[y] modern portfolio theory, whose insights will enable you to reduce risk while possibly earning a higher return
[o] investors can increase their returns by assuming a certain kind of risk
[i] psychology, not rationality, rules the market, and that there is no such thing as a random walk
[i] smart beta” and “risk parity” strategies
[z] they should constitute the core of all portfolios
[y] The efficient-market hypothesis explains why the random walk is possible.
[i] Because of the actions of the pros, the prices of individual stocks quickly reflect all the news that is available.
[b] Samuel Butler
[z] the method of beating the market, they say, is not to exercise superior clairvoyance but rather to assume greater risk
[y] The dividend of the company may be cut
[s] Thus, financial risk has generally been defined as the variance or standard deviation of returns.
[j] Although the pattern of historical returns from individual securities has not usually been symmetric, the returns from well-diversified portfolios of stocks are at least roughly symmetric.
[v] Thus, in two-thirds of the months the returns from this portfolio were between +5½ percent and –3½ percent, and 95 percent of the returns were between 10 percent and –8 percent.
[y] October 1987 is the most dramatic change in stock prices during a brief period since the 1930s
[y] there are ways in which investors can reduce risk.
[s] What Markowitz discovered was that portfolios of risky (volatile) stocks might be put together in such a way that the portfolio as a whole could be less risky than the individual stocks in
[s] quadratic programming
[o] although both companies were risky (returns were variable from year to year), the companies were affected differently by weather conditions
[j] negative covariance
[z] most investors will realize that when the market gets clobbered, just about all stocks go down
[t] anything less than perfect positive correlation can potentially reduce risk
[y] can there be too much of a good thing?
[v] fifty equal-sized and well-diversified U.S. stocks
[v] total risk is reduced by over 60 percent
[y] increases in the price of oil and raw materials have a negative effect on Europe, Japan, and even the United States,
[y] oil price increases have a very positive effect on Indonesia and oil-producing countries in the Middle East.
[y] international diversified portfolio tends to be less risky than the one drawn purely from U.S. stocks
[y] EAFE (developed foreign country
[y] The paradoxical result of this analysis is that overall portfolio risk is reduced by the addition of a small amount of riskier foreign securities.
[y] the creation of analytical tools to measure risk and, with such knowledge, reap greater rewards.
[y] all stocks tend to move up and down together
[o] what part of a security’s risk can be eliminated by diversification and what part cannot. The result is known as the capital-asset pricing model
[t] no premium for bearing risks that can be diversified away
[j] adjusting their portfolios with a risk measure known as beta
[y] remaining variability in a stock’s returns is called unsystematic risk and results from factors peculiar to that particular company
[z] beta is the numerical description of systematic risk.
[j] The beta calculation is essentially a comparison between the movements of an individual stock (or portfolio) and the movements of the market as a whole.
[o] Professionals call high-beta stocks aggressive investments and label low-beta stocks as defensive.
[s] systematic risk cannot be eliminated by diversification
[y] The chart shows that as we add more securities, the total risk of our portfolio declines, especially at the start.
[o] When thirty securities are selected for our portfolio, a good deal of the unsystematic risk is eliminated, and additional diversification yields little further risk reduction.
[z] A portfolio of sixty or more stocks with an average beta of 1½ would tend to be 50 percent more volatile than the market.
[v] securities with extra risk without the expectation of extra reward. But not all of the risk of individual
[y] The unsystematic part of the total risk is easily eliminated by adequate diversification. So there is no reason to think that investors will receive extra compensation for bearing unsystematic risk.
[y] Before the advent of the capital-asset pricing model, it was believed that the return on each security was related to the total risk inherent in that security.
[o] new theory says that the total risk of each individual security is irrelevant
[j] only the systematic component that counts as far as extra rewards go
[z] Because stocks can be combined in portfolios to eliminate specific risk, only the undiversifiable or systematic risk will command a risk premium.
[y] a number of different expected returns are possible simply by adjusting the beta of the portfolio
[j] beta came into high fashion in the early 1970s
[y] imprimatur
[v] Shakespeare’s Henry IV, Part I, Glendower boasts to Hotspur, “I can call spirits from the vasty deep.” “Why, so can I, or so can any man,” says Hotspur, unimpressed. “But will they come when you do call for them?
[b] essentially no relationship between the return of these decile portfolios and their beta measures
[o] The financial community is not ready to write an obituary for beta at this time.
