Portfolio Management Unit – III Session No. 19 Topic: Capital Market Expectations Unit – III Session No. 19 Topic: Capital Market Expectations

Session Plan Unit - III Briefing Capital Market Expectation Framework on Capital Market Expectation Challenges in forecasting: Summarizing and Q & A

Capital Market Expectations Tools for Formulating Capital Market Expectations Economic Analysis Risk and Return Asset Allocation Selection of Asset Classes Optimization Implementing the Strategic Asset Allocation Text Book: John L. Maginn et al. (2007), Managing Investment Portfolios: A Dynamic Process, John Wiley & Sons, Inc, 3 rd Edition Unit Briefing

Capital Market Expectations Capital Market Expectations (CME): the investor’s expectations concerning the risk and return prospects of asset classes, however broadly or narrowly the investor defines those asset classes. Capital market expectations are an essential input to formulating a strategic asset allocation. For example, if an investor’s investment policy statement specifies and defines eight permissible asset classes, the investor will need to have formulated long- term expectations concerning those asset classes to develop a strategic asset allocation. Capital market expectations are expectations about classes of assets, or macro expectations. By contrast, micro expectations are expectations concerning individual assets. Micro expectations are key ingredients in security selection and valuation.

Capital Market Expectations A Framework for Developing Capital Market Expectations: Specification Research Specify the model Sources of information Current Investment environment Documentation Monitoring

Capital Market Expectations 1. Specification - Specify the final set of expectations that are needed, including the time horizon to which they apply. The analyst needs to understand the specific objectives of the analysis in order to work efficiently toward them. For example, for a taxable investor with a 10-year time horizon, the portfolio manager would develop long-term after-tax expectations for use in developing a strategic asset allocation. 2. Research the historical record. Most forecasts have some connection to the past. For many markets, the historical record contains useful information on the investment characteristics of the asset, suggesting at least some possible ranges for future results. 3. Specify the method(s) and/or model(s) that will be used and their information requirements. Information requirements (economic and financial market data needs, for example) depend on the decision about method(s).

Capital Market Expectations 4. Determine the best sources for information needs 5. Interpret the current investment environment using the selected data and methods, applying experience and judgment. The analyst often needs to apply judgment and experience to interpret apparently conflicting signals within the data. 6. Provide the set of expectations that are needed, documenting conclusions. These are the analyst’s answers to the questions set out in Step 1. The answers should be accompanied by the reasoning and assumptions behind them. 7. Monitor actual outcomes and compare them to expectations, providing feedback to improve the expectations-setting process. *Steps 2 and 3 in the expectations-setting process involve understanding the historical performance of the asset classes

Capital Market Expectations Challenges in Forecasting The discussion focuses on problems in the use of data and on analyst mistakes and biases: 1.Limitations of Economic data - The analyst needs to understand the definition, construction, timeliness, and accuracy of any data used, including any biases. 2.Data measurement errors & biases - Analysts need to be aware of possible biases in data measurement of series such as asset class returns. 3.Limitations of historical estimates - With justification, analysts frequently look to history for information in developing capital market forecasts

Capital Market Expectations 4.Ex-post risk can be biased measure of Ex-Ante risk - In interpreting historical prices and returns over a given sample period for their relevance to current decision making, we need to evaluate whether asset prices in the period reflected the possibility of a very negative event that did not materialize during the period. 5.Biases in Analysts methods - Analysts naturally search for relationships that will help in developing better capital market expectations. Among the preventable biases that the analyst may introduce in such work are data – mining biases and Time – period biases 6.The failure to account for conditioning information - The analyst should ask whether there are relevant new facts in the present when forecasting the future. Where such information exists, the analyst should condition his or her expectations on it.

Capital Market Expectations 7.Misinterpretation of Correlations - In financial and economic research, the analyst should take care in interpreting correlations. 8.Psychological Traps – several psychological traps that are relevant to our discussion because they can undermine the analyst’s ability to make accurate and unbiased forecasts. – anchoring trap, status quo trap, confirming evidence trap, overconfidence trap, prudence trap, recallability trap 9.Model Uncertainty - The analyst usually encounters at least two kinds of uncertainty in conducting an analysis: model uncertainty (uncertainty concerning whether a selected model is correct) and input uncertainty

Summarizing Q & A