Investment and Portfolio Management - Assignment Example

Module of the Assignment: Investment and Portfolio Management of the Number: a) Briefly explain what is meant by risk aversion (5 marks) Risk aversion has been described as the expression of individual inclination for ‘certainty over uncertainty’ hence the need to reduce possible worst results susceptible to (Kolakowski, 2010). This are individuals who have a preference for low risk but safer guaranteed returns like a fixed bank account than high risky equities with possible or improbable return. An individual personal experience, exposure and upbringing usually influence his investment decisions fundamentally, with the tendency of those who had difficult background inclined to be risk averse while the contrary is true. The investor who prefers to bank his funds to generate a fixed ‘certain’ interest at the end of a term is the classic case of risk-averse individual while a casino gambler who bets against high ‘uncertain’ odds is at the other end of the spectrum (Pietersz, 2009). In scenario whereby an individual investment is assured of a £500 return, in the uncertain situation, a bet is considered that with a toss of a penny, the individual can get £1,000 or naught, while in the certain situation the individual will definitely receive the £500. Although both situations have a guaranteed return of £500, the uncertain situation has a 50 percent chance of garnering £1,000 or nothing. Therefore, three possible scenarios emerge: A risk averse individual will prefer the guaranteed £500 amount. A risk neutral individual has no particular inclination for either choice A risk taker individual would go for the opportunity of obtaining £1,000. Risk aversion is therefore a characteristic case of martingale effect whereby the most likely scenario is the investor risk-taker only gaining the original amount (Yates, 2009). In modern portfolio theory, risk aversion is calculated as the added subsidiary return an investor needs to admit supplementary risk, which is calculated through the standard deviation of the ROI or the square root of its variance (Baker, 2001). b) What assumptions do portfolio theory and the capital-asset pricing model make concerning the investor’s time horizon? (5 marks) Modern portfolio theory established mean-variance efficient portfolios in a fixed time horizon that ignored future market movements hence not applicable to multi-period investment horizon. Sharpe (1964), Lintner (1965) and Mossin (1966) separately have been ascribed to establishing the Capital Asset Pricing Model (CAPM) model that was developed from Markowitzs (1959) exposition of the Modern Portfolio Theory (MPT) particularly the mean-variance model. The fundamental theory of the CAPM indicates that there is a linear link involving systematic risk, as measured by beta, and projected share returns (Brewton, 2009). The CAPM model endeavours to illustrate the linkage by applying beta to describe the differences involving the likely proceeds from shares and share portfolios (Laubscher, 2002, p. 131). The CAPM assumptions are: All investors are reasonable and risk averse, with explicit motivation of maximising the expected utility at the culmination of their investment period hence an assumption of a single time horizon (derived from MPT). Ideal market conditions whereby levies, price fluctuation, business expenses, and short selling are disregarded. Investors can have access to and loan infinite funds at the risk-free rate. All chattels are substantially dividable and wholly fluid, thus investors are able to dispose them at whatever increment. All investors have analogous outlook for their investments thus have parallel accord on mean and variance, as the sole structure of market capacity hence will generate equal prospects (derived from MPT). Investment proceeds match the standard allocation The markets are in symmetry and no single person can influence the value of the investments also known as price takers (derived from MPT model). The overall quantity of chattels on the market and other capacity are predetermined in the particular period There exists no arbitrage prospect Market information is available and free to all Thus, both the MPT and CAPM are essentially based on the assumption of a rational investor in an ideal market situation and fixed time horizon. c) With reference to ‘mean reversion’, assess to what extent the risk of investments depends on an investor’s time horizon. (10 marks) The theory of mean reversion assumes that prices and returns ultimately oscillate back close to the mean or average. The perchance is to the historical standard of the value or return established on monetary average proceeds of an industry (Balvers et al, 2000). Additionally, interest rates and price-earnings ratios are affected by the mean reversion drift. Hillebrand (2003) postulates that mean-reversion occurs when a positive change in returns is reverted at varying time, hence eliminating the gains made within a day or year [see illustration Figure 1]. Figure 1 Ho and Sears (2006) argue that contemporary negative trends among