APMA Module 2: Modern Portfolio Theory & Performance Evaluation of Equities
Low; High
(blank) Sharpe indexes will appear in asset classes that have not performed well in the recent past, while (blank) Sharpe indexes will appear in asset classes that have performed well.
Overconfidence (Optimism Bias)
(blank) can lead to illusions of control which can lead to biased judgements, investing too much in investments about which they know too little, taking undue risks, and failure to realize they are at an informational disadvantage to institutional investors.
Long-term Data
(blank) helps FAs and investors keep their perspective about the returns and correlations of major asset classes and about the relative relationships of returns and risk levels over an extended period of time.
Recency; Representativeness
(blank) involves a shorter, more current time frame than (blank). This distinguishes the major difference between the two.
Framing
(blank) is the notion that it matters how a concept is presented to an individual.
MPT (Modern Portfolio Theory)
(blank) made investment managers cognizant of the importance of taking into account the entire portfolio when making investment decisions and striving to achieve investment objectives. Risk and return are not only important, but so is how the various investments perform relative to each other.
Stock Market Anomalies
(blank) reflect behavior that contradicts the efficient market hypothesis; in other words, they show that it may be possible to "beat the market". These have been identified and studied, but can change and evolve over time.
Value Line
(blank) researches stocks and then gives a rating for timeliness, with "1" being the highest, and "5" the lowest. Research has shown that investing in stocks ranked "1" over time has provided superior results, but frequent trading will increase transaction costs and reduce returns.
Stock Market Anomalies (ex.)
- January effect (buy in Dec, sell in Jan) - dividend-yield (buy stocks w/ high div) - weekend effect (buy stocks on Mondays) - Low P/E (Low P/E stocks > High P/E stocks) - size/small firm effect (small-cap > large-cap) - BV/MV effect (high BV/MV > low BV/MV) - neglected-firm effect (stocks fellowed by few) - value line effect (stocks rated 1 > stocks rated 5)
Behavioral Emotions (of Investors)
- Loss Aversion - Fear of Regret - Overconfidence (Optimism Bias) - Representativeness - Framing - Rationalization (Confirmation Bias) - Cognitive Dissonance Bias - Hindsight Bias - Self-Attribution Bias - Anchoring - Recency - Mental Accounting - Money Illusion - Availability Bias - Status Quo Bias - Endowment Bias
Asset Class Benchmarks
- S&P 500 or S&P 100 or Russell 1000 Value - S&P Mid-Cap 400 - Russell 2000 or S&P Small-Cap 600 - MSCI EAFE - S&P/IFC Investable - MSCI Emerging Markets Free Global - MSCI ACWI - Barclays Capital Aggregate Bond - Barclays Capital Municipal Bond - BoA-Merrill Lynch US High Yield - BoA-Merrill Lynch Municipal Master - Wilshire Real Estate Securities
Life Cycle Phases
- accumulation - consolidation - spending - gifting
Implementation of Tactical AA
- actively managed vs. passively managed funds - style: value vs. growth
Sector Influences
- category of general factors influencing the APT - influences that affect a company's industry - ex. factors influencing banks are different than those influencing an automobile manufacturer
Systematic Influences
- category of general factors influencing the APT - influences that affect businesses generally - ex. interest rates & changes in overall economy
Semi-Strong Form Tests
- event studies: attempt to measure how returns react to significant economic news; adjustments do happen quickly - return prediction studies: test whether there is any public info that will provide superior results for a Sh-T/L-T time horizon; abnormalities evident - predicting cross-sectional returns: all securities should have equal risk-adjusted returns & plot on SML; abnormalities evident (ex. P/E ratio anomaly)
APT Primary Factors (affecting return)
- inflation - industrial production (or changes in GDP) - risk premiums - yield curves (interest rates)
Efficient Market Assumptions
- large number of competing participants - info is readily available - transaction costs are small (or zero) - security cannot be overvalued/undervalued - investor can't outperform/underperform market - investors behave rationally & use info rationally - investor can earn a return commensurate with risk assumed, no more or less
Risk Tolerance Factors
- loss aversion (don't want to sell at a loss) - risk aversion (cause: buy high & sell low) - liquidity availability (time horizon) - proximity & priority of goals - life cycle phase - psychographics (investing emotions) - Monte Carlo simulation - VAR (Value at Risk)
Major Elements of Diversification
- overlap - correlation
Weak Form Tests
- random info: cannot determine return of a security tomorrow based on the return today - trading rules: technical analysis based solely on past info cannot be used to beat the market
Overcoming Confirmation Bias (Rationalization)
1) consciously seeking out info that opposes one's point of view 2) seek out corroborating info through company, industry, & sector info
MPT Major Trends
1) instl investing came into its own & large pools of $$ needed to be measured/controlled some how 2) emergence of ever-greater computing power made advanced analysis techniques possible 3) led to professionalization of investment mngt field & worldwide growth of CFA designation
MPT Assumptions
1) risk adverse 2) investment decisions based on expected risk & return 3) homogeneous expectations regarding return & risk for all investment opportunities available 4) have a common one-period investment horizon 5) free access to all info relevant to investment decision making (no insider info) 6) there are no transaction costs (or taxes) 7) capital market is perfectly competitive (cannot be manipulated)
House Money Effect
A person invests $1,000 in a stock and in two months sells the investment for $4,000. With mental accounting, the investor will be more conservative when reinvesting the $1,000 and tend to take greater risks with the $3,000 profit. This is called the (blank) because it is similar to a gambler in Vegas.
