix of assets to match tolerance for risk. This basic asset allocation approach is broadly consistent with MPT. More complicated versions for sophisticated investors.

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MPT assumptions: Markets are efficient (talked about previously) We know the distribution of stock returns. Portfolio risk is adequately described by the standard deviation. ▪ Returns are normally distributed. ▪ Individuals only care about standard deviations. Assumptions don’t have to hold exactly, but should be reasonably good descriptions.

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History may not predict the future Standard deviations may change ▪ Why? Correlations may change ▪ Why?

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Distributions of returns may not be normal. Asymmetric risk Skewness Downside risk Fat tails Greater risk of extreme event Underestimate risk Can investors take advantage of this?

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Cannot quantify important risks. Risk vs. Uncertainty Risk: We know the frequency (distribution of events) Uncertainty: We don’t know how often events will occur. ▪ Examples? What if we didn’t even know the event could occur?

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[T]here are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don't know we don't know. - Donald Rumsfeld

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Black Swan Risk What should an investor do? Be conservative? Be robust to shocks? Gamble on the possibility of big changes?

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The market price of risk is the extra return you expect to get for holding an additional level of risk. This is determined by the average of investors’ attitudes towards risk. The market risk premium is defined as E(R m )- R f

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Can’t evaluate risk of a security in isolation. How much risk does the security add to your portfolio? Expected return to the security “should” be a function of this risk.

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Factor models. Expected return is a function of various “factors”. Economic factors Business characteristics Market returns

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Capital Asset Pricing Model (CAPM) Risk consists of two parts Business-specific risk ▪ Which can be diversified away Market risk ▪ Which cannot be diversified away If you hold a well-diversified portfolio, only the market risk matters. Since only market risk matters, investors only need to be compensated for a security’s market risk.

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Beta (β) represents the amount of market risk. How to measure β (the non-technical version). On average, how much does the return to the asset change when the return to the market changes? ▪ If it changes an equal percentage, it has a β of 1. ▪ If it moves twice as much, it has a β of 2. ▪ If it’s movements are unrelated to the market, it has a β of 0. ▪ If it moves equally, but opposite of the market, it has a β of -1. What determines β? http://www.youtube.com/watch?v=zv_XSRVlFUE

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How much extra return do you get for a unit of risk? The market risk premium! This gives us the CAPM equation E(R i ) = R f + β i (E(R m ) - R f ) If the risk-free rate is 5%, the expected market return is 9% and the β of the security is 1.5, what return should it offer. 11% What if the β was 0.5?

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How does CAPM perform? Beta matters But it’s not the only thing that matters Multi-Factor Models

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Why evaluate performance? Does an investment strategy work? Did an money manager perform better than average? Reasons for good performance Risk Skill Luck

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Managers exceed expectations if they have higher return than they should given the risk. Usual caveats about repeat performance How to measure expectations? How to measure risk?

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Using a benchmark: Return compared with index portfolio of similar assets. Use standard deviation as a measure of risk. Sharpe Ratio = E(R i – R f )/σ Downside risk. Use a model to measure of risk.

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CAPM provides a measure of risk. R i – R f = α i + β(R m -R f ) + u i α measures excess return above that implied by the CAPM α is sometimes used as a generic term to refer to the value-added produced by the investor.

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Chapter 6 Efficient Diversification Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin.

Chapter 6 Efficient Diversification Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin.

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