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Portfolio Theory and Asset Pricing

(FINA6216)
Professor Kumar Venkataraman
James M. Collins Chair in Finance

Lecture 1: Return and Risk

Return = Profit on each dollar of Investment

I bought a share of Google for $400. One year later, I


sold the share for $600.

I bought a share of Enron for $100. One year later, I


sold the share for $20.

Profit = $600 - $400 = $200


Annual Return (%) = (200 / 400) * 100 = 50%

Profit (or Loss) = $20 - $100 = - $80


Annual Return (%) = (-80 / 100) * 100 = - 80%

Returns are easy to measure.


3

Forecasting is very difficult, especially when it concerns the


future!
- Mark
Twain

Objective - forecast the performance of our


wealth/portfolio

Simple example Lets play the role of an ESPN


analyst. Three basketball players will play in a
ballgame tonight. Our job is predict each players
score tonight.

Where do we start? Examine scores in previous games?


How many games should we examine?

Too few (2 games) or Too many (last five seasons).

What are we looking for?

Average points scored


How the scores vary from one game to the next? (tells us
about how much confidence we have in the average.)
4

Scores in the most recent 100 games

Forecast?
Which player is more RISKY?

Who is more risky?

Standard Deviation is a measure of Risk

You have less confidence in your forecast of the


guards performance. The Guard is more RISKY!

Standard Deviation = the average surprise or


deviation from your forecast (25 points). The
surprise could delight (30 points) or disappoint (20
points).

Higher the Standard Deviation, Higher the Risk.

Money managers or investment reports typically


report the portfolios standard deviations as a
measure of risk.

Define Return

P
1 P 0 D1
HPR
P0

HPR = Holding Period Return,


P0 = Beginning price,
P1 = Ending price,
D1 = Dividend during period one

Total return represents income (e.g., dividends


or interest) plus capital gains or losses.

Arithmetic vs. Geometric Mean


Year

Beginning Ending Value


Value

HPR

100

115

15%

115

138

20%

138

110.4

-20%

Arithmetic Mean (AM) = HPR/N


Geometric Mean (GM) = ((1+HPR))1/N 1
GM is a better measure of past performance
AM is a better predictor of future performance

Arithmetic versus Geometric averages


Consider a stock that is equally likely to double in value
(r=100%) or halve in value (r=-50%) in any year. The
expected return is 25%.
Suppose you randomly draw two observations (repeatedly)
from a long time series of observed (realized/actual) returns
for this stock. In some years, the return will be 100% and in
others, the return will be -50%. The exercise is equivalent to
tossing a fair coin. (Note: we sample two observations as
the two outcomes are equally likely)
On average, you will observe one observation of r=100% and
another observation of r=-50%. What is the AM and GM
based on the two observations of realized returns?
AM = 25% (note: equals the expected value)
GM = 0%

Numerical problem (old exam)

Suppose you buy 100 shares of Anushka.com at


the beginning of year 1 for $25. The stock price at
the end of the year 1 is $22, the price is $18 at
the end of year 2, the price is $28 at the end of
year 3, and the price is $29 at the end of year 4.
If Anushka.com pays no dividends, what is the
geometric mean return (annual) during the fouryear period?

Measuring Expected Return and Standard


Deviation using historical data
Year

Actual
return

Average
return

Deviations
from
average

Squared
Deviations

15%

5%

10%

100

20%

5%

15%

225

-20%

5%

-25%

625

Average

5%

Sum = 950

Variance = squared deviations average = Sum/N =


950/3 = 317
Standard Deviation = Variance = 317 = 17.8%
Reward-to-variability ratio: Return / Risk
= 5 / 17.8 = 0.28

How should we invest in August 2015?

Predict the performance of various assets


stocks, bonds, treasury bills etc.
Invest in the most attractive assets
Revisit the above steps periodically (how often?)

How to predict?

Look in the crystal ball!


Use statistics (see the Review handout)

Historical performance

World Stock Market Capitalization


Year-end 2014

Capitalization calculated at year-end 2014. Total market capitalization is $33.1 trillion. Estimates are not guaranteed. 2015
Morningstar. All Rights Reserved.

GDP Growth by Region


Five-year average annual percentage change 20102014

Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. 2015
Morningstar. All Rights Reserved.

GDP and Market Cap (all US $ T)

World GDP in PPP (2013): 87

North America: 20 (U.S.: 17)


EU: 16 (Germany: 3)
Asia: 23 (China: 13, India: 5, Japan: 5)

Equity market Capitalization:


Global: 2007: 65; 2009: 48; 2014: 69.
Equity/GDP declined from 114% in 2007 to 89% in 2014.

