More Stocks , Less Risk

As the number of stocks in a portfolio increases, the total risk or

volatility of that portfolio decreases.

Ch 1 DiversificationCh 1 Diversification

Benefits of DiversificationBenefits 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.

Diversification Helps Manage Diversification Helps Manage RiskRisk

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.

International SecuritiesInternational 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.

Asset AllocationAsset 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

Ch 2Ch 2Modern Portfolio Theory Modern Portfolio Theory

(MPT)(MPT)

Prepared by

Alex Au

IntroductionIntroduction

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.

The Need for Asset The Need for Asset AllocationAllocation

Diversification can reduce a portfolio’s 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.

Portfolio Risk and ReturnPortfolio 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.

((cont’d)cont’d)

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 portfolio’s expected rate of return should be easy to determine using the weighted average return of the individual assets.

((cont’d)cont’d)

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.

((cont’d)cont’d)

The portfolio’s risk is a function of the the individual assets and their correlation to each other.

Portfolio OptimizationPortfolio 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.

Optimizing the PortfolioOptimizing 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 client’s risk tolerance.

((cont’d)cont’d)

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

Symmetrical vs. Asymmetrical Symmetrical vs. Asymmetrical

Risk DistributionRisk DistributionSymmetrical risk distribution uses all the

optimization software to minimize risk, whereas asymmetrical is where the investors are more concerned with losses.

Why MPT Hasn’t Been Why MPT Hasn’t Been More Widely UsedMore 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.

((cont’d)cont’d)

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.

Ch 3Ch 3Structuring A Portfolio Structuring A Portfolio

By Yihui Yu

DiversificationDiversification

Objective: to add investments to the client’s 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)

The Correlation MatrixThe 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

Selecting Assets For a Selecting Assets For a PortfolioPortfolio

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.

Other FactorsOther Factors

The type of mutual fund or annuity chosen should depend on the following factors:

Client’s time horizon Any existing investment the client already

owns Client’s goals and objectives Client’s risk tolerance level

Ch 4 Asset AllocationCh 4 Asset Allocation

DefinitionDefinition

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?

Importance of Asset AllocationImportance of Asset Allocation

If you should have x% of a portfolio’s 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.

Approaches to Asset Approaches to Asset AllocationAllocation

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.

Approaches to Asset Approaches to Asset AllocationAllocation

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.

Approaches to Asset Approaches to Asset AllocationAllocation

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.

Ch 5Ch 5Market TimingMarket Timing

IntroductionIntroduction

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

Methodology: Moving AveragesMethodology: 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

Moving Averages (Continued)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

Methodology: Cash Flow IndicatorMethodology: 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%

Drawbacks to Short-term Drawbacks to Short-term TradingTrading

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

Studies: Trinity StudyStudies: 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

Charles D. Ellis StudyCharles 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”

William F. Sharpe StudyWilliam 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

Chua and Woodward StudyChua 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

Robert H. Jeffrey StudyRobert 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 S&P

– Worst-case produces 100 times less.

Roy D. Henrikson StudyRoy 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

Ibbotson StudyIbbotson 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 S&P 500

– Point: market timer has tremendous natural odds to overcome; odds increase geometrically with length of timeframe and frequency of timing interval

Timing ServicesTiming 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

Timing vs. Buy-and-HoldTiming 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

Ch 6Ch 6FORMULA TIMING FORMULA TIMING

INDICATORSINDICATORSIntroduction-Offers a mechanical timing approachCommonly used substitutes for subjective

buy-and-sell timing decisions.Requires investor input

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.

TIMING INDICATORSTIMING INDICATORS

Bear Market Endings6 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

Stocks in a recession 1973-1975In 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% growthIn 1981-82 there was a 16.5% growth.

Markets in a recession 1948-1991 There have been 9 business recessions since the end of World

War II.1. First Postwar Recession 1948-19492. Second Postwar Recession 1953-19543. Third Postwar Recession 1957-19584. Fourth Postwar Recession 1960-19615. Fifth Postwar Recession 1969-19706. Sixth Postwar Recession 1973-19757. Seventh Postwar Recession Jan 1980-June 19808. Eighth Postwar Recession 1981-19829. Ninth Postwar Recession 1990-1991

PREDICTABILITYPREDICTABILITY

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.

BEARSBEARS

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

BULLSBULLS

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

Ch 7 Timing IndicatorsCh 7 Timing Indicators

Bear Market EndingsBear Market Endings

A list of some indicators to call a market turn.

1. Investment Sentiment.

2. Market P/E.

3. Dividend Yield

4. Interest Rates

5. Market Volume

6. Advances and Declines

Stock and Markets in a Stock and Markets in a RecessionRecession

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)

Stock and Markets in a Stock and Markets in a RecessionRecession

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)

PredictabilityPredictability

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.

Bears and BullsBears 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.

Ch 8 Security AnalysisCh 8 Security Analysis

IntroductionIntroduction

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

Modern Portfolio TheoryModern 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.

CAPMCAPM

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.

Stock SelectionStock 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.

Fundamental AnalysisFundamental Analysis

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

Technical AnalysisTechnical Analysis

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

Chapter 9Chapter 9

Rebalancing the PortfolioRebalancing the Portfolio The Need for Rebalancing

-if the portfolio is not rebalanced one asset could achieve dominance

-Rebalancing keeps the portfolio diversified

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

Rebalancing Experimentation

-”Let it Ride” Study

--study performed without transaction costs or industry fees

--rebalancing doesn’t help the portfolio on either a return or risk basis

-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

-Clifton Study

--considered all costs

--annually rebalanced outperformed buy-and-hold and contingent

strategies on a risk-to-reward basis

-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

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

Compensation

-a portfolio manager should regularly bill clients for re-optimization, even if it’s infrequent

-if a manager is monitoring clients’ investments and communicating regularly, they should be paid

Ch 10 Asset Allocation Ch 10 Asset Allocation SensitivitySensitivity

IntroductionIntroduction

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)

Sensitivity to Expected Sensitivity to Expected ReturnsReturns

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 wouldn’t share it with you. Also industry users and insiders know more about you or any trader knows in future market or other market.

Review Individual Asset Review Individual Asset StatisticsStatistics

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.

The 5/25 StrategyThe 5/25 Strategy

By selecting at least 5 different asset categories and investing at least 5%, but no more 25%.

Don’t rely entirely on the program that suggests a large investment in one of these categories.