INVESTMENT IS A LIFETIME

LEARNING PROCESS (NO SHORT

CUT)

You continue to polish your investment tools/strategies from

making mistakes. You would have to find your own strategy.
 Risk and
Return: Past
and Prologue

5
OUTCOMES
Calculate various measures of return and risk
Determine the expected return and risk of portfolios
of combination of risky and risk-free assets
Evaluate investment performance by Sharpe ratio
WHY DO WE HAVE TO KNOW THOSE
HISTORICAL RETURNS

They serve as a reference point for the return you

may be expecting in the long run
It helps you determine whether the return you are
looking for is realistic/justified by risk
 TABLE 5.1 BELOW SHOWS YOU THE
QUARTERLY CASH FLOWS/RATES OF RETURN
OF A MUTUAL FUND

1st 2nd 3rd 4th

Quarter Quarter Quarter Quarter
Assets under management at start of quarter 1 1.2 2 0.8
($ million)
Holding-period return (%) 10 25 −20 20
Total assets before net inflows 1.1 1.5 1.6 0.96
Net inflow ($ million) 0.1 0.5 −0.8 0.6
Assets under management at end of quarter 1.2 2 0.8 1.56
($ million)

You were the fund manager. If you are free to calculate the average quarterly
return, what is your number? Grab a piece of paper and put down your answers
5.1 RATES OF RETURN (RECAP)
Holding-Period Return (HPR)
Rate of return over given investment period
HPR= [PS − PB + CF] / PB
PS = Sale price
PB = Buy price
CF = Cash flow during holding period
Initial investment: $100
Four year later, value of investment: $240
HPR =(240-100)/100
5.1 RATES OF RETURN (RECAP)
Measuring Investment Returns over Multiple
Periods
Arithmetic average (use table 5.1, get the results yourselves, answers
next slide)
Sum of returns in each period divided by number of periods
Geometric average (use table 5.1, get the results yourselves)
Single per-period return; gives same cumulative performance as sequence
of actual returns
Compound period-by-period returns; find per-period rate that compounds to
same final value
Dollar-weighted average return
Internal rate of return on investment
 AVERAGE QUARTELY RETURNUSING
TABLE 5.1 BEFORE Which one is a good predictor?
Arithmetic average (ignore compounding)(10+25-20+20)/4 = 8.75%
Geometric average (time weighted average, ignore periodic fluctuation) *
1.1x1.25x0.8x1.2 = (1+rG)4 , rG = 7.19%
Dollar-weighted average (account for varying amount under management)

Quarter 0 1 2 3 4
Net cash flow ($
million) -1 -0.1 -0.5 0.8 -0.6 + 1.56
Put NPV=0, IRR = 3.379% (use excel function =IRR()
much less than 8.75% or 7.19%
* Required for published data by mutual funds
5.2 RISK AND RISK PREMIUMS
How to tell the risk and the risk premium of an investment? We
can use
Scenario Analysis and Probability Distributions

Scenario analysis: Possible economic scenarios; specify

likelihood and HPR
Probability distribution: Possible outcomes with probabilities
Expected return: Mean value of distribution of HPR
Variance: Expected value of squared deviation from mean
Standard deviation: Square root of variance

Note: A risk premium is the return expected in excess of the risk-free rate of
return an investment. So it is like a kind of compensation for taking risk.
SPREADSHEET 5.1 SCENARIO ANALYSIS
FOR THE STOCK MARKET

When you are considering the price for acquiring, say a private firm in retail
industry, you may also apply scenario analysis to determine how the value of
the firm would be affect under different economic situation in order to
determine the fair price.
5.2 RISK AND RISK PREMIUMS

Apart from using scenario analysis, mean and standard

deviation can be also be estimated by using time series
of return (i.e. historical prices, you download five year
stock data and calculate the mean and standard
deviations, want a demonstration?)
do you know how to do it?
Which methods should be used? Which method is
better?
Another method is using probability distribution
(coming slide)
 FIGURE 5.1 NORMAL DISTRIBUTION WITH MEAN
RETURN 10% AND STANDARD DEVIATION 20%

Return with 68.26% Talk to me during the

probability within break or after class if
range of -10% to 30% you don’t know what
a normal distribution
is.

How many observations are expected to deviate from the mean by three or more SDs?
Ans. 0.26 out of 100 or 26 out of 10000 observations
A brief account on Value at Risk (VaR)
A measure of downside risk, you may want to ask the worst loss
that your investment will suffer with a given probability, say 5%.
Your loss will be worse than this value (the VaR) only 5% of the
time. That is 95% of the time, it will be better.
Excel: =NORMSINV(0.05) = -1.64485, for VaR of 5%
OR =NORMSINV(0.01)=-2.3263 for VaR of 1%
VaR of 5% : VaR = E(ri)+ (-1.64485) σ, knowing E(ri) and σ,
you can get VaR
e.g. 5% one day VaR of $1 million meaning it is expected to lose
$1 million in 20 days
A BRIEF ACCOUNT ON VALUE AT RISK
(VAR)
You were responsible for risk management. Using in house built-in software,
you get 0.1% one day VaR of value $10 million. How comfortable are you
with the number you get?

