1. Risk Analysis and Technical Analysis Tanveer Singh Chandok (Director of Mentorship)

2. What we have done so far GTSF Investments Committee2  Efficient Market Hypothesis  Investing Styles (IC)  Time Value of Money  Financial Statement Analysis  Valuation and important terms  Important Ratios  Fundamental Analysis (Macro/Micro)  Intro to Fixed Income

3. A quick review GTSF Investments Committee3  The 3 main styles of investing  Value  Growth  Momentum  What is the difference between going long and short? How do we “short” a stock?  Different levels of market cap  Large  Mid  Small  What does “liquidity” mean and why is it so important?

4. What we’re doing today GTSF Investments Committee4  We use statistics to measure risk  Some basic concepts  Properties of data sets  Mean – “average”  Median - “middle number”  Mode – “occurs most often”  0, 0, 2, 4, 6, 8, 10  Standard Deviations  Normal Distributions

5. What is “Risk”? GTSF Investments Committee5  Uncertainty  Risk  What are we uncertain about?  Generally:  The more uncertain the cashflows of a particular investment are the higher the risk  The higher the risk, the higher the required interest rate  Thus: Higher Risk = Higher Rate of Return  Risk – return trade-off

6. Terms GTSF Investments Committee6  “Rate of Return”  “Sample” = our dataset  Sample mean returns  Sample variance of returns

7. More terms GTSF Investments Committee7  Sample covariance  Standard Deviation  Square root of variance = σ  Sample correlation

8. Correlation Patterns GTSF Investments Committee8

9. Correlation Patterns GTSF Investments Committee9

10. Normal or “Gaussian” Distributions GTSF Investments Committee10

11. Compare to uniform distribution GTSF Investments Committee11

12. Characteristics of Probability Distributions GTSF Investments Committee12  Mean  Most likely value – “Expected value”  Variance or Standard Deviation  Volatility – “Degree of deviation from the mean value”  Skewness  Degree of asymmetry in distribution  Kurtosis  Degree of fatness in tail area

13. Standard Deviation GTSF Investments Committee13  Defined by the following equation:  Step 1: Find the mean of the dataset  Step 2: Subtract the mean from each value  Step 3: Square the values from Step 2  Step 4: Add up all the values from Step 3  Step 5: Divide the value from Step 4 by (n-1)  Step 6: Take the square root of the value from Step 5

14. Standard Deviation as a measure of risk GTSF Investments Committee14  Std. Dev. tells us what the normal distribution probability function looks like  Pros  Easy to calculate and implement  If return distribution is symmetric, the upside risk is the same as downside risk, and therefore standard deviation is a good measure of downside risk  If returns are normally distributed, standard deviation would be adequate in characterizing the risk  Upside risk vs. Downside risk

15. Standard Deviation as a measure of risk GTSF Investments Committee15  Cons  Investors are concerned about downside risk  Standard deviation includes both the above-average returns (upside risk) and the below-average returns (downside risk)  If returns are skewed, standard deviation is not the only relevant measure of risk  Holding expected return and standard deviation constant, investor would prefer positive skewed distribution

16. Risk Practice Problems GTSF Investments Committee16  You are thinking about investing in 2 companies. One of them (let’s call it ABC) has the following monthly returns  4%  2%  3%  1%  -8%  What is this stocks average return and standard deviation?

17. Risk Practice Problems GTSF Investments Committee17  The next company (DEF) has the following returns;  1%  2%  1%  3%  2%  What is this stocks average return and standard deviation?  Which stock would you most likely invest in?  What other factors should influence your decision?

18. More Risk! GTSF Investments Committee18  What about a stock’s sensitivity to the market?  When the broader market is down, individual company stocks are often down, why is that?  Traders use stocks as a way to express their views on the market, often movements in stocks are not due to company news but market news

19. Beta GTSF Investments Committee19  The most common way to see how a stock moves in relation to the broader market (represented by the S&P 500)  Beta (or market risk) is a measure of a securities relative volatility as compared to the broader market  Beta > 1 means the stock is more volatile than the market  Beta < 1 means the stock is less volatile than the market

20. Beta GTSF Investments Committee20

21. Beta Practice GTSF Investments Committee21  Consider the following security beta’s; a. 1.3 b. 1.4 c..6 d. 1.0 e..35 f. 1.9  Which stock will move the most in relation to the market? Which one will move the least?