All Financial Assets


Global: 2007: 242; 2009: 243; 2014: 294.
FA/GDP increased from 378% in 2007 to 426% in 2014.

See Market Watch article for details

Ibbotson SBBI
Stocks, Bonds, Bills, and Inflation 19262014

Past performance is no guarantee of future results. Hypothetical value of $1 invested at the beginning of 1926. Assumes
reinvestment of income and no transaction costs or taxes. This is for illustrative purposes only and not indicative of any investment.
An investment cannot be made directly in an index. 2015 Morningstar. All Rights Reserved.

Bond Market Performance


19862014

Past performance is no guarantee of future results. Hypothetical value of $1 invested at the beginning of 1986. Assumes
reinvestment of income and no transaction costs or taxes. This is for illustrative purposes only and not indicative of any investment.
An investment cannot be made directly in an index. 2015 Morningstar. All Rights Reserved.

Global Investing
19702014

Past performance is no guarantee of future results. Hypothetical value of $1 invested at the beginning of 1970. All values in
U.S. dollars. Assumes reinvestment of income and no transaction costs or taxes. This is for illustrative purposes only and not
indicative of any investment. An investment cannot be made directly in an index. 2015 Morningstar. All Rights Reserved.

Asset-Class Returns
Highs and lows: 19262014

Past performance is no guarantee of future results. Each bar shows the range of annual total returns for each asset class over the
period 19262014. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly
in an index. 2015 Morningstar. All Rights Reserved.

Global Stock Market Returns


Highest and lowest historical annual returns for each region, 19702014

Past performance is no guarantee of future results. Each bar shows the range of annual total returns for each region over the time
period analyzed. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in
an index. 2015 Morningstar. All Rights Reserved.

Histogram:
U.S. Large-Cap Returns
2005

2012
2010
2006 1999

1997

2000

1993

1988 1996

1991

1977

1992

1986 1983

1989

1969

1987 2004 1979 1982

1985

2007
Below 0
Previous 10 years

2001 1962 1990

1984 1971 1972 1976 2009 1980

1973 1946 1981 2011 1978 1968 1964 1967 2003 1955 1995
1966 1940 1953 1994 1956 1965 1952 1963 1998 1950 1975

-60 -55

2008

2002

1931 1937

1974 1930

-50 -45 -40

-35 -30

-25

-30.9
Two standard
deviations

1957 1932 1939 1970 1948 1959 1949 1951 1961 1938 1945 1958

1954

1941 1929 1934 1960 1947 1926 1944 1942 1943 1936 1927 1928 1935 1933

-20 -15 -10

-5

-9.2
One standard
deviation

10

15

12.6
(Mean)

20

25

30

35

40

45

34.3
One standard
deviation

Returns and principal invested in stocks are not guaranteed.

50

55

60

56.0
Two standard
deviations

Histogram:
U.S. Small-Cap Returns
2001
1999

Below 0
Previous 10 years

2011
2007

1997
1993

2000

1992

1998 2005
1987 1994
1984 1986
1966 1972
2002 1960 1956
1974
1970
1962
1937 2008 1973 1990 1957

1953
1948
1941
1940

1952
1951
1947
1939

2012
2010
2006
2004
1996

1988

1989
1981
1971
1959

1964
1963
1955
1934

1985
1982 1995
1978 1983
1977 1980
1968
1961
1950
1938

1991
1979
2003
1965 1976 1958
1942 1975 1954

1967

1929 1931 1930 1969 1946 1932 1926 1949 1927 1928 1935 1944 1936 1945 1943 2009
-90

-80

-70

-60

-50

-61.5
Two standard
deviations

-40

-30

-20

-10

-20.3
One standard
deviation

10

20
20.9
(Mean)

30

40

50

60

70

62.0
One standard
deviation

80

90

>
>

1933
160

103.2
Two standard
deviations

Small company stocks are more volatile than large company stocks and are
subject to significant price fluctuations, business risks, and are thinly traded.

170

Histogram:
U.S. Long-Term Government Bond Returns
2003
2006 1983 2012
Below 0
Previous 10 years

1996 1981 2001


1979 1965 1966

1990

1978 1963 1964

1962 2010

1977 1961 1953 1974 1957 2005


1987 1973 1952 1948 1972 1954 2004
1980 1968 1950 1944 1939 1949 1992

1998

1969 1959 1955 1941 1943 1938 1940 1988 2007 1971

2011
2002 1993

1999 1994 1956 1951 1946 1937 1942 1935 1936 1975 1945 1970 1997 1976 1991
2009

1967 1958 1931 1947 1933 1928 1929 1930 1926 1927 1934 1960 1984 1932 1989 2000

<
<-10

-26 -24

-29.9
Two
std. dev.

