DOCSLIB.ORG

Portfolio Theory and Asset Allocation: Some Practical Considerations

Total Page：16

File Type：pdf, Size：1020Kb

Download full-text PDF Read full-text
Portfolio Theory and Asset Allocation: Some Practical Considerations Portfolio Theory and Asset Allocation: Some Practical Considerations Econ 471/571, F19 - Bollerslev Portfolio Theory and Asset Allocation in Practice 1 Investment Horizon Mean-Variance analysis is a static problem ,! It can be applied to any horizon ,! But, the choice of horizon affects the inputs ,! With a monthly investment horizon, the expected returns and variances should be monthly It is easy to adjust the expected returns to the horizon ,! Expected returns scale with the horizon H The horizon play a more subtle role when estimating risk ,! Finance textbooks often advocate the square-root of time rule: p s(H-period return) = H × s(1-period return) ,! What is the implicit assumption here? Econ 471/571, F19 - Bollerslev Portfolio Theory and Asset Allocation in Practice 2 Investment Horizon Should an investor with a 10-year investment horizon allocate more to stocks than an investor with a 1-year horizon? ,! Intuitively, “stocks are safer in the long run” so she can afford to “wait out” any market declines Our portfolio allocation formula says that the optimal allocation to the risky portfolio depends on the ratio of its mean to its variance: 1 E(r) − r w = f A s2 ,! So, what is the answer to the previous question? ,! As an aside, what does this imply about Sharpe Ratios? ,! What does it actually look like empirically? Econ 471/571, F19 - Bollerslev Portfolio Theory and Asset Allocation in Practice 3 Investment Horizon H-period returns on the aggregate market portfolio 1927-2012: var(rH ) Horizon var(rH ) var(r1) 1-month 0.003 1-year 0.040 13.54 2-year 0.086 28.82 3-year 0.117 39.34 4-year 0.147 49.17 5-year 0.165 55.47 10-year 0.240 80.63 What is going on here? ,! “Stocks are safer in the very long-run” ,! Do the finance textbooks give the right advice? ,! To further complicate things, the variance isn’t constant through time ... Econ 471/571, F19 - Bollerslev Portfolio Theory and Asset Allocation in Practice 4 Investment Horizon Daily US equity volatility constructed from 5-minute intraday returns: CAPITAL AQR MANAGEMENT ,! Volatility clearly time-varying ,! Higher in bad economic times and periods of market distress ,! What about longer horizons? Econ 471/571, F19 - Bollerslev Portfolio Theory and Asset Allocation in Practice 5 Investment Horizon S&P 500 realized volatilities, 1990-2008: Econ 471/571, F19 - Bollerslev Portfolio Theory and Asset Allocation in Practice 6 Investment Horizon S&P 500 options implied volatilities, 2008-2010: Schwert (2011, European Financial Management ) Econ 471/571, F19 - Bollerslev Portfolio Theory and Asset Allocation in Practice 7 Dimensionality In the US there are literally tens of thousands of traded securities ,! Clearly, we cannot solve the MV optimization problem with all of these different securities Even with a "reasonable" number of securities, say N=100, the number of parameters to be estimated is prohibitively large: si’s N 100 E(ri)’s N 100 1 Cov(ri;r j)’s 2 N(N − 1) 4950 1 Total 2 N(N + 3) 5150 ,! The number of covariances to be estimated grows like N2 Index Models provide a way to reduce the dimensionality ,! A small number of common factors drive the correlations of all the assets/returns Econ 471/571, F19 - Bollerslev Portfolio Theory and Asset Allocation in Practice 8 Single Index Model The single index, or market, model assumes that returns can be decomposed into a single “systematic” (market related) part and “non-systematic” (non-market related) part: ri − r f = ai + bi(rm − r f ) + ei ,! The non-systematic ei part is truly asset-specific ,! For two different securities i and j: cov(ei;e j) = 0: ,! Is that a reasonable simplification? ,! We will later generalize this to