22. Using Beta to determine return GTSF Investments Committee22  We previously calculated expected return by taking the average of past returns  With Beta we know how a security compares to the market return  Using this information we can calculate the E(r) of a security without knowing its previous returns  E(r) = Risk Free Rate + Beta (Market Risk Premium)  Market risk premium = Market return – Risk Free Rate

23. CAPM GTSF Investments Committee23  The use of Beta, Market Return and the Risk Free Rate to determine expected return is called the Capital Asset Pricing Model or CAPM  What do you think we use for the risk free rate?  If a stock’s beta is 1.2 and the market has returned 10% on average while the risk free is 2% what is the stock’s expected return?

24. GTSF Investments Committee24

25. Alpha GTSF Investments Committee25  If everything perfectly followed CAPM then we would be able to very accurately predict what a given stock would return  If this was true then we would not need actively managed funds to gain outsized returns  “The abnormal rate of return on a security or portfolio in excess of what would be predicted by an equilibrium model like the capital asset pricing model (CAPM)”  Alpha represents a greater return for lower risk

26. Risk/Return Payoff GTSF Investments Committee26  Which portfolio manager did a better job last year and why?  Bill - 25% return  Carl - 20% return  What does the information above NOT tell us about the returns of the portfolios in question?

27. The Risk Return Payoff GTSF Investments Committee27 ● RISK! ● We haven’t accounted for the risk each manager took so we don’t know if they got those returns by picking smart investments or simply taking a lot of risk

28. Risk Adjusted Returns GTSF Investments Committee28 ● Let’s take another look at those returns ● Bill – (25% return, stdev of 20%) ● Carl – (20% return, stdev of 25%)

29. What does the Sharpe Ratio Tell Us? GTSF Investments Committee29 ● A sharpe ratio tells us how much return the portfolio gets for every “unit” of risk it takes ● A sharpe ratio of > 1 means for every unit of risk we get more than 1 unit of return ● A sharpe ratio of > 2 means that we are getting double the return for every unit of risk we take

30. Where does “risk” come from? GTSF Investments Committee30 ● Beta measures risk compared to markets ● Alpha measures risk of individual assets in terms of excess return ● If we hold multiple securities at the same time can we increase/decrease our risk? ● Correlation - the degree to which two things move together ● If we have a portfolio of highly correlated stocks then our entire portfolio will rise and fall at the same time

31. Correlation GTSF Investments Committee31  A measure of how closely two things move together

32. Why We Care About Correlation GTSF Investments Committee32

33. Diversification GTSF Investments Committee33 ● We can increase our portfolio’s risk/return relationship by diversifying ● If we hold non-correlated assets then they will move separately eliminating moves cause by correlations ● Say you have a portfolio of only Tech stocks (GOOG, APPL, MSFT) how would you diversify your holdings so a drop in the tech sector wouldn’t bankrupt you?

34. Diversification GTSF Investments Committee34

35. Technical Analysis GTSF Investments Committee35  Live demo

36. Quiz Time! What is Beta? 1.Security Risk 2.Market Risk 3.Treasury Risk 4.Interest Rate Risk

37. Quiz Time! What is Beta? 1.Security Risk 2.Market Risk 3.Treasury Risk 4.Interest Rate Risk

38. Quiz Time! How many low correlation stocks do we need to achieve the diversification benefit 1.5 2.20 3.30 4.33

39. Quiz Time! How many low correlation stocks do we need to achieve the diversification benefit 1.5 2.20 3.30 4.33

40. Quiz Time! What is NOT a component of CAPM 1.Market Risk 2.Risk Free Rate 3.Beta 4.Market Return

41. Quiz Time! What is NOT a component of CAPM 1.Market Risk 2.Risk Free Rate 3.Beta 4.Market Return