the long-term stocks indicate evidence of a ‘stationary component in stock prices’ hence depicting a mean reversion factor as prices oscillated back to their mean returns ultimately. Due to the absence of an effective symmetry system to establish the connection involving the mean reversion by stocks and market efficiency, the authors discounts the assumption of ‘market correction’ phenomenon as the reason for such scenarios. However, Fama and French (1988) assert that immobility of the stock prices is due to time deviation of the stocks or time horizon, which is realistic for market efficiency occurrence. Fama and French study of the NYSE found that stationary components within a short-run or less time horizons for stocks led to an autocorrelation but is not replicated in the longer-term stocks. Redenbaugh and Juliano (2009) have nevertheless linked the study of mean reversion to the contemporary field of behavioural finance whereby they argue that human beings are inevitably driven by the ‘herd mentality’ as opposed to ‘rational calculating machines’ (Pg. 1). Rather purposefully deciding to perform better than the general investors do, individuals are more likely to move with the herd as ‘being different from it produces both discomfort and risk’ (Pg. 1). This produces the ‘relative measurement trap’ whereby individuals do not deem investments as failed if they generally drop fewer points than the herd. Redenbaugh and Juliano illustrate how portfolio managers who only lose a third of an investors fund were considered successful. Thus in 2008, among those portfolio managers with rating of 27 percent against the S&P 500, were ranked among the top five percent thus over 60 percent of all funds performed dismally beaten by the S&P 500. The authors while advocating for an absolute return strategy, argue that fund managers who ignore the benchmark S&P 500 can obtain better returns from investing in Treasury Bills (T-bill) (Yates, 2009) Hillebrand (2003) building on the concept advanced by Black (1988) argues that mean reversion phenomenon is a major cause of stock market clashes. Using data derived from the NYSE and S&P 500 indexes he demonstrates that mean reversion is a ‘transient but recurring phenomenon’, which has not been fully appreciated or linked to the stock exchange clashes (Hillebrand, 2003, p. 23). Contrary to the fallacy that long-term investment has better or safer returns, empirical studies have demonstrated the contrary to be true thus Koijen et al (2006) asserts that return continuation (momentum) and mean-reversion are significant for investors considering the time horizon. The mean reversion experience tend to reduce the volatility of stocks in the long-term thus allowing an optimal allocation. Campbell and Viceira (2005) assert that mean reversion has a stabilising effect to the optimal long-term allocation of equities when compared to the short-term as it swells with the enhanced time horizon. Nevertheless, it has been noted that most of the customary long-term institutional investors are now shifting to shorter-term stocks, a trend that has been attributed to the rapid turnaround of portfolio managers reducing the average from 12.5 years to just two years (Bogle, 2003). The revisionist view postulates that stocks are actually safer bets than bonds or T-bill in the long-term however; no clear empirical evidence has been established to illustrate the link between the time horizon and short-term volatility. Campbell (2002) attempted to establish the linkage of how the volatility diminished with time thus correlating the mean reversion that has been revealed to reduce the instability of stocks in the long-term. The prospect of the time horizon as the main driver for the optimisation of stocks in the long-term can therefore be discerned as the risk premium gradually disseminates thus in effect reducing the risk of the stock returns (Wachter, 2002). d) ‘Investors who want high risk /return should hold high risk shares; investors who desire low risk/return should hold low risk shares Explain reasons for agreeing or disagreeing with this statement, with reference to the financial interior decorator fallacy. (10 marks) Conservative investors generally desire low-risk low return stocks that generally run for long periods as opposed to high-risk takers who prefer the higher returns but face future uncertainties in their stock returns. The revisionist view therefore assert that stocks which are generally regarded as volatile and high-risk investments are actually safe as long as the individual aims at the long-term stocks that are less uncertain. This view is supported by the Risk Research International (2009) who have studied Australian worst stocks returns for a 30-year period and concluded that equities are actually better in the long-term as compared to bonds or T-bills. Within the initial period (≤ 4 years), the stocks equalled the bonds rates and henceforth outperformed them [see figure 2] (RRI, 2009). Figure 2 Source: RRI (2009), Pg. 3 However as Bernstein (1992) ‘interior decorator fallacy’ states, an individual investor’s, expectation