allow for K > 1 common factors Econ 471/571, F19 - Bollerslev Portfolio Theory and Asset Allocation in Practice 9 Single Index Model The covariances implied by the single index model are: 2 cov(ri;r j) = bib jsm 8i 6= j For the variances: 2 2 2 2 si = bi · sm + sei ,! The variances are unaffected by the model The correlation between the two assets i and j is therefore: 2 bib jsm ri; j = sis j Econ 471/571, F19 - Bollerslev Portfolio Theory and Asset Allocation in Practice 10 Single Index Model Instead of N × (N − 1)=2 individual covariances, for the single index model we only need: ,! N betas, one for each of the assets ,! The variance of the market (the common factor) For a K-factor model we would need N × K betas and K factor variances ,! The covariances are deduced solely from the K common (macro) factors that affect all securities ,! For a small number of factors, the reduction in the number of parameters to be estimated can be substantial ,! This also facilitate the implementation of traditional security analysis. Why? Econ 471/571, F19 - Bollerslev Portfolio Theory and Asset Allocation in Practice 11 Single Index Model The beta of asset i with portfolio m in the single index model is formally defined by: cov(ri;rm) bi = var(rm) Where do these betas come from? ,! They may be estimated by time series regressions ,! Assume the same single index model holds for T consecutive time periods: ri;t − r f ;t = ai + bi(rm;t − r f ;t ) + ei;t ; t = 1;:::;T ,! What are the assumptions here? ,! We will revisit this issue in more detail later ... Econ 471/571, F19 - Bollerslev Portfolio Theory and Asset Allocation in Practice 12 BKM Beta Estimation Econ 471/571, F19 - Bollerslev Portfolio Theory and Asset Allocation in Practice 13 BKM Beta Estimation bHP = 2:03 bDELL = 1:23 Econ 471/571, F19 - Bollerslev Portfolio Theory and Asset Allocation in Practice 14 BKM Beta Estimation bBP = 0:47 bSHELL = 0:67 bS&P500=? Econ 471/571, F19 - Bollerslev Portfolio Theory and Asset Allocation in Practice 15 BKM Beta Estimation Econ 471/571, F19 - Bollerslev Portfolio Theory and Asset Allocation in Practice 16 Six Country Example Consider the problem of investing in the following six countries: France, Germany, Japan, Switzerland, UK and the USA ,! 504 monthly aggregate equity index returns from 1970 to 2011: FRA GER JAP 0.3 0.25 0.25 0.2 0.2 0.2 0.15 0.15 0.1 0.1 0.1 0.05 0 0.05 0 −0.1 0 −0.05 −0.05 −0.2 −0.1 −0.15 −0.1 −0.3 −0.2 −0.15 −0.4 −0.25 −0.2 0 100 200 300 400 500 0 100 200 300 400 500 0 100 200 300 400 500 SWZ UK USA 0.25 0.6 0.2 0.2 0.5 0.15 0.15 0.4 0.1 0.1 0.3 0.05 0.05 0.2 0 0 0.1 −0.05 −0.05 0 −0.1 −0.1 −0.1 −0.15 −0.15 −0.2 −0.2 −0.2 −0.3 −0.25 0 100 200 300 400 500 0 100 200 300 400 500 0 100 200 300 400 500 Econ 471/571, F19 - Bollerslev Portfolio Theory and Asset Allocation in Practice 17 Six Country Example Six countries: France, Germany, Japan, Switzerland, UK and the USA Sample means, variances and covariances: 0 1:02 1 0 44:0 30:9 17:9 23:8 26:5 17:0 1 B 1:00 C B 30:9 41:8 16:3 24:6 22:1 16:0 C B C B C B 0:94 C B 17:9 16:3 39:0 15:2 16:4 10:0 C µˆ = B C Sˆ = B C B 1:06 C B 23:8 24:6 15:2 28:8 21:3 13:7 C B C B C @ 1:03 A @ 26:5 22:1 16:4 21:3 41:8 17:0 A 0:88 17:0 16:0 10:0 13:7 17:0 20:5 ,! What are the annual means and variances? ,! Correlations? Now, let’s try to use a single index model ,! We need to specify the common factor Econ 471/571, F19 - Bollerslev Portfolio Theory and Asset Allocation in Practice 18 Six Country Example, Single Index Model Take the “global” market index as the common factor ,! An equally weighted average of the six country portfolios ,! Var(rG) = 22:1 The resulting b’s and covariances implied by this single index model are: 0 1:211 1 0 44:0 30:6 23:2 25:7 29:3 19:0 1 B 1:147 C B : 41:8 22:0 24:3 27:7 18:0 C B C B C B 0:869 C B :: 39:0 18:4 21:0 13:6 C b = B C S = B C B 0:963 C B ::: 28:8 23:3 15:1 C B C B C @ 1:098 A @ :::: 41:8 17:2 