Meaning? Expect to lose $10million in 1000 days or in about 4 years

Actual outcome: you lose $10 million in a year!

More frequent than expected!

5.2 RISK AND RISK PREMIUMS
VaR calculated before assume normality
Real return may not be normal
Deviation from Normality and Value at Risk
(VaR), we need to consider
Kurtosis: Measure of fatness of tails of probability distribution;
indicates likelihood of extreme outcomes
Zero for normal distribution
Higher kurtosis means higher frequency of extreme values
(can you draw the graph?)
Skew: Measure of asymmetry of probability distribution
SKEW

Extreme negative value more frequent than extreme positive value

Pictures from
http://www.statisticshowto.com/probability-and-statistics/skewed-
distribution/
5.2 RISK AND RISK PREMIUMS
Risk Premiums and Risk Aversion
Risk-free rate: Rate of return that can be earned with
certainty, guess a number?
Risk premium: Expected return in excess of that on
risk-free securities
Excess return: Rate of return in excess of risk-free
rate
Risk aversion: Reluctance to accept risk
RISK AVERSION
http://www.investopedia.com/terms/r/riskaverse.asp
Can we quantify one’s degree of aversion?
We look at one’s willingness to trade off risk against expected
return.
Define A, the measure of risk aversion (the price of risk). An
investor investing her entire wealth in portfolio Q:
A= [E(rQ) – rf ]/σ2Q ,
the ratio of portfolio risk premium to its variance (the price of
risk)
A is a number, say, 2, 3.5, 4.2, etc.
You would demand a higher risk premium if you are more risk
averse (hold less risky asset)
5.2 RISK AND RISK PREMIUMS
The Sharpe (Reward-to-Volatility) Ratio
[E(rp) – rf ]/σp
Ratio of portfolio risk premium to standard deviation
Can use Sharpe ratio for Mean-Variance Analysis (i.e.
analyzing the return and risk)
i.e. Rank portfolios by Sharpe ratios

If you form portfolio of Hang Seng Composite LargeCap Index, MidCap Index
and SmallCap Index. Which portfolio would have highest risk premium and
lowest risk?
That is , which one should have highest Sharpe ratio? If you are interested in the
subject, check it out.

Note: http://www.hsi.com.hk/HSI-Net/HSI-Net
EXAMPLE
A risk-averse investor with a risk aversion of A = 3. Treasury bills
are paying a 1% rate of return. The investor should invest entirely in
a risky portfolio with a standard deviation of 20% only if the risky
portfolio's expected return is at least greater than or equal to 13%
= = 13%
What does it mean if A has a larger value, e.g. A=4?
If you are more risk-averse, you will demand a higher return for the
same risk.
A=4, E(Rp) = 17%
RISK AVERSION

http://analystnotes.com/graph/portfolio/SS12SBsubc1.gif
5.3 THE HISTORICAL RECORD
World and U.S. Risky Stock and Bond Portfolios
U.S. large stocks: Standard & Poor's 500 largest cap
U.S. small stocks: Smallest 20% on NYSE, NASDAQ,
and Amex
U.S. Treasury bonds: Barclay's Long-Term Treasury
Bond Index

Why do we want to look at the historical data?

FIGURE 5.4 RATES OF RETURN ON US
STOCKS, BONDS, AND BILLS

Which investment should have

a higher risk premium?
Fig 5.5 for text

What is the risk premium

for US small stock?
5.4 INFLATION AND REAL RATES OF RETURN,
YOU MAY REFER TO SECTION 5.2 IF YOU READ THE TEXT

Equilibrium Nominal Rate of Interest

Fisher Equation (Irving Fisher 1930)
R = r + E(i)
E(i): Current expected inflation
R: Nominal interest rate
r: Real interest rate
Note: Real rate measure the growth rate of
purchasing power
5.4 INFLATION AND REAL RATES OF
RETURN, YOU MAY REFER TO SECTION 5.2 IF YOU READ THE
TEXT