[t] probably impossible) to measure beta with any degree of precision
[z] when the market index (against which we measure beta) is redefined to include human capital and when betas are allowed to vary with cyclical fluctuations in the economy, the support for the CAPM and beta as a predictor of returns is quite strong
[y] arbitrage pricing theory (APT)
[o] the systematic elements of risk in particular stocks and portfolios may be too complicated to be captured by beta
[b] the laborer in a Ford plant will find that holding Ford common stock is particularly risky, because job layoffs and poor returns from Ford stock are likely to occur at the same time.
[o] stocks tend to suffer as interest rates go up
[y] Two factors are used in addition to beta to describe risk. The factors derive from their empirical work showing that returns are related to the size of the company (as measured by the market capitalization) and to the relationship of its market price to its book value.
[y] highly profitable companies with persistent profit margins have tended to be successful companies in the future.
[y] It appears that the only way to obtain higher long-run investment returns is to accept greater risks.
[y] My own guess is that future risk and factor measures will be even more sophisticated—not less so.
[y] decisions with the objective of maximizing their wealth and are constrained only by their tolerance for bearing risk
[o] built on the premise that stock-market investors are rational
[b] trades of irrational investors will be random and therefore cancel each other out without affecting prices
[z] smart rational traders will correct any mispricings that might arise from the presence of irrational traders
[j] Daniel Kahneman and Amos Tversky—
[y] Behavioral finance then takes that statement further by asserting that it is possible to quantify or classify such irrational behavior.
[t] four factors that create irrational market behavior: overconfidence, biased judgments, herd mentality, and loss aversion
[y] In a strict sense, the word “arbitrage” means profiting from prices of the same good that differ in two markets.
[s] hardworking arbitrageurs can smooth out irrational fluctuations in stock prices and create an efficiently priced market.
[b] remainder of this chapter explores the key arguments of behavioral finance in explaining why markets are not efficient and why there is no such thing as a random walk down Wall Street
[v] Behavioral finance, however, says that this behavior is continual rather than episodic.
[j] One of the most pervasive of these biases is the tendency to be overconfident about beliefs and abilities and overoptimistic about assessments of the future.
[y] One class of experiments illustrating this syndrome consists of asking a large group of participants about their competence as automobile drivers in relation to the average driver in the group or to everyone who drives a car.
[y] (almost) all the students consider themselves above average.
[i] another experiment involving students, respondents were asked about likely future outcomes for themselves and their roommates. They typically had very rosy views about their own futures, which they imagined to include successful careers, happy marriages, and good health. When asked to speculate about their roommates’ futures, however, their responses were far more realistic.
[j] Even in judging athletic ability, an area where self-deception would seem more difficult, at least 60 percent of the male respondents ranked themselves in the top quartile.
[t] Daniel Kahneman has argued that this tendency to overconfidence is particularly strong among investors.
[o] few investors are able to set accurate confidence intervals.
[o] If an investor tells you he is 99 percent sure, he would be better off assuming that he was only 80 percent sure.
[z] And men typically display far more overconfidence than women, especially about their prowess in money matters.
[y] many individual investors are mistakenly convinced that they can beat the market.
[y] speculate more than they should and trade too much
[o] hindsight bias. Such errors are sustained by having a selective memory of success. You remember your successful investments.
[v] Hindsight promotes overconfidence and fosters the illusion that the world is far more predictable than it really is.
[y] leads to a general tendency for so-called growth stocks to be overvalued
[o] long-term tendency of “growth” stocks to underperform “value” stocks
[t] reversion to the mean
[s] when subjects were questioned after a period of playing the game, they were convinced that they had a good deal of control over the movement of the ball.
[b] (The only subjects not under such an illusion turned out to be those who had been clinically diagnosed with severe depression.)
[v] the prices at which players were willing to sell their cards were systematically higher for those who chose their cards than for the group who had simply been given a card.
[j] violation of a fundamental axiom of probability theory (the conjunction rule): the probability that somebody belongs to both category A and category B is less than or equal to the probability that she belongs to category A alone
[o] underuse of base-rate probabilities
[y] requires knowledge about base rates—that is, the percentage of people who are criminals
[y] research shows that groups tend to make better decisions than individuals.
[y] wisdom of crowd
[o] individual decisions by consumers and producers leads the economy to produce the goods and services that people want to buy
[z] demand and supply
[s] there is a madness to crowd behavior, as we have seen from seventeenth-century tulip bulbs to twenty-first-century Internet and meme stocks.
