More Stocks , Less Risk

1
Ch 1 Diversification

• More Stocks , Less Risk
• As the number of stocks in a portfolio
  increases, the total risk or volatility of that
  portfolio decreases.

2
Benefits of Diversification

• Diversification is the act of combining assets
  with dissimilar behavior for the purpose of
  producing a portfolio with an optimal risk/return
  tradeoff.
• NOT PUTTING ALL YOUR EGGS IN ONE
  BASKET
• By diversifying, a deep loss in one asset class
  may be offset by gains in another.
• The net result is a more stable portfolio.

3
Diversification Helps Manage Risk

• In an ideal world, investors would find
  securities that offer consistently high return
  with little risk. However in the real world there
  is no such thing.

4
International Securities

• International stocks and bonds are another major
  asset class to consider. There have been some
  instances when foreign securities have
  outperformed their U.S. counterparts.
• The diversification benefits of international
  securities, have generated high interest in
  global markets. To reduce the total volatility
  risk of some portfolios, it would be wise to
  invest internationally as well.

5
Asset Allocation

• The most important investment decision is the
  asset mix of a portfolio.
• The five major asset classes investors are
  concerned with their investment needs are
• Day-to-Day, Emergencies, Saving for a Near-Term
  Purchase, Long-Term Savings, and Retirement.
• The understanding of five major investment
  fundamentals aids in a assembling a portfolio
  are
• Tradeoff between risk and return
• Diversification Benefits
• Long-Term Investing and Compounding Returns
• Liquidity and Marketability Considerations
• Tax Deferral Benefits
• However the most important decision is the Asset
  Allocation choice

6
Ch 2Modern Portfolio Theory (MPT)

• Prepared by
• Alex Au

7
Introduction

• MPT takes into account of different possible
  outcomes, project results with a high degree of
  certainty, have the ability to be fine tuned on a
  regular basis, stay within selected parameter and
  reduce your overall risk.
• MPT let investors choose their own risk level.
• MPT work with proper diversification to reduce
  risk and increase return.

8
The Need for Asset Allocation

• Diversification can reduce a portfolios risk and
  improve return.
• Since each asset class have a different
  uncertainty it is necessary to consider the range
  of possible outcome for each asset class.

9
Portfolio Risk and Return

• Investors want a high expected return, but at the
  same time they want an asset with low standard
  deviation.
• Expected return and standard deviation are
  estimated from historical data.
• Investors are not concern with holding a asset in
  isolation, but rather with the risk of the entire
  portfolio.

10
(contd)

• Portfolio risk not only depend on the riskiness
  of its component assets, but also on how the
  return are related to one another.
• Risk that can be eliminated by diversification
  does not command a risk premium.
• A portfolios expected rate of return should be
  easy to determine using the weighted average
  return of the individual assets.

11
(contd)

• Correlation coefficient is the measure of the
  relationship between the rate of return behavior
  of each asset versus every other asset.
• First-order autocorrelations of a return series,
  is the return in one period that is related to
  the return in the next period.
• Cross correlations show how much one series
  returns are related to another.

12
(contd)

• The portfolios risk is a function of the the
  individual assets and their correlation to each
  other.

13
Portfolio Optimization

• Efficient portfolio have a mixture of assets,
  whereas inefficient portfolio has assets that
  make higher risk-adjusted incremental
  contributions to portfolio return than other
  assets.
• Efficient frontier refers to the collection of
  all efficient portfolios corresponding to the
  full range of portfolio risk possibilities.

14
Optimizing the Portfolio

• Once the expected return, standard deviation, and
  cross-correlation have been estimated for the
  asset classes than mathematical calculation to
  derive the asset allocations for portfolios on
  the efficient frontier.
• Optimal portfolio will always have a subjective
  dimension because there is no way to directly
  measure a clients risk tolerance.

15
(contd)

• Managers expectation of return on asset class
  may not be in line with the benchmark return,
  therefore it is not recommended that the
  managers returns be used in place of benchmark
  estimates.

16
Symmetrical vs. Asymmetrical Risk Distribution

• Symmetrical risk distribution uses all the
  optimization software to minimize risk, whereas
  asymmetrical is where the investors are more
  concerned with losses.

17
Why MPT Hasnt Been More Widely Used

• The software is expensive (from 50,000 to
  200,000 per year).
• Index funds and foreign funds were not widely
  accessible.
• Most planners do not have the theoretical and
  practical education to implement MPT.
• Asset allocation and MPT did not receive
  mainstream press coverage.

18
(contd)

• MPT calculates different combinations of assets
  that yield the maximum expected return at each
  level of risk, as measured by standard deviation.
• It is important to understand that the expected
  return, standard deviation and correlation of the
  assets in the portfolio are merely forecasts
  based on past performance.

