Risk, Return, and Knowing Who You Are

FNCE 455Class Session #1Lloyd KurtzSanta Clara University

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Topics

• Course Overview

• Knowing Who You Are

• Risk

• Return

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Course Overview

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Introductory items

• Who is this guy?

• Any calendar details we need to know about?• Yes, no class 4/18 or 5/28

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Three main objectives

• Introduce you to a standard body of investment knowledge• Learning objectives in Syllabus

• Teach you how to analyze investments

• Help you make good decisions about your own finances

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Class content

• First Half – Elements and Theory• Elements of Investing (this week)• Portfolio Diversification• Asset Pricing• Market Efficiency

• Second Half – Practice• Fixed Income and REITS• Equities• Options

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The books

• Bodie, Kane, and Marcus• Standard comprehensive text• Provides basic course structure• Efficient markets perspective• Aware of practitioners (CFA Institute)• Updated for events of 2008-09

• Fox• Intellectual history of financial theory• Provides depth and context for material presented in

BK&M• Helps explain events of 2008-09

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The books (continued)

• Graham and Zweig• ‘The best book about investing ever written.’

- Warren Buffett

• Value investment perspective• Provides three additional viewpoints

• Graham - influential value investor• Buffett – Graham’s most famous disciple• Zweig – modern financial journalist

• Greenblatt• How-to guide by a modern practitioner• Brief and clearly written• Includes access to an online quantitative model

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Angel

• Syllabus will be online

• Course managed primarily through ‘Lessons’ tab

• One folder per class session

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Your grade

• Mid-Term* 30%• Written Assignments 35%• Final Exam* 35%

* Exams are non-cumulative and open book/open note. Questions will focus primarily on the Learning Objectives (see syllabus).

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Investment game

• Log into StockTrak and register to play• URL: http://tinyurl.com/84nyqdv• Discount coupon in Bodie, Kane, & Marcus book?

• Make a plan

• Invest your money!• Trading begins: 4/9/2012• Trading ends: 6/8/2012

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Advice

• Consider asset allocation issues

• Take advantage of what you know

• Consider your temperament

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Knowing Who You Are

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Why it’s important

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“If you don’t know who you are, the market is an expensive place to find out.”– George Goodman writing as ‘Adam Smith’

“[T]he investor’s chief problem – and even his worst enemy – is likely to be himself.”– Graham, p. 8

Ways to think about who you are

•Questionnaire Approach

•Life Cycle Approach

•Investor Temperament Approach

•Cognitive Illusions

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Questionnaire approach

• “Time for Investing’s Four-Letter Word” in BK&M, pages 700-701

• Example on Angel

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Problems with questionnaires

• Behavior is self-reported

• Hypothetical situations are often unrealistic

• Risk tolerances change over time

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Life cycle approach

• Early Career• Maximum tolerable risk and return

• Mid-Career• Moderating appetite for risk

• Late-Career (Brink of Retirement)• Sharply reduced appetite for risk

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Adapted from Robert D. Milne, “Determination of Portfolio Policies: Individual Investors” in Managing Investment Portfolios: A Dynamic Process

Careful Impetuous

Confident Individualist Adventurer

Anxious Guardian Celebrity

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Investor temperament

Adapted from Ronald W. Kaiser, “Individual Investors” in Managing Investment Portfolios: A Dynamic Process

Method of Action

Level of

Confidence

More on the types• Adventurers

• “Typically entrepreneurial and strong-willed…”• Focused on the main chance, they often resist diversification.

• Celebrities• “Celebrities are fashion followers who are worried about being left out… As a result

they are the best prey for maximum turnover brokers.”• Need to be ‘saved from themselves.’

• Individualists• “Strong-willed and confident, but not rash…”• “They are often contrarian investors because they do sit back and think about where

they want to go and which investments make good value sense…”

• Guardians• “Guardians are people who are cautiously trying to preserve their wealth.”• Tend to be highly loss averse.• May be too conservative, focus too much on cash and bonds.

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Cognitive illusions: are you immune?

1) A bat and a ball cost $1.10 in total.  The bat costs $1.00 more than the ball.  How much does the ball cost?

2) If it takes five machines five minutes to make five widgets, how long would it take 100 machines to make 100 widgets?

3) In a lake, there is a patch of lilypads.  Everyday, the patch doubles in size.  If it takes 48 days for the patch to cover the entire lake, how long would it take for the patch to cover half of the lake?

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Adapted from Shane Frederick, “Cognitive Reflection and Decision Making”, Journal of Economic Perspectives, Fall 2005.

Answers

• 1) 5 cents

• 2) five minutes

• 3) 47 days

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Risk

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The first assumption

You can’t earn superior returns unless you are willing to assume greater risk.

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The first assumption (cont’d)

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“Risk aversion implies that investors will accept a lower reward (as measured by their portfolio expected return) in exchange for a sufficient reduction in risk (as measured by the standard deviation of their portfolio returns).”

- Bodie, Kane & Marcus, p.121

Risk has multiple dimensions• Volatility

• The primary risk metric in the BK&M text.

• Liquidity • “[T]he speed and ease with which an asset can be sold and still

fetch a fair price.” - BK&M p. 704

• Costs / Cash Flows• “Don’t buy nuttin’ what eats.” - Kenneth Fisher

[Translation: Don’t invest in things that will require indeterminate additional cash commitments in the future.]

• Valuation• “Risk is not inherent to an investment; it is always relative to the

price paid.” – Seth Klarman

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Risk can be a relative term…

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Standard Deviation of Annual Returns, 1926-2008

Source: SBBI 2009 Yearbook

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The trade-off between risk and returns of a potential investment portfolio

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“Risk”

Ret

urn

Return

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Rates of return: single period

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P

DPPHPR0

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HPR = Holding Period Return

P0 = Beginning price

P1 = Ending price

D1 = Dividend during period one

Rates of return: single period

Ending Price = 48.00

Beginning Price = 40.00

Capital Gain = 8.00

Dividend = 2.00

HPR = (8.00 + 2.00 )/ (40.00) = 25%

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Costs of trading

• Commission: fee paid to broker for making the transaction

• Spread: cost of trading with dealer• Bid: price dealer will buy from you• Ask: price dealer will sell to you• Spread: ask - bid

• Combination: on some trades both are paid

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Rates of return: single periodWith commissions and taxes

Ending Price = 48.00Less 1% Commission = 47.52

Beginning Price = 40.00Add 1% Commission = 40.40

Capital Gain Before Commission = 8.00Capital Gain After Commission = 7.12

Capital Gain After 15% Tax = 6.05

Dividend = 2.00Dividend Taxed at 15% = 1.70

HPR = (6.05 + 1.70 )/ (40.40) = 19%

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Ending Price = 48.00Less 1% Commission = 47.52

Beginning Price = 40.00Add 1% Commission = 40.40

Capital Gain Before Commission = 8.00Capital Gain After Commission = 7.12

Capital Gain After 15% Tax = 6.05

Dividend = 2.00Dividend Taxed at 15% = 1.70

HPR = (6.05 + 1.70 )/ (40.40) = 19%Less 3% Inflation = 16%

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Rates of Return: single periodWith commissions, taxes, and inflation

Focus on net real returns

Returns should be evaluated in the context of:• The costs incurred to achieve them• The rate of inflation• The risk incurred

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Adjusting portfolio returns for risk

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Sharpe Ratio = Risk PremiumSD of Excess Return

For more on the Sharpe ratio, see Bodie, Kane, & Marcus, p. 121.