[z] of “group think.” Groups of individuals will sometimes reinforce one another into believing that some incorrect point of view is, in fact, the correct one. Surely, the wildly overoptimistic group forecasts
[y] Asch added a diabolical twist to the experiment. In some of the experiments, he recruited six of the seven participants to deliberately give the wrong answer and to do so before the seventh participant had a chance to express an opinion
Solomon
[o] determine whether people gave in to the group knowing that their answers were incorrect or whether their perceptions had actually changed
[s] it appeared that what other people said actually changed what subjects believed they saw.
[y] look up at an empty sky for sixty seconds
lol
[o] mutual-fund managers were more likely to hold similar stocks if other managers in the same city were holding similar portfolios
[y] epidemic model
[z] One of the most important lessons of behavioral finance is that individual investors must avoid being carried away by herd behavior.
[j] Kahneman and Tversky’s most important contribution is called prospect theory, which describes individual behavior in the face of risky situations where there are prospects of gains and losses.
[b] Losses are considered far more undesirable than equivalent gains are desirable.
[v] “how the choice is framed.
[s] Kahneman and Tversky concluded that losses were 2½ times as undesirable as equivalent gains were desirable.
[i] In the face of sure losses, people seem to exhibit risk-seeking behavior.
[y] “framing” effect.
[y] Investors find it very difficult to admit, even to themselves, that they have made a bad stock-market decision.
[y] On the other hand, investors are usually quite proud to tell the world about their successful investments that produced large gains.
[o] These emotions of pride and regret may be behind the tendency of investors to hold on to their losing positions and to sell their winners.
[v] clear disposition among investors to sell their winning stocks and to hold on to their losing investments. Selling a stock that has risen enables investors to realize profits and build their self-esteem
[j] Even if the investor believed that his losing stock would recover in the future, it would pay to sell the stock and purchase a stock in the same industry with similar prospects and risk characteristics.
[t] Individuals weigh these losses much more heavily than gains.
[j] if the problem is framed differently, so that one must actively “opt out” of the savings plan, participation rates will be much greater
[t] The arbitrageur could conceivably lose on both sides of the trade.
[o] The market can remain irrational longer than the arbitrageur can remain solvent.
[z] Sophisticated speculators such as hedge funds were not a correcting force during the bubble period. They actually helped inflate the bubble by riding it rather than attacking it.
[b] there are also times when short selling is not possible or at least severely constrained
[y] For an arbitrage to be effective, there must be a similar fairly priced security that can be bought to offset the short position and that can be expected to rise if some favorable event occurs that influences the whole market or the sector to which the security belongs.
[o] old adage about the game of poker: If you sit down at the table and can’t figure out who the sucker is, get up and leave because it’s you
[t] in the game of amateur tennis, most points are won not by adroit plays on your part but rather by mistakes on the part of your opponent.
[j] Just as the tennis amateur who simply tries to return the ball with no fancy moves is the one who usually wins, so does the investor who simply buys and holds a diversified portfolio comprising all of the stocks that trade in the market.
[s] what had drawn their attention to the stock they had most recently purchased. A typical response was that a personal contact, such as a friend or relative, had recommended the purchase
[t] social households—those who interact with their neighbors, or attend church—are substantially more likely to invest in the market than nonsocial households
[o] Any investment that has become a topic of widespread conversation is likely to be hazardous to your wealth.
[i] The media tend to encourage such self-destructive behavior by hyping the severity of market declines and blowing the events out of proportion to gain viewers and listeners.
[y] investors tend to put their money into mutual funds at or near market tops
[o] may avoid taxes completely if stocks are held until distributed as part of one’s estate
[y] Warren Buffett: Lethargy bordering on sloth remains the best investment style. The correct holding period for the stock market is forever
[z] average household in the sample earned an annual return of 16.4 percent, while the market returned 17.9 percent. In contrast, the annual return to the portfolio of households that traded the most was only 11.4 percent
[b] men tended to be more overconfident and trade far more frequently than women.
[v] The source of women’s superior returns was the way they trade, or more accurately, their propensity not to trade.
[s] The hot IPOs are snapped up by the big institutional investors or the very best wealthy clients of the underwriting firm.
[i] “I do not know of anybody who has done it [market timing] successfully and consistently.”
