AF4 Risk measurement and Management 2018/19 29/6/2018 Audley Financial Training

Audley Financial Training Specific Risks Capital Risk Inflation Risk Income Risk Interest Rate Risk Currency Risk Shortfall Risk Provider Risk Counterparty risk Liquidity risk 29/6/2018 Audley Financial Training

Audley Financial Training What return can I expect? I need to achieve a return of x%, how can I achieve that without taking too much risk? If I accept your advice how much could I lose? 29/6/2018 Audley Financial Training

What return can I expect? B Year 1 5.00% 4.00% Year 2 6.00% Year 3 -8.00% -3.00% Year 4 10.00% 3.00% Year 5 12.00% 7.00% Year 6 2.00% Year 7 Year 8 -12.00% -2.00% Year 9 14.00% 8.00% Year 10 Average Two investments A & B. Over the past 10 years A has produced an average return of 4% and B 3% However we can see that A has produced a wider range of results. It was more volatile than B. Is it possible to measure this volatility? 29/6/2018 Audley Financial Training

Audley Financial Training Measuring volatility Volatility is a measure of how much the actual return will differ from the expected return Volatility = Risk Rather than use terms such “high” or “low” volatility it is possible to measure it on an objective basis. There are two measures: Standard Deviation: Measures the historic volatility of a security or fund Beta: Measures historic volatility of a security or fund against a benchmark 29/6/2018 Audley Financial Training

Audley Financial Training Standard Deviation A B Year 1 5.00% 4.00% Year 2 6.00% Year 3 -8.00% -3.00% Year 4 10.00% 3.00% Year 5 12.00% 7.00% Year 6 2.00% Year 7 Year 8 -12.00% -2.00% Year 9 14.00% 8.00% Year 10 Mean SD 8.34% 3.56% You don’t need to know how to calculate this! The SD of A is 8.34% The SD of B is 3.56% So what! 29/6/2018 Audley Financial Training

Audley Financial Training The maths bit A B Year 1 5.00% 4.00% Year 2 6.00% Year 3 -8.00% -3.00% Year 4 10.00% 3.00% Year 5 12.00% 7.00% Year 6 2.00% Year 7 Year 8 -12.00% -2.00% Year 9 14.00% 8.00% Year 10 Mean SD 8.34% 3.56% 68% of future returns should fall between the mean and plus/minus 1 SD A 4% +/- 8.34% = 12.34% or -4.34% B 3% +/- 3.56% = 6.56% or -0.56% 95% of future returns should fall between the mean and plus/minus 2 SD A 4% +/- 16.68% = 20.68% or -12.68% B 3% +/- 7.12% = 10.12% or – 4.12% 99% of future returns should fall between the mean and plus/minus 3 SD A 4% +/- 25.02% = 29.02% or -21.02% B 3% +/- 10.68% = 13.68% or -7.68% 29/6/2018 Audley Financial Training

How useful is SD? It is an objective measure. Low volatile assets do not tend to become highly volatile in the short term. It is a difficult concept for the average investor to understand How useful is SD? 29/6/2018 Audley Financial Training

Audley Financial Training Beta A measure of an asset’s volatility against a benchmark (e.g. FTSE100) Benchmark has a Beta of 1 A security that is historically more volatile than the market has a beta greater than 1. A security that is historically less volatile than the market has beta of less than 1 29/6/2018 Audley Financial Training

Audley Financial Training Beta Theory Beta measures the volatility of an asset or fund against an index If you wanted a portfolio with lower volatility (and a lower performance than the benchmark ) you would select shares with a beta of less than 1 If you want higher volatility (and a higher performance) you would select shares with a beta of more than 1 But there is no agreed method of calculating beta. Plus the beta will change over time 29/6/2018 Audley Financial Training

Audley Financial Training Beta examples (2012, 2016, 2017, 2018) Tesco 0.678 0.8468 0.9636 0.9566 Barclays 1.81 1.3073 0.9149 0.4933 BP 1.68 1.2780 1.2468 1.3510 M & S 1.06 1.0330 1.0531 1.0108 Glaxo 0.4878 0.8589 1.2108 1.0862 All the above are sourced from the FT 29/6/2018 Audley Financial Training

Beta applied to a portfolio Assume a portfolio with 20% allocated to five shares with different beta. A 0.85, B 1.31, C 1.28, D 1.033, E 0.86. What is the portfolio beta? (20% x 0.85) + (20% x 1.31) + (20% x 1.28) + (20% x 1.033) + (20% x 0.86) 0.17 + 0.26 + 0.26 + 0.21 + 0.17 = 1.07 We would expect the performance to be slightly higher (or lower) than the FTSE 100 29/6/2018 Audley Financial Training

Audley Financial Training Increasing the Beta To increase beta increase weightings in B and C and reduce A & E (10% x 0.85) + (30% x 1.31) + (30% a 1.28) +(20% x 1.033) + (10% x 0.86) O.085 + 0.39 + 0.38 + 0.2 + 0.87 = 1.925 Performance should now be better than the index but if it falls the loss would be greater 29/6/2018 Audley Financial Training

Audley Financial Training What return can I expect? 29/6/2018 Audley Financial Training

Capital Asset Pricing Model A formula that attempts to predict the return on an asset Inputs are: Risk free return Market return Beta of the security Formula is: Return = Risk Free return + beta (market return – risk free return) Only variable is the beta 29/6/2018 Audley Financial Training

