1. AF4 Risk measurement and Management
2018/19
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2. Audley Financial Training
Specific Risks
Capital Risk
Inflation Risk
Income Risk
Interest Rate Risk
Currency Risk
Shortfall Risk
Provider Risk
Counterparty risk
Liquidity risk
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3. 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?
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4. 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?
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5. 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
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6. 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!
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7. 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% +/ % = 20.68% or %
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% +/ % = 29.02% or %
B 3% +/ % = 13.68% or -7.68%
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8. 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?
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9. 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
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10. 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
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11. Audley Financial Training
Beta examples (2012, 2016, 2017, 2018)
Tesco
Barclays BP
M & S
Glaxo
All the above are sourced from the FT
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12. 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 What is the portfolio beta?
(20% x 0.85) + (20% x 1.31) + (20% x 1.28) + (20% x 1.033) + (20% x )
= 1.07
We would expect the performance to be slightly higher (or lower) than the FTSE 100
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13. 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 = 1.925
Performance should now be better than the index but if it falls the loss would be greater
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What return can I expect?
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15. 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
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CAPM example
Risk free return = 1%
Market return = 5%
Beta = 1.2
Expected return = 1% + 1.2(5% - 1%)
Expected return = 1% x 4%
Expected return = 1% + 4.8%
Expected return = 5.8%
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17. 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
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18. Managing and mitigating risk
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19. 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
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20. 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
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It is impossible to reduce systematic risk by diversification
Non systematic risk can be reduced by diversification
Diversification
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22. Systematic and Non Systematic Risk
Why does the non-systematic risk level off?
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23. 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
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24. 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
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25. 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
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26. Audley Financial Training
Correlation of assets X Y Z
+ 0.42
-0.35
-0.76
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27. 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
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28. Audley Financial Training
Efficient Frontier
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29. 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.
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30. 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
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31. 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
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32. It is impossible to eliminate risk It is possible to control risk
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33. Portfolio Construction
The art of mixing various asset classes to provide the optimum result for the client
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34. 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
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35. 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
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36. 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.
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37. 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
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