-8

-6

-4

-6.0
One standard
deviation

-2

6
5.9
(Mean)

10

12

14

16

18

20

17.9
One standard
deviation

22

1995
1985 1982 2008

1986
24

26

28

30

32

29.9
Two standard
deviations

>
>

40

42

U.S. Government bonds are guaranteed by the full faith and credit of the
U. S. government as to the timely payment of principal and interest.

2012
2011
2010
2009
2008
2004
2003
2002
1958
1955
1954
1953
1952
1951
1950
1949
1948
1947
1946
1945
1944
1943
1942
1941
1940
1939
1937
1936
1935
1934
1933
1932
1938 1931

Histogram:
U.S. Treasury Bill Returns
Below 0
Previous 10 years

-18

-16

-14

-12

-10

-8

-6

-4

-2

-2.6
Two
std. dev.

2005
2001
1994
1993
1992
1972
1965
1964
1963
1962
1961
1960
1959
1957
1956
1930
1928
1927
1926
2

0.5
One
std. dev.

2007
2006
2000
1999
1998
1997
1996
1995
1991
1987
1977
1976
1975
1971
1968
1967
1966
1929
4

3.6
(Mean)

1990
1988
1986
1985
1978
1973
1970
1969

1989
1984 1982
1983 1980
1974 1979

1981

8
10
12
14
6.8
9.9
One
Two
std. dev. std. dev.

16

18

20

22

24

U.S. Government bonds are guaranteed by the full faith and credit of the
U. S. government as to the timely payment of principal and interest

Ibbotson SBBI
Summary statistics 19262014

Past performance is no guarantee of future results. *The 1933 small company stock total return was 142.9%. This is for illustrative
purposes only and not indicative of any investment. An investment cannot be made directly in an index. 2015 Morningstar. All
Rights Reserved.

Returns Before and After Inflation


19262014

Past performance is no guarantee of future results. Assumes reinvestment of income and no transaction costs or taxes. This is for
illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. 2015
Morningstar. All Rights Reserved.

Risk premium

Stocks are more risky than bonds


Investors are risk averse (dislike risk).
Equity Risk premium: EXTRA reward (returns) for
bearing the risk of investing in equities, rather
than in low risk investments, such as bills or
bonds.

A key determinant for asset allocation, valuation,


and cost of capital.

Future risk premium is not directly observable. As


a result, a good starting point is the risk premium
observed from historical data.

Risk Premiums and Real Returns in the United


States (1926 2014)
Risk
Series Premiums%
Sm Stk
13.4
Lg Stk
8.6
LT Gov
2.4
T-Bills
---

Real
Returns%
13.9
9.1
2.9
0.5

Estimate of risk premium based on historical


data:
8% - 9%
What patterns do we observe in global financial
markets?

Article: Risk and Return in the 20th and 21st


Centuries
Measures returns on equities, bonds, bills, and inflation
in 12 countries over the entire 20th century.
1.

Equities are the best performing asset class in all


countries

2.

Equities had the highest risk

3.

Outperformed bonds and inflation by a considerable


margin

Equities proved more volatile than bonds, while bonds


were more risky than bills.

Bond investors were hurt by high and unexpected


levels of inflation during the century.

Summary of stylized facts

Asset classes that provide higher return are more


risky
Return: Small Stocks > Large Stocks > Bonds
> Bills
Risk: Small Stocks > Large Stocks > Bonds >
Bills

These rankings hold in global markets as well.

Tradeoff between risk and return:


Does an expected risk premium provide
adequate compensation for the additional
risk?

Risk Versus Return


Stocks, bonds, and bills 19262014

Past performance is no guarantee of future results. Risk and return are measured by monthly annualized standard deviation and
compound annual return, respectively.
This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index.
2015 Morningstar. All Rights Reserved.

Critical Question: How to Invest?


The most fundamental decision of investing is the
allocation of your assets: How much should you
own in stocks and bonds? How much should you
own in cash reserves?
That decision [has been shown to account] for
an astonishing 94% of the differences in total
returns achieved by institutionally managed
pension funds.There is no reason to believe that
the same relationship does not hold true for
individual investors.
John Bogle (founder, Vanguard)

How professionals manage money?


- Asset Allocation
Asset allocation is the process
of combining asset classes such
as domestic stocks, international
stocks, bonds, real estate,
private equity, hedge funds and
cash in a portfolio in order to
meet your goals.

