Risk, Uncertainty, & MPT: Rethinking Risk, Diversification & Asset Allocation

Transcription

1 Risk, Uncertainty, & MPT: Rethinking Risk, Diversification & Asset Allocation Hal Ratner CIO-Europe Morningstar Investment Management Europe November 13, Morningstar. All Rights Reserved. These materials are for informational and/or illustrative purposes only. Morningstar Investment Management is a division of Morningstar, which includes Morningstar Associates, LLC, Morningstar Investment Services, Inc., and Ibbotson Associates, Inc., all registered investment advisors and wholly owned subsidiaries of Morningstar, Inc. All investment advisory services described herein are provided by one or more of the registered investment advisor subsidiaries. The Morningstar name and logo are registered marks of Morningstar. This presentation includes proprietary materials of Morningstar. Reproduction, transcription or other use, by any means, in whole or in part, without the prior, written consent of Morningstar is prohibited. For financial professional use only

2 Investors

3 Core Investment Principles Investors People invest to consume they don t derive utility from wealth People derive utility from expected consumption To the degree anyone derives utility from current wealth it is solely because of its connection to planned consumption 3 For financial professional use only. Not for public distribution.

4 Investors: Balance Sheet Assets Financial Capital Human Capital PV of Earnings used for Pre-Retirement Expenses PV of Earnings directed toward Savings PV of future Social Security and Pensions Liabilities Future Expenses PV of Pre-Retirement Expenses PV of Post-Retirement Expenses PV of Bequest Surplus (Deficit) What is the true risk of any portfolio that exists to pay for a liability? It is NOT the standard deviation of the asset portfolio It is NOT the performance of your asset portfolio relative to the asset portfolios of your peers The TRUE risk is that it won t be able to pay for the liability! 4 For financial professional use only. Not for public distribution.

5 Investors: Understanding Total Economic Wealth Tradable Financial Capital An individual s total saved assets Includes tradable assets such as stocks and bonds Non-Tradable Human Capital An individual s ability to earn and save Includes skills embodied within one s education, intelligence, charisma, and experience 5 For financial professional use only. Not for public distribution.

6 utility Investors: Risk Aversion Investor with Moderate Risk Aversion High U(C) Utility B C Low A $0 $10 $20 $30 $40 $50 $60 consumption Consumption Source: Morningstar Associates, LLC. For illustrative purposes only. 6 For financial professional use only. Not for public distribution.

7 Investors in the Market 7 For financial professional use only. Not for public distribution.

8 Core Investment Principles Risk Management How do we define risk management? Estimating the probability distribution of events Assigning subjective values to each probability-weighted event (e.g. risk aversion) We care ONLY about risk as it is experienced by an end investor 8 For financial professional use only. Not for public distribution.

9 Confronting Risk A Stylised Illustration Define all possible Outcomes: -22,9-19,2-15,5-11,7-8,0-4,3-0,5 3,2 6,9 10,7 14,4 18,1 21,9 Quarterly Returns 9 For financial professional use only. Not for public distribution.

10 Confronting Risk A Stylised Illustration Convert each Outcome into an Event by Assigning it a Probability: 25% 22% 14% 9% 1% 1% 3% 5% 4% 4% 6% 4% 2% -22,9-19,2-15,5-11,7-8,0-4,3-0,5 3,2 6,9 10,7 14,4 18,1 21,9 Quarterly Returns 10 For financial professional use only. Not for public distribution.

11 Confronting Risk A Stylised Illustration Transform each Event into a Certainty-Equivalent Value: 25% 22% 14% 9% 1% 1% 3% 5% 4% 4% 6% 4% 2% -34,2-26,6-20,0-14,2-9,1-4,5-0,5 3,1 6,3 9,2 11,8 14,2 16,3 Certainty-Equivalent Returns 11 For financial professional use only. Not for public distribution.

12 Confronting Risk A Stylised Illustration Transform each Event into a Certainty-Equivalent Value: 12 For financial professional use only. Not for public distribution.

13 Risk versus Uncertainty 13 For financial professional use only. Not for public distribution.

14 Risk vs. Uncertainty: What Do We Know? Surprisingly little We don t know the future distribution of capital market returns We don t know the true risk capacity of our clients (nor do they) We don t know the true risk tolerance of our clients because they can rarely articulate it and it tends to be unstable Financial economics is a social science We must manage ambiguity 14 For financial professional use only. Not for public distribution.

15 Risk versus Uncertainty The possibility of saying anything about a thing rests on the assumption that it preserves its identity, or continues to be the same thing in the respect described, that it will behave in future situations as in the past Frank Knight Cost of Production & Price Over Long and Short Periods, Journal of Political Economy. vol. 29, no. 4, For financial professional use only. Not for public distribution.

16 Uncertainty The Black Swan An event that is inconsistent with past data but that happens anyway 16 For financial professional use only. Not for public distribution.