should reflect their specific ‘attitudes to risk’ thus if someone is risk averse, then their expectations should not be overly elevated as investment decisions rule of thumb states that, ‘the higher the risk, the higher the returns’ and vice versa. Despite the timorous attitude of some investor who prefer investing in low-risk stocks or fixed assets, contemporary analysis indicate that socks as envisioned by this conservative investors are not so risky. Bernstein’s assertion of attitude to risk or the interior decorator fallacy theorem indicates that the risk takers stand a greater chance of accumulating wealth as well as losing it as there bold investment decisions, gamble pay off, or land them in serious financial quagmires. Siegel (1994) research study similarly proved that equities tend to outperform bonds and T-bills when examined from a long-term perspective. His historical research dating back to 1802 comprehensively demonstrated the superiority of stocks held for a long period as results indicated that equities outperformed T-bills by 61.26 percent during the over 100 period. A study covering a 20-year rolling times, revealed that equities outperformed bonds in 91.28 percent of the time while also doing better than T-bills 94.19 percent of the time (Siegel, 1994). Connelly (1996) thus affirmed that, ‘the larger the investment horizon, the larger the portion of the portfolio that should be devoted to common stocks and other high-return assets’ (Pg. 20). One of the most fundamental problems faced by portfolio managers is that investors generally expect high returns in the short term but are also risk averse hence cannot realistically expect to obtain much relief from their investments. By avoiding risk, the investor is in effect forfeiting quick high returns viewed as fraught with danger of having entire stocks wiped out. Investors therefore tend to chase the growth stocks once they have already appreciated that may be in a return curve rather than patiently investing and waiting on the unknown stocks for the long haul. High-risk investors therefore embrace Bernstein’s ‘interior decorator fallacy’ or the maxim that ‘No risk, no return. Nothing ventured, nothing gained. Buy low and risky, sell high and safe.’ Nonetheless, firms tend to gravitate towards the outlook of their investors over time hence the possibility of long-term investors benefiting is higher than that of short-term investors. Samuelson (1994) however disputes the assertion that equities risk premium decline in the long-term arguing on the assumption of utility theory, that investors should be more concerned about the value of their wealth rather than the proceeds or terminal wealth. Investing decisions tend to be rather irrational thus; the assumption of time diversification may not hold depending on certain conditions as most investors are more inclined to follow the recent events rather than any long-term objective. Bennyhoff (2008) consequently argues the aspect of time diversification may affect them either way as long-term investments can also be affected by fluctuations in the market as it happens for the short-term stocks. Investors who desire high returns must therefore expect to face some degree of risk by investing in equities particularly in those stocks that are on the rise rather than backing the normal trend of ‘herd mentality’ which will yield minimally if at all. The investor must however diversify as acknowledged by Campbell and Viceira (2005) who advise that a mix of the short term and long term as well as fixed stocks like Bonds and T-bills is the only guaranteed way a portfolio can outperform the national index. This theorem negates the notion of identifying a distinct guaranteed stock method as advocated by Redenbaugh and Juliano (2009) absolute return strategy who postulate that bond and t-bills are the best vehicle for optimising returns. Similarly, studies have positively verified the presumption by various analysts that long-term investment are actually no risk for investors desirous about optimally generating the best results Campbell and Viceira (1999); Wachter (2002). Bernstein assertion of ‘interior decorator fallacy’ aptly reflect the attitude of investors risk aversion thus an investor who is conservative invariably expects a moderate returns but no major shocks or losses among their investments. Conversely, those investors that are not overly risk averse or risk takers will expect higher returns from their investment but must also be ready to bear heavy losses in the event their outlay does not pan out. e) Critically review the empirical evidence as to whether or not security returns are linearly related to beta. (10 marks) The notion of beta β was pioneered by Markowitz (1959) which is applied to determine the systematic risk of an investment or stock thus indicates the expected price of a share in relation to its market return. The historical performance of stocks is crucial and share price index in determining the expected performance. The straight line illustrating the link between the rate of return of a stocks and the market rate is describes as