Stocks

Bonds

Understand the familys nearand long-term goals and build a


portfolio consistent with it.
Consider both investments
return and the investments risk.
Build optimal portfolios based on
the concept of diversification.

Cash

Asset Allocation: Four Step Process

STEP 1: Measuring Portfolio Risk and


Return
STEP 2: Assessing Risk Tolerance
STEP 3: Modeling Investment Options
STEP 4: Optimal Asset Allocation

Maximize investor welfare based on available


options and investor preference

STEP 1:
Measuring Portfolio Return
and Risk

Definitions
Portfolio Return: Weighted average of the rates of
return of each asset comprising the portfolio, with
the portfolio proportions as weights
Portfolio Return: rp = W1 r1 + W2 r2
Portfolio Risk: When two risky assets with
variances 12 and 22 are combined into a
portfolio, the portfolio variance p2 is given by:
Variance: p2 = W1212 + W22 22 + 2W1W2Cov(r1,r2)
p2 = W1212 + W22 22 + 2W1W21212
where Cov = covariance and = correlation

When assets move together, no benefits


(see Return&Risk.xls)
Value
Investment A

Portfolio

= +1
Investment B

Time

When assets are off-sync


Substantial diversification benefits
Value

Investment C
Portfolio

= -1
Investment D

Time

The Magic of Risk Reduction!


Portfolio: Invest 50% in Stock A and 50% in the other Asset.
Asset A: E(R)=10%, SD(A)=20%
(see Return&Risk.xls)

Asset B

Asset C

Asset D

E(R)

10%

10%

10%

SD

20%

20%

20%

1.0

0.0

-1.0

Portfolio
E(R) (%)

10%

10%

10%

Portfolio
SD (%)

20%

14%

0%

Correlation
w. Asset A

Takeaways
If one holds equal amounts of risky securities:
Portfolio expected return is the average of the
expected returns of the assets in the portfolio.
If the assets are perfectly positively correlated,
the portfolio standard deviation is the average of
the standard deviations of the assets in the
portfolio.
In all other cases, the portfolio standard deviation
is less than the average of the standard
deviations of the assets in the portfolio.
Thus, diversification causes risk reduction without
a corresponding reduction in expected return.

How does diversification work?


Prob. Suntan Umbrella Portfolio
Lotion
50% each
Sunny year
0.50 12%
-6%
3%
Rainy year
0.50 -6%
12%
3%
Expected Return
3%
3%
3%
Risk
Risky
Risky Risk free
In this extreme case, the portfolio of two risky
assets is risk free.
Most corporate securities move together so
complete elimination of risk through
diversification is impossible.
As long as securities are not perfectly positively
correlated, diversification will always reduce risk.
(short answer question on a prior exam)

Degree of Correlation
between Equity Sectors
High
Medium
Low
Basic
materials
Consumer
cyclical
Consumer
non-cyclical
Energy
Financial
Health care
Industrial
Technology
Telecommunications
Utilities

Consumer
Basic Consumer
nonEnergy
materials cyclical
cyclical

Financial

Health
Industrial
care

Technology

Telecom. Utilities

19922014

Risk Reduction in A Portfolio


Ratio of Portfolio
Average Standard
Standard Deviation to
Number of Stocks
Deviation of Annual Standard Deviation
in Portfolio
Portfolio Returns
of a Single Stock
1
49.24%
1.00
10 23.93
0.49
50 20.20
0.41
100 19.69
0.40
300 19.34
0.39
500 19.27
0.39
1,000
19.21
0.39
Table 1 in Meir Statman, How Many Stocks Make a Diversified Portfolio? Journal of
Financial and Quantitative Analysis 22 (September 1987), pp. 35364.
These figures are from were derived from E. J. Elton and M. J. Gruber, Risk Reduction
and Portfolio Size: An Analytic Solution, Journal of Business 50 (October 1977), pp.
41537.

Portfolio Diversification

Harvard Case: Beta Management


Your objective is to help fund manager Sarah Wolfe
choose between two stocks, CALREIT and Brown, to be
held as part of her diversified portfolio.
Data: Spreadsheet provides two years of monthly return
data for CALREIT, Brown and Vanguard index (S&P
500) fund.

Calculate the standard deviation of assets.


Calculate the standard deviation of portfolios.
Calculate the beta of CALREIT and Brown by
regressing stock returns on S&P 500 index.
Interpret your findings. Relevance of single-security
risk versus risk relevant for a portfolio.