A 0:712 ::::: 20:5 Econ 471/571, F19 - Bollerslev Portfolio Theory and Asset Allocation in Practice 19 Six Country Example, Single Index Model Historical and implied single index model correlations: 0 1 0:72 0:43 0:67 0:62 0:57 1 B : 1 0:40 0:71 0:53 0:55 C B C B :: 1 0:45 0:41 0:35 C Cˆ =B C versus B ::: 1 0:61 0:56 C B C @ :::: 1 0:58 A ::::: 1 0 1 0:71 0:56 0:72 0:68 0:63 1 B : 1 0:54 0:70 0:66 0:62 C B C B :: 1 0:55 0:52 0:48 C CIndex Model = B C B ::: 1 0:67 0:62 C B C @ :::: 1 0:59 A ::::: 1 Not much difference here ,! Why? Econ 471/571, F19 - Bollerslev Portfolio Theory and Asset Allocation in Practice 20 BKM Recap Six-stock MVE portfolios, BKM Figure 8.5: ,! Estimated efficient frontiers very close I Why? Econ 471/571, F19 - Bollerslev Portfolio Theory and Asset Allocation in Practice 21 Single Index Model and Time-Varying Correlations One reason that MV theory fails in practice is that the world is non-stationary ,! The past is not always a good predictor of the future A common belief among market practitioners is that in times of high uncertainty (market volatility), asset correlations tend to increase ,! As correlations increase, the benefits to diversification decrease ,! Case in point, 2008-09 financial crises Recall that within the single index model: b b s2 r = i j m i; j 2 2 2 1=2 2 2 2 1=2 (bi · sm + se;i) (b j · sm + se; j) 2 ,! All else equal, an increase in the volatility of the common factor sm, implies an increase in the pairwise correlations (provided bi > 0 and b j > 0) ,! Index models can help make sense of time-varying correlations Econ 471/571, F19 - Bollerslev Portfolio Theory and Asset Allocation in Practice 22 Single Index Model and Diversification Consider an equally weighted portfolio of N assets The variance of the portfolio equals: N N N 2 1 2 1 sp = 2 ∑ si + 2 ∑ ∑ sis jri j N i=1 N i=1 j=1 i6= j 1 ' s¯ 2 + s¯ 2 × r¯ N ,! What happens as more and more assets are included in the portfolio? ,! The average variance
Load more

Recommended publications
  • Asset Securitization
    L-Sec Comptroller of the Currency Administrator of National Banks Asset Securitization Comptroller’s Handbook November 1997 L Liquidity and Funds Management Asset Securitization Table of Contents Introduction 1 Background 1 Definition 2 A Brief History 2 Market Evolution 3 Benefits of Securitization 4 Securitization Process 6 Basic Structures of Asset-Backed Securities 6 Parties to the Transaction 7 Structuring the Transaction 12 Segregating the Assets 13 Creating Securitization Vehicles 15 Providing Credit Enhancement 19 Issuing Interests in the Asset Pool 23 The Mechanics of Cash Flow 25 Cash Flow Allocations 25 Risk Management 30 Impact of Securitization on Bank Issuers 30 Process Management 30 Risks and Controls 33 Reputation Risk 34 Strategic Risk 35 Credit Risk 37 Transaction Risk 43 Liquidity Risk 47 Compliance Risk 49 Other Issues 49 Risk-Based Capital 56 Comptroller’s Handbook i Asset Securitization Examination Objectives 61 Examination Procedures 62 Overview 62 Management Oversight 64 Risk Management 68 Management Information Systems 71 Accounting and Risk-Based Capital 73 Functions 77 Originations 77 Servicing 80 Other Roles 83 Overall Conclusions 86 References 89 ii Asset Securitization Introduction Background Asset securitization is helping to shape the future of traditional commercial banking. By using the securities markets to fund portions of the loan portfolio, banks can allocate capital more efficiently, access diverse and cost- effective funding sources, and better manage business risks. But securitization markets offer challenges as well as opportunity. Indeed, the successes of nonbank securitizers are forcing banks to adopt some of their practices. Competition from commercial paper underwriters and captive finance companies has taken a toll on banks’ market share and profitability in the prime credit and consumer loan businesses.