19
Ch 3Structuring A Portfolio

• By Yihui Yu

20
Diversification

• Objective to add investments to the clients
  portfolio that are not closely related to his
  other investments
• Measurement correlation coefficients.
• - coefficient 0 (no direct relationship)
• - coefficient 1 (perfect positive relation)
• - coefficient -1 (perfect negative relation)

21
The Correlation Matrix

• Concept compare one investment o another and
  report the correlation coefficient
• Investment categories for the matrix
• - domestic stock
• - foreign stock
• - bonds
• - cash equivalents
• - real assets

22
Selecting Assets For a Portfolio

1. The assets that the client refuses to get rid of
   should be included.
2. Several investment categories are represented.
3. Each category should comprise at least 5 of the
   portfolio.
4. Recommended weightings should be rounded off to
   the nearest whole number.

23
Other Factors

• The type of mutual fund or annuity chosen should
  depend on the following factors
• Clients time horizon
• Any existing investment the client already owns
• Clients goals and objectives
• Clients risk tolerance level

24
Ch 4 Asset Allocation
25
Definition

• Asset allocation is the process of distributing
  portfolio investments among the various available
  investment categories.
• Process involves three decisions
• 1. Which types of investments should be
  included or excluded?
• 2. How much weight should be given to each
  asset?
• 3. Which vehicles should be used?

26
Importance of Asset Allocation

• If you should have x of a portfolios holdings
  in growth and income funds versus some other
  percentage figure is much more important than
  trying to gauge if ht investment should be made
  now or in six months.

27
Approaches to Asset Allocation

• Strategic asset allocation is a passive approach
  that focuses on long-range policy decisions to
  determine the appropriate asset mix.
• It does not attempt to predict or time the
  market. The portfolio is fully invested at all
  times. Risk is reduced by using several different
  investment categories.

28
Approaches to Asset Allocation

• Tactical asset allocation is an active approach
  that generally uses market predictions to change
  the asset mix in order to exploit superior
  predictive ability through such techniques. This
  strategy believes that market inefficiencies can
  constantly be found and that short-term trading
  can take advantage of such inefficiencies.

29
Approaches to Asset Allocation

• Dynamic asset allocation is an active technique
  that reacts to changing market conditions by
  making relatively frequent changes in the asset
  mix with the goal of providing downside
  protection in addition to upside participation.

30
Ch 5Market Timing
31
Introduction

• Essence of market timing in any investment is to
  buy low and sell high
• Use of leading indicators
• A blending of business analysis with technical
  projections
• Reaction to leading indicators sometimes opposite
  of expectations
• Investors take advantage of market inefficiencies
• Switching of portfolios of high/low betas
  according to market conditions

32
Methodology Moving Averages

• Straight or simple moving average is the sum of a
  data series divided by the total units involved
• Commonly used 30 and 60 day moving averages
• Exponential moving average is a weighted moving
  average
• Smoothes out minor fluctuations in trends
• More reliable

33
Moving Averages (Continued)

• Two basic rules
• Buy signals rendered whenever price of fund rises
  above level of moving averages employed
• Sell signals rendered when price level falls
  below level of moving averages employed

34
Methodology Cash Flow Indicator

• Based on the concept of contrary thinking
• Buy at peak pessimism sell at peak optimism of
  market
• Example Mutual fund cash position
• Large increase/decrease may indicate bear/bull
  market expectations
• Historically, rise above 10 leads to major
  upward market move converse at 8 normal at 9

35
Drawbacks to Short-term Trading

• Market timers have to be right twice when they
  are getting in and again when they are exiting
  the market
• The more moves, the greater the chance for
  mistakes
• May lose advantage of deferred taxation

36
Studies Trinity Study

• Observations on nine peak-to-peak cycles since
  WWII May 29, 1946 through Aug. 25, 1987
• About 1.7 times more up months than down 309 vs.
  187
• Average bull market up 104.8 vs. Average bear
  market drop of 28
• Bull markets last three times as long as bear
  markets 41 up months vs. 14 down months
• Even in bear markets, on average 3 to 4 months
  out of 10 are up months
• On average, 8 of 41-month bull market duration
  accounted for 60 of total returns

37
Charles D. Ellis Study

• All 100 pension funds engaged in some market
  timing
• Not one improved rate of return
• 89 of 100 lost as a result of timing

38
William F. Sharpe Study

• Market study from 1934 to 1972
• Market timer with 2 in trading costs, choosing
  once a year between stocks and cash, would have
  to be right at least 82 of the time to do as
  well as a buy-and-hold stock investor

39
Chua and Woodward Study

• To be successful at market timing, investors
  require forecast accuracy for at least
• 80 of all bull markets, 50 of all bear
  markets
• 70 of all bull markets, 80 of all bear markets
  or
• 60 of all bull markets, 90 of all bear markets

40
Robert H. Jeffrey Study

• If market timing is only accurate 50 of the
  time, probable outcomes
• Best-case real dollar return, only two times
  greater than from continuous investment in SP
• Worst-case produces 100 times less.