Absolute Value; Relative Measure
Alpha is the only measure that computes (blank); while the three other measures are used for comparative purposes and compute a (blank).
Efficient Capital Market
An (blank) is one where securities prices adjust rapidly to the arrival of new information and current securities prices reflect all information about the security.
PEG (PE/growth) Ratio
Another popular approach to valuation is the (blank). It allows investors to compare companies with different growth expectations. It is more complex than using the other ratios.
Foreign Markets
Because of the information inefficiencies in (blank), opportunities to earn superior returns may be available.
DIJA
Because the (blank) is not capitalization (value) weighted, it is not used in modern portfolio theory analysis. It will not be used as a benchmark by Morningstar.
P/E Ratio
If a company has positive earnings but pays no dividends, then the (blank) approach is used to determine the intrinsic value of a stock, because the DDM can only be used when a company pays dividends.
Above
If the expected return for an asset was greater than the required return, the asset would be considered undervalued and would plot (blank) the SML.
Below
If the expected return for an asset was less than the required return, the asset would be considered overvalued and would plot (blank) the SML.
1952; Harry Markowitz
In (blank), (blank) published an article that is regarded as the first development of modern portfolio theory.
1; 3
In general, stocks with PSRs of less than (blank) are undervalued and those with PSRs greater than (blank) may be overvalued.
0.50
Managers taking on higher levels of risk are expected to achieve higher rates of return, and this can be measured by the IR. Managers with IRs of (blank) or higher are often in the top quartile of their asset class.
Perfect Financial Market
Markowitz relied on a set of assumptions to make standard deviation a meaningful measure of portfolio risk. The set of assumptions implies a theoretical (blank).
Equal to; Below
Once a company's intrinsic value is computed, then an investor will buy the stock if the current market price is (blank) or (blank) the intrinsic value.
Fees
One of the greatest obstacles that an active manager has to overcome is (blank).
Unexpected Changes; Superior Performance
One of the key, and greatest, distinguishing features of the APT is the influence of (blank) in the factors that affect a security's price. This would not be incorporated into the price of a security and, under the EMH, all publicly known information is incorporated into security prices. Therefore, one who can successfully apply APT principles may be able to achieve (blank).
Profession
Other than the three major trends that emerged out of the beginnings of MPT, the main trend that emerged was that investment management had evolved into a (blank).
Upper Boundary
Per MPT, a risk-adverse investor would limit his/her portfolio choices to the (blank) of the investment opportunity set.
Mean-variance Frontier; Investment Opportunity Set
Portfolios outside the (blank) cannot exist for any extended period of time under the Markowitz model. The set of asset combinations inside the parabola is called the (blank), which is the set of all possible portfolio one could invest in.
Jensen (Alpha); Treynor
The (blank) and (blank) indexes are shown to be dependent on beta; if beta cannot be relied upon because of a low R^2 with a market index, then any of the computations that include beta in the calculation are suspect and need further investigation by the investor.
Indifference Curve (Figure 4)
The (blank) is a graphical expression of the utility function in the dimensions of expected return and risk (standard deviation). For a given level of return, at a certain point an investor is indifferent to the amount of risk they're taking to achieve that return.
Value Line
The (blank) is an equally weighted index, giving the same weight to each of the approximately 1,700 stocks in the index. Only the percentage change in each of the stocks is considered, while market price and capitalization are not relevant.
Price-to-Book Ratio (P/B)
The (blank) is another approach to valuation that has a rich historical basis. It is calculated by dividing shareholders' equity by the number of shares outstanding. This method has fallen out of use by most investors.
Treynor Index
The (blank) is more limited in its use because beta is used in its calculation. Also, generally, the security or portfolio being analyzed must be part of a diversified portfolio.
Alpha (Jensen Index)
The (blank) is used to compare the actual return to the required return. It is one of the most widely used measures of investment performance because investors believe that it measures the value added by an active portfolio manager.
