Chapter One

1. Chapter One • Introduction of Portfolio Theory

2. Part One The asset classes

3. Basic principles • There are many asset classes and many of them are useful to investors. • Some asset classes are noted for their long term stability (low risk), others for their high returns. • Generally speaking, the higher the reward you are after, the more risk you’ll need to take. • Portfolios can be constructed that exhibit superior risk and return relationships to any single asset, because one can significantly reduce risk by diversification.

4. Why risk and return are linked

5. When two investments appear to offer identical risk, investors will prefer to buy the higher returning one. If the market is peopled by reasonably well informed investors, there simply won’t be any high returning low risk investments left and nobody will buy high risk assets with a low expected return.

6. In a portfolio construction context “risk” is usually measured with some sort of measure of price volatility. • There are other risks of course that need to be taken into account.

7. Inflation risk is a major problem with the more “conservative” asset classes such as fixed interest and cash. Many pensioners find to their horror that they can no longer live off their savings, despite the conservatism of their strategy, simply because inflation devalued their money and the portfolio did grow enough to keep up. • It is necessary for all but the most short term oriented investors to consider at least some exposure to growth assets like shares and property, just to fight inflation.

8. Major asset classes: shares • Shares are part interests in businesses. How good a return you get on your share depends to a large extent on the fundamental business developments of the company itself and on the price you paid for the share.

9. Averaged out over many companies, shares as an asset class tend to respond to interest rates and the economy. • Although in the last few years many markets have fallen substantially, shares are still the highest performing asset class over the long term.

10. Shares generally go up in price over the long term because businesses don’t pay out 100% of their profits as dividends, they keep some to grow the value of the business itself. • Over the long term, shares have beaten inflation.

11. Major asset classes: property • There are many types of property to invest in, each are different. • The highest income yield comes generally from commercial and industrial property.

12. Major asset classes: fixed interest • A “fixed interest” investment is a debt that can be bought and sold. • The borrowers are usually governments and companies. A typical fixed interest investment pays a regular “coupon” (interest payment) and will repay the principle on maturity.

13. Some fixed interest securities have a maturity of several decades, others are shorter term. • The actual price of a fixed interest investment will fluctuate in response to many things, most particularly interest rates. If general interest rates fall, the price of a long term fixed interest security will usually rise such that the “yield to maturity” is similar to those of other investments with a similar risk. On the other hand, if interest rates rise, fixed interest investments fall.

15. Major asset classes: cash • “Cash” may mean currency, but in an investment context cash is just a really short term highly liquid fixed interest investment. • Longer term fixed interest investments are usually called “bonds”, shorter term fixed interest investments may be called “notes” and really short term ones are often called “bills”.

16. Cash management trusts usually invest in a portfolio of high quality short term fixed interest investments. Because of the short maturity, these fixed interest investments are not as sensitive to interest rate changes and thus don’t have a great deal of capital volatility.

17. Other asset classes • Shares, property, bonds and cash are the major asset classes, but there are many others to choose from.

18. Hedge funds are sometimes called a distinct asset class as they pursue unconventional strategies that give them performance very different to the asset classes that they invest in.

19. “Private equity” is basically a shares investment, but in companies not listed on a stock exchange. • Agribusinesses are agricultural investments in things like tree farms and vineyards.

20. Some people also consider commodities like gold to be an asset class of its own, and many people consider collectibles, race horses and fine wines to be useful alternative investment asset classes.

21. The point of portfolio construction • A portfolio is often more than the sum of its parts. Because not all asset classes perform the same way over the short term, a portfolio of many asset classes usually offers a superior overall relationship between risk and return to any single asset

22. A portfolio consisting only of shares would have done badly in the last few years since the market crashed, but property has performed very well. This is quite typical, more “defensive” asset classes often do well when equities are falling.

23. A diversified portfolio has a reasonable long term growth rate because over time all asset classes offer a positive return, but being invested across different asset classes smooths out returns and offers a more predictable growth rate.

24. Part Two Creating diversified portfolios

25. How diversification reduces risk There are two mechanisms by which diversification reduces risk: dilution and interference. • Dilution is easy to understand, if you swap half your shares for cash then you lose half your equity exposure and therefore half your equity risk. If the market crashed tomorrow you’d only lose half as much

26. “Interference” is where negative movements in some assets are partly cancelled by positive ones in other assets. A good example is with property vs. shares, in the recent bear market in shares property did very well while shares did badly, the opposite may be true in the next few years.