Audley Financial Training CAPM example Risk free return = 1% Market return = 5% Beta = 1.2 Expected return = 1% + 1.2(5% - 1%) Expected return = 1% + 1.2 x 4% Expected return = 1% + 4.8% Expected return = 5.8% 29/6/2018 Audley Financial Training

Audley Financial Training Problems with CAPM What is the risk free rate? What is the market return? Is Beta accurate? CAPM is based on these assumptions: All investors are rational making decisions on the basis of risk and reward All investors have identical holding periods There are many buyers and sellers and no one can influence the price There are no transaction costs. Information is free and available to all All investors can borrow and unlimited amounts can be borrowed at the risk free rate Liquidity of any asset can be ignored 29/6/2018 Audley Financial Training

Managing and mitigating risk 29/6/2018 Audley Financial Training

Audley Financial Training “Don’t put all your eggs in one basket” DIVERSIFY! The principles of diversification have developed into Modern Portfolio Theory. This in turn is based on some key principles Managing risk 29/6/2018 Audley Financial Training

Systematic and Non-Systematic Risk The price of shares will vary. This volatility arises from: Systematic or market risk Non-systematic, that is risk inherent to the company An attack on or by North Korea would reduce the price of almost all shares. A pharmaceutical company having to withdraw a drug would affect its share price but not other companies 29/6/2018 Audley Financial Training

Audley Financial Training It is impossible to reduce systematic risk by diversification Non systematic risk can be reduced by diversification Diversification 29/6/2018 Audley Financial Training

Systematic and Non Systematic Risk Why does the non-systematic risk level off? 29/6/2018 Audley Financial Training

Audley Financial Training Correlation Correlation refers to the way in which two securities move in relation to each other Positive Correlation move in the same direction Negative Correlation move in the opposite direction No correlation means there is no related movement 29/6/2018 Audley Financial Training

Audley Financial Training If A falls by 10%, as the correlation is +0.5 B should fall by 5% A & B are positively correlated as they tend to move in the same direction If A rises by 10% andB by 5%, the correlation is said to be +0.5 A B A B 29/6/2018 Audley Financial Training

Audley Financial Training If C falls by 10%, as the correlation is -0.5 D should rise by 5% C & D are negatively correlated as they tend to move in the opposite direction If C rises by 10% and D falls by 5%, the correlation is said to be -0.5 C D C D 29/6/2018 Audley Financial Training

Audley Financial Training Correlation of assets X Y Z + 0.42 -0.35 -0.76 29/6/2018 Audley Financial Training

Modern Portfolio Theory Asset allocation is the most important factor in determining performance It is possible to achieve a portfolio that will give the highest performance for a given level of risk Conversely given a target return it is possible to calculate the lowest level of risk that must be accepted. Emphasis is place on holding assets that are negatively correlated 29/6/2018 Audley Financial Training

Audley Financial Training Efficient Frontier 29/6/2018 Audley Financial Training

Audley Financial Training How useful is all this? The past 60 years have seen many theories about how optimal returns can be made. Most of these are based on the premise that investors always behave rationally. There is now an increasing view that investors behave irrationally. If there was a method of accurately predicting future performance we’d all be millionaires! All the preceding ideas can be used as a proof of the benefits of diversification. 29/6/2018 Audley Financial Training

Irrational behaviour (Behavioural Finance) Fear of losing money Follow the herd, get sucked into bubbles Invest at the top of the market Believe current trends will continue Averse to cutting losses Knowledge bias More unhappy with a loss than an equivalent gain Reluctance to accept error made 29/6/2018 Audley Financial Training

The five stages of a bubble Displacement: Awareness of a new “paradigm” Boom. Prices rise rapidly, more investors are drawn in FOMO Euphoria: Prices skyrocket Profit taking: the smart money moves out Bust. Reality moves in, panic selling, price plunges 29/6/2018 Audley Financial Training

It is impossible to eliminate risk It is possible to control risk 29/6/2018 Audley Financial Training

Portfolio Construction The art of mixing various asset classes to provide the optimum result for the client 29/6/2018 Audley Financial Training

Modern Portfolio Theory states: Asset allocation is the key determinant of a portfolio’s performance. Otherwise known as a Top Down approach. It applies whether you are recommending a portfolio of pooled investments for a client with a modest amount to invest Or a discretionary fund management with a high net worth client 29/6/2018 Audley Financial Training

Audley Financial Training Chicken before egg Asset Allocation Security Selection The decision about how assets are split between cash, bonds and shares. A vital part of the investment process and as important as security selection Deciding what securities to have in each asset class 29/6/2018 Audley Financial Training

Day 1 objectives By the end of the event delegates will be able to:   Identify the characteristics and risks of the main asset classes. Accurately calculate and interpret the main performance measures of a Bond Accurately calculate and interpret the main performance measures of shares Accurately calculate and interpret the primary financial data in a company’s balance sheet and accounts Understand how economic factors can affect the performance of different assets. 29/6/2018 Audley Financial Training

Day 1 objectives (continued) Understand and analyse an asset’s Standard Deviation and Beta Calculate accurately the output of the Capital Asset Pricing Model and explain its limitations Explain the differences between systematic and non-systematic risk Explain the concept of the Efficient Frontier Explain how correlation is measured. Understand the principles of Modern Portfolio Theory Understand how economic factors affect different investment classes 29/6/2018 Audley Financial Training