PSR (Price-to-Sales Ratio)
The (blank) method can be used with any company to find intrinsic value, but it is especially useful when a company pays no dividends and has no earnings.
Zero Growth (Dividend in Perpetuity)
The (blank) model is commonly used to evaluate stocks whose dividend is fixed and will never grow. It is most frequently encountered with preferred stocks with a fixed dividend and no maturity date.
Efficient Frontier; Indifference Curve
The Markowitz model by itself cannot be used to select an optimal portfolio because it only identifies the (blank). The (blank) also needs to be added in to find the investor's willingness to bear risk.
Utility Function
The actual portfolio the investor selected depends upon his/her (blank), which reflects a given investor's trade-off between risk and return.
Steeper; Flatter
The more risk adverse an investor is, the (blank) the slope is for that investor's indifference curve. Conversely, the less risk adverse an investor is, the (blank) the slope for that investor's indifference curve.
Perfectly Positively Correlated
The most important feature of the CML is that all assets located on the line are (blank) with the market portfolio, which is a fully diversified portfolio. Real-life portfolios do not usually meet this standard.
Disposition Effect
The tendency to keep losing investments and sell profitable investments is called the (blank).
Sharpe Index; Treynor Index
Two other indexes, the (blank) and the (blank), are used to compare the stock or mutual fund's excess return with a benchmark index or with another similar stock or mutual fund.
Industry P/E Ratio; Market P/E Ratio
When using the P/E approach, two benchmarks are considered, the (blank) and the (blank). The ratio for the company is compared against both of these benchmarks.
VAR (Value at Risk)
alternative measure of risk that calculates the $$ amount of potential loss over a specified holding period & confidence interval; premier risk mngt tool & technique in the 1990s; developed by JPM
Tactical AA
attempts to improve portfolio returns through periodic revision of the asset mix; uses securities selection & market timing
Availability Bias
bias centers on giving more importance to data or info that is easy to obtain; not an easy task even for a professional
Arbitrage
buying a security in an underpriced market & simultaneously selling the same security in an overpriced market to profit from the difference in price between the two markets
Dynamic AA (DAA) (Dynamic Hedging Strategy)
changes asset mix as the market changes; risky assets are sold to buy riskless assets as portfolio loses value & riskless assets are liquidated in favor of risky assets as the value rises; key: change AA as the risky asset's behavior changes
Strategic AA
changes in the amounts invested in each of the asset classes are driven by changes in the adviser's predictions of returns, risk, & correlations in certain asset classes; approach is contrarian in nature; form of buying low & selling high
Core/Satellite AA
combination of strategic & tactical AA enabled by dividing a portfolio into a core holding of stocks & bonds, often low-cost, & a remaining portion used to take advantage of opportunities in the market
SML (Security Market Line)
graph showing the relationship between systematic risk (measured by beta) and the required return for a specific investment for any given level of risk; determined by CAPM; Micro
CML (Capital Market Line)
graph showing the relationship between total risk (standard deviation) and return for a portfolio of securities in which risky securities are combined with a risk-free asset; standard deviation goes up as riskier securities are added, then required return also goes up; Macro
Efficient Frontier
graph that represents various combinations of securities plotted so that a maximum expected return is shown for each incremental risk level; for any given level of risk there is an optimal return
Performance Index
helps investors properly measure the performance of their stocks or funds against other similar securities for each asset class
Random Walk
hypothesis that states that future stock prices are random; indicates that all info up to this point in time has been priced into the security & any future price movement will be based on future info we cannot predict
Hindsight Bias
if a financial professional recommends an investment that does well, a client tends to think of that recommendation as one he/she liked from the start, even if that was not the case; and vice versa
Weak Form of EMH
implies investors should not be able to achieve above-average returns consistently using trading rules based upon historical info; technical analysis is of no value but fundamental analysis can help investors
Endowment Bias
individuals value an owned asset more than those that are not owned; can lead to holding inappropriate assets for one's situation & risk tolerance; tends to be strong with inherited assets
CAPM (Capital Asset Pricing Model)
investment model that establishes the link between an investment's risk, as measured by its beta, and its required return; two forms: Macro & Micro
Representativeness
involves making judgements based on stereotypes; method the brain uses to classify things rapidly and thereby create shortcuts (ex. politics); investors become overly negative about investments that have done poorly in the past & overly positive about investments that have done well in the past; result: stocks can become undervalued/overvalued
Mental Accounting
involves treating one dollar different from another depending on where it comes from, where it is kept, & how it is spent; can lead to being too quick to spend, too slow to save, & too cons/agg with investing; distracts investor from considering the total portfolio; ex. gift of $$ from Grandma is invested more cons than $$ earned from job