    [Show full text]
  • Financial Literacy and Portfolio Diversification
    WORKING PAPER NO. 212 Financial Literacy and Portfolio Diversification Luigi Guiso and Tullio Jappelli January 2009 University of Naples Federico II University of Salerno Bocconi University, Milan CSEF - Centre for Studies in Economics and Finance DEPARTMENT OF ECONOMICS – UNIVERSITY OF NAPLES 80126 NAPLES - ITALY Tel. and fax +39 081 675372 – e-mail: [email protected] WORKING PAPER NO. 212 Financial Literacy and Portfolio Diversification Luigi Guiso and Tullio Jappelli Abstract In this paper we focus on poor financial literacy as one potential factor explaining lack of portfolio diversification. We use the 2007 Unicredit Customers’ Survey, which has indicators of portfolio choice, financial literacy and many demographic characteristics of investors. We first propose test-based indicators of financial literacy and document the extent of portfolio under-diversification. We find that measures of financial literacy are strongly correlated with the degree of portfolio diversification. We also compare the test-based degree of financial literacy with investors’ self-assessment of their financial knowledge, and find only a weak relation between the two measures, an issue that has gained importance after the EU Markets in Financial Instruments Directive (MIFID) has required financial institutions to rate investors’ financial sophistication through questionnaires. JEL classification: E2, D8, G1 Keywords: Financial literacy, Portfolio diversification. Acknowledgements: We are grateful to the Unicredit Group, and particularly to Daniele Fano and Laura Marzorati, for letting us contribute to the design and use of the UCS survey. European University Institute and CEPR. Università di Napoli Federico II, CSEF and CEPR. Table of contents 1. Introduction 2. The portfolio diversification puzzle 3. The data 4.
    [Show full text]
  • The Portfolio Currency-Hedging Decision, by Objective and Block by Block
    The portfolio currency-hedging decision, by objective and block by block Vanguard Research August 2018 Daren R. Roberts; Paul M. Bosse, CFA; Scott J. Donaldson, CFA, CFP ®; Matthew C. Tufano ■ Investors typically make currency-hedging decisions at the asset class rather than the portfolio level. The result can be an incomplete and even misleading perspective on the relationship between hedging strategy and portfolio objectives. ■ We present a framework that puts the typical asset-class approach in a portfolio context. This approach makes clear that the hedging decision depends on the strategic asset allocation decision that aligns a portfolio’s performance with an investor’s objectives. ■ A number of local market and idiosyncratic variables can modify this general rule, but this approach is a valuable starting point. It recognizes that the strategic asset allocation decision is the most important step toward meeting a portfolio’s goals. And hedging decisions that preserve the risk-and-return characteristics of the underlying assets lead to a portfolio-level hedging strategy that is consistent with the portfolio’s objectives. Investors often look at currency hedging from an asset- • The hedging framework begins with the investor’s class perspective—asking, for example, “Should I hedge risk–return preference. This feeds into the asset-class my international equity position?”1 Combining individual choices, then down to the decisions on diversification portfolio component hedging decisions results in and currency hedging. a portfolio hedge position. This begs the question: Is • Those with a long investment horizon who are a building-block approach the right way to arrive at the comfortable with equity’s high potential return and currency-hedging view for the entire portfolio? Does volatility will allocate more to that asset class.
    [Show full text]
  • Six Steps to an Effective Asset Allocation Step 1
    SIX STEPS TO AN EFFECTIVE ASSET ALLOCATION STEP 1 Define Your Goals Just as important as what you’re saving for is when you’ll need the money. Whether your goal is short term (up to three years), intermediate term (three to 10 years) or long term (10 years or longer) you will need to balance the amount of risk you are willing to assume with an investment strategy designed to meet your goal. The longer your time horizon, the more you should lean towards equities to take advantage of the potential returns historically associated with stock investments. The shorter your time horizon, the more you will need to weight your allocation toward fixed and cash investments to avoid the short- term volatility associated with stocks. If your aim is building retirement security, it’s important to remember that your time horizon extends far beyond the day you retire. Depending on when you retire, it is possible that your retirement will span 30 years or longer, which means your investments will need to keep working to provide future income and keep pace with inflation. Consider leaving some of your money invested in stocks, which provide the potential of growth to support your future needs. STEP 2 Gauge Your Risk Tolerance With investing, your risk tolerance should be based on two factors: your time horizon (see Step 1) and your attitude toward investment volatility. For example, if you’re not comfortable with the stock market’s inevitable ups and downs, you may be inclined to weight your portfolio toward fixed-income investments such as bonds and money markets.