41
Roy D. Henrikson Study

• Study on 116 mutual funds from 1968 to 1980
• Virtually all fund managers showed no significant
  ability to time purchases for superior performance

42
Ibbotson Study

• Study on security returns from 1949 to 1998
• If investor missed 5 best years for common stocks
  and invested in T-bills instead, 1 in stocks at
  end of 1925 would only become 127, instead of
  578 if invested continuously in SP 500
• Point market timer has tremendous natural odds
  to overcome odds increase geometrically with
  length of timeframe and frequency of timing
  interval

43
Timing Services

• Many investors rely on newsletters or timing
  services for timing signals
• Timing services also track fund performance and
  recommend specific funds to buy
• Minimum account 25,000
• Plus 2 annual management fee

44
Timing vs. Buy-and-Hold

• Q Which does better?
• A It depends
• Performance measurements strongly influenced by
  period of comparison
• Buy-and-hold is better in upward trend markets
• Timing is better in declining markets
• In good markets, all can do well. Therefore,
  timing services may help cut losses

45
Ch 6FORMULA TIMING INDICATORS

• Introduction-
• Offers a mechanical timing approach
• Commonly used substitutes for subjective
  buy-and-sell timing decisions.
• Requires investor input

46

• 3 Types of formula plans includes
• Constant Dollar Plans- requires investor to set
  the dollar value of the aggressive portfolio.
• Constant Ratio Plan- maintains the value of the
  aggressive portfolio relative to the value of the
  conservative portfolio.
• Variable Ratio Plan- mechanical portfolio
  management plan that requires extensive
  forecasting.

47
TIMING INDICATORS

• Bear Market Endings
• 6 indicators that tell investors when it is time
  to start buying stocks again
• Investment Sentiment
• Market P/E
• Dividend Yield
• Interest Rates
• Market Volume
• Advances and Declines

48

• Stocks in a recession 1973-1975
• In 1973-75 during the beginning of the recession,
  there was a 7.8 growth in the S P 500.
• In 1980 there was a 14.6 growth
• In 1981-82 there was a 16.5 growth.

49

• Markets in a recession 1948-1991
• There have been 9 business recessions since the
  end of World War II.
• First Postwar Recession 1948-1949
• Second Postwar Recession 1953-1954
• Third Postwar Recession 1957-1958
• Fourth Postwar Recession 1960-1961
• Fifth Postwar Recession 1969-1970
• Sixth Postwar Recession 1973-1975
• Seventh Postwar Recession Jan 1980-June 1980
• Eighth Postwar Recession 1981-1982
• Ninth Postwar Recession 1990-1991

50
PREDICTABILITY

• Businesses tend to occur in most major nations
  about twice in each 10-year period.
• National Bureau of Economic Research is one of
  the most respected economic organizations to
  study business cycles.

51
BEARS

• Bear markets is any market when share prices
  reach a two-year low.
• Bear markets occur about twice every 10 years
• The best way to predict a bear market may be to
  realize bear markets end when least expected

52
BULLS

• A bull market is defined any time when share
  prices reach a two-year high.

53
Ch 7 Timing Indicators
54
Bear Market Endings

• A list of some indicators to call a market turn.
• Investment Sentiment.
• Market P/E.
• Dividend Yield
• Interest Rates
• Market Volume
• Advances and Declines

55
Stock and Markets in a Recession

• First Postwar Recession- Nov 1948- Sep. 1949 ( 11
  months)
• Second Postwar Recession- July 1053- April 1954 (
  10 months)
• Third Postwar Recession- August 1957- March 1958
  ( 8 months)
• Fourth Postwar Recession- April 1960- Jan. 1961 (
  10 months)

56
Stock and Markets in a Recession

• Fifth Postwar Recession- Dec. 1969 to Oct 1970 (
  11 months)
• Sixth Postwar Recession- Nov. 1973 to Feb. 1975 (
  16 months)
• Seventh Postwar Recession Jan. 1980 to June
  1980 ( 6 months)
• Eighth Postwar Recession- July 1981 to Oct 1982 (
  16 months)
• Ninth Postwar Recession- July 1990 to March 1991
  (9 months)

57
Predictability

• Business recession tend to occur in most major
  nations about twice in each 10-year period, but
  we have never been able to find any person or
  organization who could correctly predict either
  bear markets or business recessions.