Minimum Variance Frontier
large parabola that traces the outside of all the portfolio combinations that an investor could possibly choose from; theoretically includes every publicly traded asset, as well as even non-publicly traded asset, around the world
Arbitrage Pricing Theory
multi-factor model that is an alternative to the CAPM; an unspecified number of general factors are used; as the overpriced & underpriced assets move closer to equilibrium in all markets, an investor profits as the spread decreases
Cognitive Dissonance Bias
newly acquired info conflicts with preexisting understandings causing mental discomfort; individuals will often perform significant rationalizations in order to maintain psychological stability
Money Illusion
misunderstanding people have in relating nominal rates/prices with real (infl-adj) rates/prices; ex. 7% gain w/ 8% infl vs. 4% gain w/ 2% infl
Optimal Portfolio
portfolio that maximizes an investor's expected return consistent with that investor's given level of risk
Recency
problem of putting too much weight on current events data and not enough weight on past, historic trends; expect market to continue to rise in a bull market & a current bear market to get worse; ex. 1990s bull market (optimism) & market sell-off in 2008 (pessimism)
Mean-variance Optimization
requires that we look at the return (mean) & standard deviation (variance) of each asset as well as the correlation of each asset with every other asset
Information Ratio
similar to Sharpe index; focused on the manager's excess return over the benchmark return relative to the tracking error (or active risk); measures active return over active risk
Modern Portfolio Theory
showed how to derive the expected return and risk for a portfolio and how to achieve an effective diversification effect; standard deviation is the measure for portfolio risk
Strong Form Tests
shown by research that this form of the EMH does not hold
Tracking Error (Active Risk)
standard deviation of the difference between the returns on the portfolio and the returns on the benchmark
Strong Form of EMH
stock prices fully reflect all public & private info; no group of investors should be able to consistently achieve above-average returns; assumes perfect market with all info available at no cost; not even insider info could beat the market
Behavioral Finance
study of investor behavior; looks at emotions, irrational decision-making, and biases that come into play when individuals invest & handle $$
Rationalization (Confirmation Bias)
suggests investors search for and rely on info that supports their decisions; can also be referred to as data mining or reporting only evidence that supports your case
Illusion of Control Bias
tendency to believe one can control or influence outcomes when not possible; consequences include excessive trading & inadequately diversified portfolios; ex. employees taking on too much exposure to their employer's stock
Anchoring
tendency to hold certain beliefs even when faced with new info that should alter those beliefs affectively creating tunnel vision; overcoming this involves questioning the rationale being used to value a security; ex. analysts under reacting to unexpected earnings announcements
Status Quo Bias
tending to choose whatever option ratifies, confirms, or continues the existing situation when faced with a selection of choices; can blind investors to changing situations & perhaps lead them to not make adjustments they should; ex. treasury note yields vs. S&P 500 dividend yields
Non-constant (Multistage) Dividend Growth Model
theory behind this method of the DDM is that many companies in their earlier growth stages will have dividend growth rates that are not sustainable over long periods of time, at some point the growth rate will slow as the company enters a more mature stage of growth
Semi-Strong Form of EMH
trading rules based upon info after it becomes publicly available should not result in consistently above-average returns; fundamental analysis is of no value; only way to beat the market is to trade on inside info (can be illegal)
Self-protecting Bias
type of Self-Attribution Bias; irrational denial of responsibility for failure
Self-enhancing Bias
type of Self-Attribution Bias; tendency to claim an irrational degree of credit for successes
Selective Perception
type of cognitive dissonance; individuals only register info that appears to affirm an already chosen decision (ex. confirmation bias)
Selective Decision Making
type of cognitive dissonance; rationalizes actions that enable a person to adhere to the original course; occurs when commitment to an original decision course is high (ex. investor continues to invest in bad investment in order to not "waste" or sink funds)
Constant Dividend Growth Model
type of dividend growth valuation which is used to calculate the intrinsic value of a dividend paying stock with the assumption that dividends will continue to grow at the same rate in perpetuity
Sample-size Neglect
type of representativeness; investor failing to accurately consider the sample size of data used to make a judgement; investor makes an assumption that a small sample size is representative of the larger body of data
Base-rate Neglect
type of representativeness; investors attempting to determine the potential success of a new investment by comparing it to an already understood category or previously held investment; investor relies on stereotypes
Sharpe Index
useful for comparing one security's risk-adjusted return with that of another security or with a benchmark return; assumes the portfolio is not diversified
Intrinsic Value
value of a security that is computed using a discounted cash flow approach to valuation; important assumption is that dividends are a constant percentage of a corporation's earnings (payout ratio is constant)