(Modern Portfolio Theory Review)

Transcription

1 (Modern Portfolio Theory Review) IFS-A76898 Charts 1-9 Reminder: You must include the Modern Portfolio Theory Disclosure pages with all charts you select to use, either individually or as a group. Information as of December 31, 2002 unless otherwise noted

2 Expectations for Return & Tolerance for Risk More Conservative Moderate More Aggressive Moderately Aggressive Very Aggressive Return Moderately Conservative Very Conservative This chart is for illustrative purposes only and does not reflect the performance of any specific investment. IFS A76898 Chart #1 Risk Using CAPM

3 Modern Portfolio Theory Review Modern Portfolio Theory Review Efficient Frontiers Efficient Frontier D B Targeted Return E C A Inefficient Portfolio For illustrative purposes only. This does not reflect the performance of any specific investment. See Disclosure Page IFS A76898 Chart #2 Standard Deviation

4 Modern Portfolio Theory Review Capital Asset Pricing Model CAPM Efficient Frontier Targeted Return X Market Portfolio Risk Free Rate For illustrative purposes only. This does not reflect the performance of any specific investment. See Disclosure Page IFS A76898 Chart #3 Risk

5 Modern Portfolio Theory Review Risk Specific Risk Standard Deviation Diversifiable Risk Total Risk Market Risk/Systematic Risk For illustrative purposes only. This does not reflect the performance of any specific investment. See Disclosure Page IFS A76898 Chart #4 Number of Holdings

6 Modern Portfolio Theory Review Excess Returns Manager A Return Passive Index Risk When using Beta: Manager A - Passive Index = Alpha For illustrative purposes only. This does not reflect the performance of any specific investment. See Disclosure Page IFS A76898 Chart #5 When using Standard Deviation: Manager A - Passive Index = Incremental Return

7 One Standard Deviation Mean Return 68% of Observations -1 Standard Deviation This chart is for illustrative purposes only and does not reflect the performance of any specific investment. IFS A76898 Chart #6 +1 Standard Deviation

8 Two Standard Deviations Mean Return 95% of Observations -2 Standard Deviation This chart is for illustrative purposes only and does not reflect the performance of any specific investment. IFS A76898 Chart #7 +2 Standard Deviation

9 Diversification & Its Effect on Risk Negative Correlation Return % period 1 period 2 period 3 period 4 period 5 period 6 For illustrative purposes only. This does not reflect the performance of any specific investment. See Disclosure Page IFS A76898 Chart #8 Asset A _ Asset B 50% A/ 50% B X

10 Diversification & Its Effect on Risk Positive Correlation Positive Correlation Return % period 1 period 2 period 3 period 4 period 5 period 6 Asset A Asset B 50% A/ 50% B For illustrative purposes only. This does not reflect the performance of any specific investment. See Disclosure Page IFS A76898 Chart #9

11 Disclosure Page For illustrative purposes only. This does not reflect the performance of any specific investment. Securities products & investment advisory services offered through Prudential Securities, 199 Water Street, New York, NY , Member SIPC & Prudential Financial Planning Services which is a division of PruCco Securities, 751 Broad Street, Newark, NJ Member SIPC. Pruco Securities & Prudential Securities are both Prudential companies. ALPHA: A measure of the manager s relative value added as compared to a blended market index. The alpha measures the riskadjusted return above (+) / below (-) the security market line. The security market line represents the blend between U.S. T- bills and a market index. A positive alpha implies that the manager has added value to the return of the portfolio over that of the market. Returns with negative alpha do not reflect any positive contribution by the manager over the performance of the market. An alpha of zero implies that a manager has provided a return that is equivalent to the market return for the manager s specific risk class. Alpha does not factor in volatility risk. Alpha assumes the manager is fully diversified. Alpha will vary from quarter to quarter, so the alpha of any five-year period should be used carefully. Alpha = Return - (Beta x Index Return) BETA: Beta is a measure of how a manager s portfolio has performed in relationship to the market (market or systematic risk). A manager that has performed directly in line with the market will have a beta of A manager whose returns were more volatile than the market will have a beta of greater than 1.00, and a manager with less volatile returns will have a beta of less than Disregarding the impact of stock selection (unsystematic risk), over 3-5 year, we expect a fully diversified portfolio with a beta of 1.20 to have about a 20% higher return than the market. Similarly, for a portfolio with a beta of.80, we expect a 20% lower return than the market over time. Page 1 out of 2

12 R-SQUARED: R-squared measures how well a portfolio is diversified against the market index. The more diversified a portfolio is, the less risk related to an individual security (unsystematic risk) it has. R-squared values can range from 0 to 1.00, with the market index at 1.00 For a portfolio with an R-squared of.90, 90% of the portfolio risk can be attributed to being in the market (systematic risk). The remaining 10% is associated with company/issue specific (unsystematic) risk. Higher R- Squared values indicate more reliable alpha and beta statistics and are useful in assessing a manager s investment style. STANDARD DEVIATION: Standard deviation measures the volatility of a portfolio s returns compared to the average return of the portfolio. Approximately 68% of the time, the total return will vary from its average total return by no more than plus or minus the deviation figure. Since it measures total variation of return, standard deviation is a measure of total risk, unlike beta, which measures market risk. CORRELATION: This statistic measures how well a portfolio s returns have moved in tandem with an index or other portfolios. Correlation coefficients fall between and A correlation coefficient of 1.00 between a portfolio and an index means that the portfolio returns have moved in perfect tandem with the index. (If the index goes up, the portfolio goes up). A correlation coefficient of means that the portfolio returns have moved in perfect negative tandem with the index. (If the index goes up the portfolio goes down). Page 2 out of 2