58
Bears and Bulls

• A bear market is defines as any market when share
  prices reach a two-year low.
• A bull market is defined any time when share
  prices reach a two-year high.

59
Ch 8 Security Analysis
60
Introduction

• The capital asset pricing model and efficient
  markets theory has been demonstrated both
  theoretically and empirically that
  diversification reduces the risk of a portfolio.

61
Modern Portfolio Theory

• Markowitz showed that investor should hold
  diversified portfolios containing financial
  assets that are less than positively correlated
  with each other.
• William Sharpe, John Lintner and Jan Mossin
  extended this theory called Capitail Asset
  Pricing Model.

62
CAPM

• CAPM provides a theory of the relationship
  between securities and portfolio rates of returns
  and those of a representative market index that
  is a proxy for the overall stock market.
• Betas are calculated using past security and
  portfolio data and hence are simply estimates of
  future relationships.

63
Stock Selection

• Neither chart reading (technical analysis) nor
  analysis of corporate financial statements
  (fundamental analysis) can provide above-average
  investment returns on a risk-adjusted basis.

64
Fundamental Analysis

• The fundamental analysts tools indlude
  macro-economic data, corporate financial reports,
  industry data, and comments from corporate
  officers and company memoranda.looking to
  determine whether a specific companys stock is
  undervalued or overvalued.

65
Technical Analysis

• Technical approach involves the use of past price
  and volume and other external data to assess the
  crowds attitude toward the market and specific
  stocks.

66
Chapter 9Rebalancing the Portfolio

• The Need for Rebalancing
• -if the portfolio is not rebalanced one asset
  could achieve dominance
• -Rebalancing keeps the portfolio diversified

67

• Approaches to Reevaluation
• -buy-and-hold strategy- do nothing at all
• -calendar approach- rebalance the portfolio back
  to its original allocations i.e. monthly,
  quarterly annually
• -contingent approach- make changes based on
  pre-specified percentage change in allocations
  from o.g. policy

68

• Rebalancing Experimentation
• -Let it Ride Study
• --study performed without transaction costs
  or industry fees
• --rebalancing doesnt help the portfolio on
  either a return or risk basis

69

• -Stine and Lewis Study
• --considered transaction costs
• --rebalancing does lower risk, while
  sacrificing little return in exchange
• --annual rebalancing makes more sense than
  quarterly rebalancing
• --the best option is the contingent strategy,
  with the asset varying more than 7.5 to 10
  from o.g. position

70

• -Clifton Study
• --considered all costs
• --annually rebalanced outperformed
  buy-and-hold and contingent strategies on a
  risk-to-reward basis

71

• -Short Holding Period Study
• --transaction costs included
• --contingent strategy, with asset varying
  7-10 from o.g. position produces less risk
  than annual rebalancing, requires fewer
  rebalances and lower transaction costs

72

• Conclusions
• -rebalance only when a portfolio reaches a
  predetermined level of risk exposure
• -because the contingent strategy is easy to
  monitor and requires no sophisticated
  programming, management costs are minimal
• -if the portfolio manager does elect a calendar
  strategy, annual balancing produces the best
  results

73

• Compensation
• -a portfolio manager should regularly bill
  clients for re-optimization, even if its
  infrequent
• -if a manager is monitoring clients investments
  and communicating regularly, they should be paid

74
Ch 10 Asset Allocation Sensitivity
75
Introduction

• Overall, U.S. equities had excellent return in
  the 1980s and 1990s. Foreign equities performed
  fairly well during these two decades.
• It is well known by MPT followers that of the
  three components that comprise the model program
  (historical returns, standard deviations and
  correlation coefficients)

76
Sensitivity to Expected Returns

• Although managed futures, venture capital, oil
  and gas, and other limited partnerships have very
  good historical returns, they still have some
  shortcoming of each of these investments.
• -guru, bank brokerage firm, insurance company, or
  financial planning group had such information ,
  they certainly wouldnt share it with you. Also
  industry users and insiders know more about you
  or any trader knows in future market or other
  market.

77
Review Individual Asset Statistics

• Whenever or wherever you see a return or standard
  deviation figure that you strongly doubt, note
  it. But it assumes that you have done research
  not just based on experience or recent history.

78
The 5/25 Strategy

• By selecting at least 5 different asset
  categories and investing at least 5, but no more
  25.
• Dont rely entirely on the program that suggests
  a large investment in one of these categories.