[o] three new investment strategies are called smart beta, risk parity, and ESG investing
[t] the core of every investment portfolio should consist of low-cost, tax-efficient, broad-based index funds
[s] the risk of the market can be measured by beta and that the beta of the market is defined to have a value of 1
[y] there have been long periods when stocks did poorly and produced inferior returns compared with safe assets. During the nine years from March 2000 to March 2009, stock prices actually declined
[j] Sharpe Ratio
[o] William Sharpe, one of the developers of the capital-asset pricing model (CAPM)
[o] strategy A is preferred because it has a higher Sharpe Ratio
[s] investors tend to be overconfident in their ability to project earnings growth and thus overpay for “growth” stocks
[z] Because earnings growth is so hard to forecast, it’s far better to be in low-multiple stocks.
[y] historical evidence that a portfolio of stocks with relatively low earnings multiples (as well as low multiples of book value, cash flow, and/or sales) produces above-average rates
[j] It is possible to purchase portfolios that divide the broad stock-market portfolio into two components—the “value” and the “growth” components. The “value” component holds those stocks with the lowest price-earnings and price-to-book ratios.
[t] Another pattern that academic investigators have found is the tendency over long periods of time for small-company stocks to generate larger returns than large-company stocks.
[o] found that a sequence of random numbers had the same appearance as a time series of stock prices.
[j] recent work has indicated that the random-walk model does not strictly hold. Some patterns appear to exist in the development of stock prices. Over the short holding periods, there is some evidence of momentum in the stock market
[o] Investors can use this fact to fashion a variety of “betting against beta” portfolio strategies.
[y] there are ETFs that tilt the portfolio toward stocks that are exhibiting relative strength compared with the whole market.
[z] we have considered employing factor tilts (or flavors) such as “value,” “size,” and “momentum” singly in constructing portfolios
[s] momentum factor is negatively correlated with the market beta, value, and size factors
[t] decades ending in 2022 when “value” stocks severely lagged the returns of “growth” stocks
[o] avoids this so-called “inefficiency” by adjusting the weight of each stock to its economic footprint such as earnings, assets, and the like. He calls this “Fundamental Indexing.”
[v] nine basis points (9/100 of one percent)
[o] weighting each stock in an index equally, rather than by its total capitalization, an investor can obtain similar results to those from some of the multifactor models
[z] Equally-weighted portfolios have different diversification and risk characteristics than capitalization-weighted portfolios. They are also tax inefficient.
[o] In general, the records of “smart beta” funds and ETFs have been spotty.
[j] Investors should be aware that if any factor becomes richly priced, as “smart beta” funds become increasingly popular, the results could well be disappointing.
[o] the work environment that Dalio created at Bridgewater has been described as toxic
[t] “risk parity” investment techniques. The evidence-based principle on which it rests is that relatively safe assets often provide higher returns than are appropriate for their level of risk
[o] Investors can therefore improve their results by leveraging low-risk assets, buying them with some borrowed money, so as to increase their risk and return.
[i] people underbet favorites and overpay for long shots with the possibility of winning big.
[o] 60 percent stocks and 40 percent bonds or use the 60/40 benchmark as a proxy for their performance benchmark
[o] Thus far we have illustrated risk-parity portfolios using only two asset classes: stocks and bonds. In practice, risk-parity portfolios will include a number of asset classes.
[j] in the early 1980s U.S. Treasury bonds had double-digit yields. In 2020, 10-year Treasury yields were less than one percent
[z] The actual historical results for the Bridgewater All Weather (12% strategy) Fund is shown in the table below. The fund did not produce returns higher than a Vanguard Balanced Index Fund and its Sharpe ratio was considerably lower.
[b] Risk-parity portfolios are clearly not optimal in all economic circumstances. Nevertheless, the use of leverage is one investment technique that needs to be in the investor’s tool box.
[v] risk parity should not be considered as simply a leveraged bet on holding fixed-income securities. Rather the technique should be judged as being appropriate in some circumstances for investors who hold a broadly diversified portfolio (including international securities) and wish to enhance the entire portfolio’s return and risk with the use of leverage
[y] “You can do well by doing good.”
[o] some correlations between the credit ratings of Standard and Poor’s and Moody’s is over 0.99.
[t] Apple gets a high ESG rating of 73 out of 100 from Refinitiv.
[y] assuaged
[o] popularity of ESG investing has led many companies to a practice of “greenwashing.”
[y] Only DSI has a long-run performance record. Over the ten-year period ending in 2022, the fund underperformed the broad-based index fund VTSAX. It is also far from clear that the holdings in these funds are all worthy of ESG merit.
[o] In trying to do well by doing good, you may achieve neither objective.
[z] High net worth investors might consider adding a multifactor smart beta offering or a risk-parity portfolio to the overall mix of their investments.
[o] The embedded cost of borrowing through derivatives is typically lower than the cash financing rate.