U.S. History of Interest Rates, Inflation, and

Real Interest Rates
Since the 1950s, nominal rates have increased
roughly in tandem with inflation
Look at the blue- and red-lines on the graph
(next slide)
1930s/1940s: Volatile inflation affects real rates of
return
FIGURE 5.5 INTEREST RATES, INFLATION,
AND REAL INTEREST RATES 1926-2010
5.5 ASSET ALLOCATION ACROSS PORTFOLIOS
A simple way to control risk, we start with
1. Asset Allocation
Portfolio choice among broad investment classes
(stocks, bonds, bills, commodities, real estate, rolex,
bitcoin, etc.). A little sidetrack, if it is wartime, what
would you want to get?
2. Complete Portfolio
Entire portfolio, including risky and risk-free assets
3. Capital Allocation
Choice between risky and risk-free assets
5.5 ASSET ALLOCATION ACROSS
PORTFOLIOS
The Risk-Free Asset
Treasury bonds (still affected by inflation)
Price-indexed government bonds, TIPS (like ibond
in H.K.), less affected by inflation
Money market instruments effectively risk-free
Risk of CDs and commercial paper is very small
compared to most assets
5.5 ASSET ALLOCATION ACROSS PORTFOLIOS

How much you are going to allocate in risky assets depends

on your preference.
Your complete portfolio expected return and risk will be:
E(rC) = yE(rp) + (1 − y)rf
σC = yσp + (1 − y) σrf
p: risky portfolio
y: proportion of investment budget in risky portfolio
rf: rate of return on risk-free asset
E(rp): expected rate of return of risky portfolio
σp, σc : standard deviation of risky, complete portfolio return
E(rC): expected return on complete portfolio
NOTE ON RISK PORTFOLIO P
P can be formed buy simply investing in stocks or bonds
or a combination of stocks and bonds
e.g. 40% in stocks with expected return 16% and 60% in
bonds with expected return 4%
What is the expected return of P?
E(rp) = 0.4x0.16 + 0.6x0.04
FIGURE 5.6 INVESTMENT OPPORTUNITY SET
You are given a risk-free asset (rf =7%) and a risky portfolio,
E(rp)=15%, what are your choices? What are the expected return
and standard deviation if you allocate 80% in risky portfolio?

Sharpe ratio
5.5 ASSET ALLOCATION ACROSS PORTFOLIOS

Capital Allocation Line (CAL)

Plot of risk-return combinations available by
varying allocation between risky and risk-free
Risk Aversion and Capital Allocation
y: Preferred capital allocation, can be found below:

Think about this, when the price of risk of a risky portfolio matches
your degree of aversion, what would you do?
Invest all your money in that portfolio, so y = 1
EXAMPLE OF LEVERED COMPLETE PORTFOLIO

You have $300,000 and borrow $150,000, and all invest

in risky asset with expected return 20% and standard
deviation of 25%. Calculate the expected return and risk
of your complete portfolio.
y= 450,000/300,000=1.5
1-y = -0.5 (a short position in risk-free asset ,i.e. you
borrow at, say risk free rate of 4%)
E(rc) = (-0.5)(0.04) + (1.5)(0.2) =
σc = 1.5 x 0.25 =
5.6 PASSIVE STRATEGIES AND THE
CAPITAL MARKET LINE
Passive Strategy
Investment policy that avoids security analysis (you
believe securities are fairly priced)
Capital Market Line (CML)
Capital allocation line using market-index portfolio
as risky asset
Line joining risk free T-bills and the market index
(say S&P500 or Hang Seng Index)
WARREN BUFFETT: VANGUARD’S BEST
SALESMAN (FROM FT.COM AUGUST 31, 2014)
Jack Bogle, the founder of Vanguard, has called Warren
Buffett the mutual fund group’s best salesman after the
billionaire investor recommended Vanguard’s funds to his
wife in his will.
Mr Buffett said his advice for the cash left to his wife was that 10
per cent should go to short-term government bonds and 90 per
cent into a very low-cost S&P 500 index fund…………….
Does it look like what we just mentioned?
TABLE 5.4 EXCESS RETURN STATISTICS
FOR S&P 500 READ THE TEXT FOR UPDATED DATA TO 2013

Excess Return
(%)
Average Std Dev. Sharpe Ratio
1926-2010 8.00 20.70 .39
1926-1955 11.67 25.40 .46
1956-1985 5.01 17.58 .28
1986-2010 7.19 17.83 .40

If a wealth management consultant told you that he can help you earn
a return of 12% a year with Sharpe ratio of 0.6 by investing in
US stocks, do you buy it?
5.6 Passive Strategies and the Capital Market Line

Cost and Benefits of Passive Investing

Passive investing is inexpensive and simple
Expense ratio* of active mutual fund averages 1%
Expense ratio of hedge fund averages 1%-2%, plus
10% of returns above risk-free rate
Active management offers potential for higher
returns
* A measure of the cost to operate a mutual fund.
EXERCISES

Check the outcomes on p.3

Try Q5, Q7, Q8, Q11 and Q12 at home