17 The Black Turkey Risk NOT Uncertainty An event that is everywhere in in the data it happens all the time but to which one is willfully blind. Laurence B. Siegel, Black Swan or Black Turkey? The State of Economic Knowledge and the Crash of , Financial Analysts Journal, July/August For financial professional use only. Not for public distribution.

18 A Flock of Turkeys Nominal price return unless otherwise specified. Asset Class Time Period Peak to Trough Decline U.S. stocks (real total return) % U.S. stocks (DJIA, daily) % Long U.S. Treasury bond (real total return) % U.S. stocks % U.K. stocks (real total return) % Gold % Oil % Japan stocks % U.S. stocks (S&P) % U.S. stocks (NASDAQ) % U.S. stocks (S&P) % Source: Laurence B. Siegel, Black Swan or Black Turkey? The State of Economic Knowledge and the Crash of , Financial Analysts Journal, July/August For financial professional use only. Not for public distribution.

19 Risk NOT Uncertainty The credit crisis of 2008 and the current European debt crisis were foreseeable events. Europe s increasing debt, declining competitiveness, aging population, and political inertia Credit crisis Increasing integration of the US mortgage market into global financial system, increased production of un-analysable securities, flawed methods of defining risk and risk premia 19 For financial professional use only. Not for public distribution.

20 An Integrated World 20 For financial professional use only. Not for public distribution.

21 An Integrated World 21 For financial professional use only. Not for public distribution.

22 An Integrated World Markets are increasingly structurally integrated 22 For financial professional use only. Not for public distribution.

23 An Integrated World Structural correlations have been rising 23 For financial professional use only. Not for public distribution.

24 An Integrated World Think Efficiency not Diversification 24 For financial professional use only. Not for public distribution.

25 Diversification is not Efficiency Simply having more securities does little if anything for efficiency You need to look at market structure A portfolio consisting of every stock (or asset class) in the world is less efficient than a portfolio of the MSCI AC World Index and Global Sovereigns 25 For financial professional use only. Not for public distribution.

26 Asset Allocation Did asset allocation fail in 2008? A) Yes B) No 26 For financial professional use only. Not for public distribution.

27 Basic Asset Allocation Worked in 2008: Stock, Bonds, Cash Asset Class Total Returns in 2008 (EUR) European Equities (43.3%) US Equities (33.7%) Asian Equities (34.1%) Global Govt 16.3% Euribor 5.1% Returns shown are hypothetical; indices (Citi GBP EuroDep 3 Mon GBP (%Total Return),IBOXX GBP Corp TR (%Total Return), MSCI Europe Ex UK GR USD GBP (%Total Return), S&P 500 TR GBP (%Total Return), and FTSE AllSh TR GBP (%Total Return) are unmanaged and not available for direct investment. Assumes reinvestment of all capital gains and dividends and does not account for transactions costs or taxes. Past performance is not indicative of future results. 27 For financial professional use only. Not for public distribution.

28 Did Asset Allocation Fail in 2008? Starting Wealth Jan 2008: 100 Very Aggressive Aggressive Moderate Conservative Europe US Asia Governments Cash Ending Wealth Dec Returns shown are hypothetical; indices (Citi GBP EuroDep 3 Mon GBP (%Total Return),IBOXX GBP Corp TR (%Total Return), MSCI Europe Ex UK GR USD GBP (%Total Return), S&P 500 TR GBP (%Total Return), and FTSE AllSh TR GBP (%Total Return) are unmanaged and not available for direct investment. Assumes reinvestment of all capital gains and dividends and does not account for transactions costs or taxes. Past performance is not indicative of future results. 28 For financial professional use only. Not for public distribution.

29 Describing Security Returns: Rethinking the Bell Curve 29 For financial professional use only. Not for public distribution.

30 Ibbotson SBBI Stocks, Bonds, Bills, and Inflation 1926 Sept 2012 $16,655 Small stocks 11.7 Large stocks 9.9 Government bonds 5.4 Treasury bills 3.6 Inflation % stock / 40% bond 8.5 $3,449 $1,193 $93 $21 $13 Returns shown are hypothetical; indices are unmanaged and not available for direct investment. Assumes reinvestment of all capital gains and dividends and does not account for transactions costs or taxes. Past performance is not indicative of future results. 30 For financial professional use only. Not for public distribution.

31 The Flaw of Averages Compound annual return % Small stocks Large stocks Government bonds Treasury bills Inflation 60% stock / 40% bond For financial professional use only. Not for public distribution.

32 Utility, Beautility, Futility Risk isn t experienced the same way by everyone. Certainty-Equivalent (MRAR) Returns at Varying Levels of Risk Aversion and Realized Risk Risk Return Return on S&P /2012 adjusted for various levels of standard deviation. 32 For financial professional use only. Not for public distribution.

33 33 For financial professional use only. Not for public distribution.