    [Show full text]
  • FX Effects: Currency Considerations for Multi-Asset Portfolios
    Investment Research FX Effects: Currency Considerations for Multi-Asset Portfolios Juan Mier, CFA, Vice President, Portfolio Analyst The impact of currency hedging for global portfolios has been debated extensively. Interest on this topic would appear to loosely coincide with extended periods of strength in a given currency that can tempt investors to evaluate hedging with hindsight. The data studied show performance enhancement through hedging is not consistent. From the viewpoint of developed markets currencies—equity, fixed income, and simple multi-asset combinations— performance leadership from being hedged or unhedged alternates and can persist for long periods. In this paper we take an approach from a risk viewpoint (i.e., can hedging lead to lower volatility or be some kind of risk control?) as this is central for outcome-oriented asset allocators. 2 “The cognitive bias of hindsight is The Debate on FX Hedging in Global followed by the emotion of regret. Portfolios Is Not New A study from the 1990s2 summarizes theoretical and empirical Some portfolio managers hedge papers up to that point. The solutions reviewed spanned those 50% of the currency exposure of advocating hedging all FX exposures—due to the belief of zero expected returns from currencies—to those advocating no their portfolio to ward off the pain of hedging—due to mean reversion in the medium-to-long term— regret, since a 50% hedge is sure to and lastly those that proposed something in between—a range of values for a “universal” hedge ratio. Later on, in the mid-2000s make them 50% right.” the aptly titled Hedging Currencies with Hindsight and Regret 3 —Hedging Currencies with Hindsight and Regret, took a behavioral approach to describe the difficulty and behav- Statman (2005) ioral biases many investors face when incorporating currency hedges into their asset allocation.
    [Show full text]
  • Arbitrage Pricing Theory
    Federal Reserve Bank of New York Staff Reports Arbitrage Pricing Theory Gur Huberman Zhenyu Wang Staff Report no. 216 August 2005 This paper presents preliminary findings and is being distributed to economists and other interested readers solely to stimulate discussion and elicit comments. The views expressed in the paper are those of the authors and are not necessarily reflective of views at the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors. Arbitrage Pricing Theory Gur Huberman and Zhenyu Wang Federal Reserve Bank of New York Staff Reports, no. 216 August 2005 JEL classification: G12 Abstract Focusing on capital asset returns governed by a factor structure, the Arbitrage Pricing Theory (APT) is a one-period model, in which preclusion of arbitrage over static portfolios of these assets leads to a linear relation between the expected return and its covariance with the factors. The APT, however, does not preclude arbitrage over dynamic portfolios. Consequently, applying the model to evaluate managed portfolios is contradictory to the no-arbitrage spirit of the model. An empirical test of the APT entails a procedure to identify features of the underlying factor structure rather than merely a collection of mean-variance efficient factor portfolios that satisfies the linear relation. Key words: arbitrage, asset pricing model, factor model Huberman: Columbia University Graduate School of Business (e-mail: [email protected]). Wang: Federal Reserve Bank of New York and University of Texas at Austin McCombs School of Business (e-mail: [email protected]). This review of the arbitrage pricing theory was written for the forthcoming second edition of The New Palgrave Dictionary of Economics, edited by Lawrence Blume and Steven Durlauf (London: Palgrave Macmillan).