the security’s distinctive line while the slope is its beta line (Antony and Jeevanand, 2007). The linear relationship between the ROI and its systematic risk is demonstrated by the CAPM mathematical formula [see below]. Figure 3 The CAPM therefore employs beta to establish the relationship between the diverse security returns. Thus, beta is used to ascertain the non-diversifiable risk inherent and express the expected proceeds. The CAPM has been found to be the most viable model of predicting expected returns on an asset. The forecasted equity growth rate is calculated using the CAPM. This method assumes that shareholders expects a rate of return equivalent to the risk free rate plus a risk premium, and is expressed, as the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. Beta is used to deduce the non-diversifiable risk hence is the approximation of the risk to the market portfolio, which means beta appraises the volatility of the stocks comparative to the share portfolio (Laubscher, 2002). The basis of the CAPM model is factored on three primary assumptions. These include: i) The preference of risk-free rate of return hence is not hampered by either a variance or covariance from proceeds from the market. The most viable in this instance are treasury bonds or T-bill. ii) Return on the market – the CAPM assumes an optimal market condition, which is not beset by normal risks and fluctuations. Although ideally the market portfolio should be employed, the national bourse indexes are nevertheless employed. iii) Beta – this enjoins the investors’ prospect to those prevailing in the market. Nevertheless, the use of historical betas to deduce the expected betas has been criticised as unrealistic. Beta has been demonstrated through several studies to be linearly related to risk with the CAPM providing the best manifestation of risk assessment with high beta stocks producing superior average proceeds than low-beta stocks [see illustration below: Figure 4 ] Figure 4 : Beta and Average Return for Portfolios formed on Size Davis (2003) The general findings on the linear correlation between beta and expected return can be summarised as outlined by Reilly and Brown (1997, Pg. 315) and Laubscher (2002, Pg. 117). Beta is correlated to historical proceeds but has the best illustration of returns and risk when compared to the standard deviation thus the linear relationship between risk and returns is positive. Betas for specific stocks are deemed unbalanced but conversely those for the entire portfolio are steady. Low-beta stocks generate better proceeds than expectations while conversely high-beta stocks perform less spectacularly from expectations. Though the fundamental relationship linking beta and predicted returns is positive, the slope of the curve is flatter than forecasts. The theory of stock price performance is invariably guided by the Markowitz (1952, 1959) model of a single-phase period. The investor collects a portfolio with an aim of capitalizing on profits within a tolerable level of risk that can calculated by the variance or standard deviation of the portfolio’s return. [depicted by the upward movement in Figure: 5]. Thus, the investor’s main objective is to develop higher proceeds from the portfolio at a minimum exposure of risk along the upper limit of the curve known as the ‘efficient frontier’ from which the least risky stocks are selected (Davis, 2003). Figure 5: Markowitz Portfolio Selection Source: Adapted from Markowitz (1952, 1959) Several analysts have however questioned the veracity of beta a viable measure of market performance, as it does not reflect market changes thus the need to use the elasticity that is market susceptible but concede it is still a viable measure off security performance. (Banz, and Breen, 1986); (Barber and D. Lyon, 1997); (Campbell and Viceira, 2005); (Fama and French, 1996); (Laubscher, 2002). Antony and Jeevanand (2007) therefore assert that the best measure of the expected performance of a security in cognizance of market changes should apply a regression method that will indicate the linkage between X and Y. Thus: Y = a + b X (2) Where a and b are constants. Other models advanced that have beta as the central factor include the Arbitrage Pricing Theory (APT) by Ross (1976), an improvement on the CAPM model by incorporating arbitrage opportunities; Mertons (1973) Intertemporal Capital Asset Pricing Model (ICAPM) that deviates from the static CAPM and APT integrating time variation; the Consumption-Based Capital Asset Pricing Model (CCAPM); Basu’s (1977). Security returns have therefore been empirically linked to beta whereby the CAPM continues to dominate academic studies even in the face of mounting criticisms is still relevant as financial forecaster of expected returns in stock markets performance. References Antony, Cyriac and Jeevanand, E.S. (2007) The Elasticity of the Price of a Stock and Its Beta. Journal of Applied Quantitative Methods , Vol. No. 3 Fall: Pg. 334 -341. Arnold, G. (2002) Financial Management. 2nd ed. London: Financial Times Pitman. 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