Correlation Can Help Evaluate Potential Diversification Benefits


Asset-class correlation 19262014

Past performance is no guarantee of future results. Correlation ranges from 1 to 1, with 1 indicating that the returns move
perfectly opposite to one another, 0 indicating no relationship, and 1 indicating that the asset classes react exactly the same. This is
for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. 2015
Morningstar. All Rights Reserved.

The Case for Diversifying


20052014

Past performance is no guarantee of future results. *The return of the portfolio is higher than the returns of the constituent asset
classes due to a phenomenon called the rebalancing bonus, which occurred due to the unusual behavior of stocks and bonds over
the time period analyzed. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made
directly in an index. 2015 Morningstar. All Rights Reserved.

Potential to Reduce Risk or Increase Return


19702014

Past performance is no guarantee of future results. Risk and return are measured by standard deviation and compound annual return,
respectively. They are based on
annual data over the period 19702014. This is for illustrative purposes only and not indicative of any investment. An investment
cannot be made directly in an index.

International markets help diversification


International Securities:

Diversification

Diversifiable Risk
100%

Universe of securities
20%

US securities only

12%

US & foreign securities


0

10

20

# stocks in portfolio

Domestic Versus Global


19702014

Past performance is no guarantee of future results. Risk and return are based on annual data over the time period analyzed. This is
for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. 2015
Morningstar. All Rights Reserved.

Financial Crisis bloodbath (WSJ, 10/13/08)

53

2008

Step II
Assessing Risk Tolerance
(Chapter 6)

Do I like Risk?
Assume Initial Investment: $100
State

Probabilit
y

Risk
free

Good

0.5

105

110

115

130

Bad

0.5

105

85

95

90

E(Value)

105

97.5

105

110

Risk
Premium

-7.5

Gamble: Asset B; Fair game: Asset C


Utility Scores or Ranking:
Asset B < Asset C < Risk free Asset <? Asset D

How did you rank these assets?

Do these assumptions seem reasonable?

Prefer more wealth to less wealth.


Prefer less risk to more risk.
Derive less and less satisfaction with each unit of
incremental wealth. (consider the satisfaction of
a desert after a five course meal vs when
starved!)
Experience a greater disutility from a decline in
wealth than from an equal increase in wealth.
Prefer a certain prospect to an uncertain prospect
of equal value.
May be indifferent between assets with different
payoffs of return and risk. (say, between a donut
and a bagel.)
More tolerant to risk as we become wealthier.

Risk Preference & Utility

Map the Return-Risk tradeoff to a utility function

Simple Utility Function AIMR / CFA /Theorists

U = E ( r ) - 0.005 A 2
A = measures the degree of risk aversion

Investors view of risk

Extensions incorporate complex utility functions

Risk Lover or Risk Seeker: A < 0


Risk Neutral: A = 0
Risk Averse (dislikes risk): A > 0
What is my A? refer WSJ article on risk tolerance

Standard assumption: Investors are risk averse (A > 0)


(Note that there is substantial evidence from financial
data in support)

Assessing tolerance for risk (WSJ article)

Hard to quantify fine line between greed and


fear
Risk questionnaire investing experience,
financial security, tendency to make risky or
conservative choices

Used by financial advisers, brokerage firms, and


mutual fund companies and institutional players.
Corporations: To ensure that managers in different
parts of a firm are employing consistent decision
behavior in their treatment of risk.

Map questionnaire scores (answers) to Risk


Tolerance

Conservative investor: A > 5 (9 to 14 points)


Moderate investor: A = 3, 4 (15 to 20 points)

Which asset class do you prefer?


Stocks, bonds, and bills 19262014

Past performance is no guarantee of future results. Risk and return are measured by monthly annualized standard deviation and
compound annual return, respectively.
This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index.
2015 Morningstar. All Rights Reserved.

Indifference curve: Modeling risk tolerance in


the mean variance framework

Dominated assets are easy to remove from


consideration.
The choice among undominated assets is dictated by
the investors personal tradeoff between risk and
return.

(refer Excel sheet: Risk&Return.xls Indifference curves)


Investor is indifferent between different assets on
curve
An increase in utility results in parallel shifts in the
curve
An investors utility from a risky asset depends on the
risk preferences
This will lead to differences in asset allocation

Numerical problem (old exam)

Consider a portfolio that offers an expected


return of 12% and a standard deviation of 18%. Tbills offer a risk-free 7% rate of return. Describe
the entire range of A for which the risky portfolio
is still preferred to bills. You may assume the
common form of utility function: U = E(R)
(0.005*A*2), and risk averse investors.