    [Show full text]
  • Building Efficient Hedge Fund Portfolios August 2017
    Building Efficient Hedge Fund Portfolios August 2017 Investors typically allocate assets to hedge funds to access return, risk and diversification characteristics they can’t get from other investments. The hedge fund universe includes a wide variety of strategies and styles that can help investors achieve this objective. Why then, do so many investors make significant allocations to hedge fund strategies that provide the least portfolio benefit? In this paper, we look to hedge fund data for evidence that investors appear to be missing out on the core benefits of hedge fund investing and we attempt to understand why. The. Basics Let’s start with the assumption that an investor’s asset allocation is fairly similar to the general investing population. That is, the portfolio is dominated by equities and equity‐like risk. Let’s also assume that an investor’s reason for allocating to hedge funds is to achieve a more efficient portfolio, i.e., higher return per unit of risk taken. In order to make a portfolio more efficient, any allocation to hedge funds must include some combination of the following (relative to the overall portfolio): Higher return Lower volatility Lower correlation The Goal Identify return streams that deliver any or all of the three characteristics listed above. In a perfect world, the best allocators would find return streams that accomplish all three of these goals ‐ higher return, lower volatility, and lower correlation. In the real world, that is quite difficult to do. There are always trade‐ offs. In some cases, allocators accept tradeoffs to increase the probability of achieving specific objectives.
    [Show full text]
  • The Impact of Portfolio Financing on Alpha Generation by H…
    The Impact of Portfolio Financing on Alpha Generation by Hedge Funds An S3 Asset Management Commentary by Robert Sloan, Managing Partner and Krishna Prasad, Partner S3 Asset Management 590 Madison Avenue, 32nd Floor New York, NY 10022 Telephone: 212-759-5222 www.S3asset.com September 2004 Building a successful hedge fund requires more than just the traditional three Ps of Pedigree, Performance and Philosophy. As hedge funds’ popularity increases, it is increasingly clear that Process needs to be considered the 4th P in alpha generation. Clearly, balance sheet management, also known as securities or portfolio financing, is a key element of “process” as it adds to alpha (the hedge fund manager’s excess rate of return as compared to a benchmark). Typically, hedge funds surrender their balance sheet to their prime broker and do not fully understand the financing alpha that they often leave on the table. The prime brokerage business is an oligopoly and the top three providers virtually control the pricing of securities financing. Hedge funds and their investors therefore need to pay close heed to the value provided by their prime broker as it has a direct impact on alpha and the on-going health of a fund. Abstract As investors seek absolute returns, hedge funds have grown exponentially over the past decade. In the quest for better performance, substantial premium is being placed on alpha generation skills. Now, more than ever before, there is a great degree of interest in deconstructing and better understanding the drivers of hedge fund alpha. Investors and hedge fund managers have focused on the relevance of asset allocation, stock selection, portfolio construction and trading costs on alpha.
    [Show full text]
  • The Role of Gold in Today's Global Multi-Asset Portfolio
    Gold October 2019 The Role of Gold in Today’s Global Multi-Asset Portfolio SPDR® Gold Strategy Team Investors have often used gold tactically in their portfolios, with an aim to help preserve wealth during market corrections, times of geopolitical stress or persistent dollar weakness. But given gold’s historically low or negative correlation with most other asset classes (See Figures 2 and 3), we believe that in addition to gold’s tactical benefits, its function as a core diversifying asset may demonstrate that gold can potentially play a more long-term strategic role in an investor’s portfolio. In fact, research has shown that the modern multi-asset portfolio may be more efficient with a strategic allocation to gold playing a crucial role as a potential core diversifier.1 In this paper, we examine how including gold in a hypothetical multi-asset portfolio that also includes global stocks, various classes of fixed income, real estate, private equity, and commodities may improve its risk-return characteristics. We found that holding between 2% and 10% of SPDR® Gold Shares (GLD®) between January 1, 20052 and September 30, 2019 may have improved the hypothetical portfolio’s cumulative returns and Sharpe ratio and lowered its maximum drawdown, as compared to a portfolio without any gold-backed investments. See Figure 7 for asset weightings of hypothetical portfolios. Gold as an Investable Since 1971, when President Nixon removed the US dollar from the gold standard, the price of gold Asset: From IPO to ETF has increased from $43.28/oz. to $1,485.30/oz at the end of September 2019.