27. Interference and correlation “Correlation” is the word given to the extent to which assets move together, this is measured with statistical formulae. Correlations can range from -1 (perfectly negatively correlated) through to +1 (perfectly positively correlated).

28. If asset B tends to move in the opposite direction to asset A then these two assets are said to have “negative correlation”, and they can be highly effective at cancelling out each other’s volatility. If the assets both trend upwards over the longer term a combination of them will have a return equal to the average of the two assets’ returns but with substantially reduced volatility.

29. the greatest Negatively correlated assets cancel most amount of each other’s volatility.

30. Negative correlation isn’t essential • Assets don’t need to be negatively correlated to have some volatility smoothing. • As long as the correlation is less than +1 the assets will be at least a little bit different and at least some volatility will be cancelled.

31. Most real world assets are positively correlated because most prices are related somehow to important “macro”factors like global economic growth, interest rates, oil prices etc. • Even if negative correlations are rare, substantial volatility reduction is possible by using assets with a low positive correlation.

32. The “efficient frontier” is the name given to the line that joins all portfolios that have achieved a maximum return for a given level of risk (portfolios that are “efficient”). If you chart every possible portfolio that could be constructed out of a group of assets and plotted a point on a risk vs. return chart, the resulting plot usually looks much like the chart in next slide. The top of the curve is the efficient frontier, anything below that curve is an “inefficient” portfolio, anything actually on the curve, or close to it, is an “efficient” portfolio

34. Efficient vs. inefficient portfolios • It is impossible to predict in advance which portfolios will be the most efficient as this would require knowing in advance asset class performance and correlations • A portfolio that has been diversified into a variety of asset classes should be close to efficient over the longer term, provided it is rebalanced regularly.

35. Rebalancing • Rebalancing a portfolio is the process of adjusting a portfolio to bring it back to its original asset allocation. • Since assets perform differently at different times, the portfolio is likely to drift from your desired asset allocation. • Failure to rebalance means that a portfolio can change risk profile over time and may no longer be appropriate.

36. A few simple rules of portfolio construction • If you have two assets with roughly equal expected returns, putting 50% into each is a way to hedge one’s bets (and spread the risk) without compromising expected return at all. The lower the correlation of those assets, the more the risk will be reduced

37. If   1 1,2  1/21 + 1/22 Mean of X1 Mean of X2 Where P = ½ [X1] + ½ [X2]

38. If  = 1 Then all the portfolios are here

39. If   1 • Then all the portfolios are here

40. This Means the “boundary”of the possible portfolioslooks like this

41. Mean Maximizes Utility Standard Deviation

42. Combine with Risky Assets Mean ? Risky Assets Risk Free Asset Standard Deviation

43. Mean Risk Free Asset Standard Deviation

44. Actually, this holds true with a greater number of investments. If you have 5, 10 or 1,000 assets • There is such a thing as “diversifiable” risk, as you add extra assets to the portfolio the volatility tends to decrease – but only up to a point. When a portfolio reaches a certain level of diversification the only way to reduce risk is to add lower risk assets which will reduce volatility by dilution, this usually reduces the return

45. Diversification can also increase returns A higher return may often be obtained from rebalancing the portfolio as a result of “reversion to the mean”. If you believe that at some point in the future two assets will give the same cumulative return then it would make sense to invest in the asset class with the worst recent performance and sell the one with the best performance!

46. Rebalancing does precisely this, although it is normally seen only as a risk management technique. This is why the diversified portfolio did a little better than all three component asset classes. A small “rebalancing premium” is quite common because last year’s worst performing asset class often outperforms last year’s best performing asset class this year.

47. Pushing out the efficient frontier • Investors desire higher returns with lower risk. There is however a limit to what can be achieved with a particular set of assets, that limit is drawn on charts as the efficient frontier. • By adding more assets we can change the shape of the efficient frontier. Assets carry two items of interest to us, their returns and their correlation with the rest of the portfolio.

48. Refining our asset allocation • There is wide acceptance that so-called “value” stocks outperform “growth” stocks, and “small companies” tend to outperform “large companies”, at least over the longer term

49. Their higher long term performance is very interesting, but so too is the fact that they often have a low correlation to large growth companies, the dominant stocks in the market. • They provide what asset allocation is independent source of risk and return. This may enable us to improve the efficient frontier.

50. The stock market is dominated by what would be classified as “large growth companies”, also known as “blue chips”. 蓝筹 As a portion of market capitalisation, the very largest companies dominate the market and so an exposure in market weightings tends to have a very small amount of small company and value exposure