    [Show full text]
  • Beyond Asset Allocation: Three Pillars of a Robust Retirement Josh Davis Managing Director Head of Client Analytics Executive Summary
    IN DEPTH • JUNE 2020 AUTHORS Beyond Asset Allocation: Three Pillars of a Robust Retirement Josh Davis Managing Director Head of Client Analytics Executive Summary • Common wisdom holds that asset allocation has the biggest impact on portfolio returns. Yet for retirees, a far bigger factor is the sequence of returns in their portfolio. An uncooperative asset market early in retirement can have lifelong repercussions. • Fortunately, retirees can manage this risk with three pillars of retirement planning: a realistic, goal-oriented spending strategy; careful management of withdrawals to minimize Sean Klein Executive Vice President lifetime taxes; and an effort to maximize the value of their Social Security benefits. Client Solutions & Analytics • The effect of these three strategies, though small individually, is significant when they are combined. We estimate that a 65-year-old retiree with $1 million could enjoy up to 50% higher initial consumption and 30% higher lifetime consumption on an after-tax basis with the same level of risk. Introduction THE UNPREDICTABLE EFFECT OF ASSET ALLOCATION Despite the heavy focus it receives in the financial industry, asset allocation does not typically have the biggest impact on overall wealth in retirement. In general, additional investment risk is associated with a modestly higher chance of running out of money early in retirement, but investors should seek to offset risk with higher overall portfolio returns, which will be relied upon to sustain spending later in life. For retirees, though, this familiar investment relationship is distorted over time by taking distributions and thus spending down the portfolio. This small change can lead to many unintuitive results.
    [Show full text]
  • Multi-Factor Models and the Arbitrage Pricing Theory (APT)
    Multi-Factor Models and the Arbitrage Pricing Theory (APT) Econ 471/571, F19 - Bollerslev APT 1 Introduction The empirical failures of the CAPM is not really that surprising ,! We had to make a number of strong and pretty unrealistic assumptions to arrive at the CAPM ,! All investors are rational, only care about mean and variance, have the same expectations, ... ,! Also, identifying and measuring the return on the market portfolio of all risky assets is difficult, if not impossible (Roll Critique) In this lecture series we will study an alternative approach to asset pricing called the Arbitrage Pricing Theory, or APT ,! The APT was originally developed in 1976 by Stephen A. Ross ,! The APT starts out by specifying a number of “systematic” risk factors ,! The only risk factor in the CAPM is the “market” Econ 471/571, F19 - Bollerslev APT 2 Introduction: Multiple Risk Factors Stocks in the same industry tend to move more closely together than stocks in different industries ,! European Banks (some old data): Source: BARRA Econ 471/571, F19 - Bollerslev APT 3 Introduction: Multiple Risk Factors Other common factors might also affect stocks within the same industry ,! The size effect at work within the banking industry (some old data): Source: BARRA ,! How does this compare to the CAPM tests that we just talked about? Econ 471/571, F19 - Bollerslev APT 4 Multiple Factors and the CAPM Suppose that there are only two fundamental sources of systematic risks, “technology” and “interest rate” risks Suppose that the return on asset i follows the
    [Show full text]
  • Hedge Funds: Finding the Right Allocation
    Hedge Funds: Finding the Right Allocation Some hedge funds have garnered outstanding returns in recent years, but it’s crucial to consider a number of key factors before deciding how much to invest HEDGE FUNDS REPRESENT A NEW FRONTIER FOR going to go up—the longs—but also sell short the stocks much of the broad investing public. Recent newspaper he thinks are going to go down. And hedge fund man- headlines have trumpeted their spectacular successes agers can access a variety of financial instruments, like and equally spectacular failures. So the question invest- stock and bond index futures and options, and other ment managers hear most frequently from their clients financial derivatives such as swaps, caps and floors, and comes as no surprise: How much should I invest in currency forwards. They also have the ability to tap into hedge funds? some unique investment strategies in which performance may have little to do with the general ups and downs of In order to answer that question, it’s imperative to sepa- the markets. rate the facts from the hype. There’s no question that hedge fund investments have grown tremendously, from For example, a number of hedge funds seek out returns $200 billion in 1995 to $1.1 trillion just 10 years later.1 by betting on events. Merger arbitrage funds focus on They’ve attracted investors from across the wealth spec- the outcome of mergers following this logic: Shares of trum—from professional investors like large university stocks about to be acquired can trade at a discount to endowments and pension plans to some of the world’s the offer price, reflecting the risk that the deal won’t go wealthiest families and, more and more, the so-called through.
    [Show full text]