Understanding the Principles of Investment Planning Stochastic Modelling/Tactical & Strategic Asset Allocation

Transcription

1 Understanding the Principles of Investment Planning Stochastic Modelling/Tactical & Strategic Asset Allocation John Thompson, Vice President & Portfolio Manager London, 11 May 2011

2 What is Diversification and Asset Allocation?

3 Why Diversify? A Look at Risk The risk of an asset can be divided into two parts Systematic Risk (also called un-diversifiable risk, market risk, or beta risk) Unsystematic risk (also called diversifiable risk, non-market risk, or idiosyncratic risk)

4 Stock Diversification Company risk Market risk Number of stocks in portfolio Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index.

5 Asset Class Diversification Risk 14% % 10.8% 9.8% 8 9.2% 8.9% 8.7% 8.5% 8.3% Number of asset classes in portfolio Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index.

6 Diversification in Bull Markets (February 2003-October 2007) Pound Sterling Bull market $2,500 2,000 1, Stocks 50/50 Stocks portfolio Bonds 50/50 portfolio Gilts B u ll M a rk e t $2,084 $1,653 $1,274 Bear market $1, , $1, ,000 1, $ Feb-03 Oct Oct Oct Oct Oct Oct Nov Nov M ay-03 Aug-03 Nov-03 Feb-04 May-04 Aug-04 Nov-04 Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. Feb-05 M ay-05 Aug-05 Nov-0 5 Feb-06 M ay-06 Aug-06 Nov-06 Feb-07 $491 May-07 Aug

7 Diversification in Bear Markets (October 2007-March 2009) Bull market $2, Stocks 50/50 Stocks portfolio 1.2 Bonds 50/50 Stocks portfolio Gilts 50/50 portfolio 2,000 Gilts 1 Pound Sterling 0.8 1, , Bear Market $2,084 $1,653 $1,274 Bear market $1, , $1, , $ Oct Oct Oct Oct Oct Oct Nov Nov Oct-07 Nov-07 Dec-07 Jan-08 Feb-08 Mar-08 Apr-08 May-08 Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. Jun-08 Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 $491 Feb-09 Mar

8 Why Correlation Matters?

9 Correlation and Asset Allocation Correlation measures the similarity or dissimilarity of asset classes relative to one another most asset classes Range of Correlations Correlations range from -1 to 1, with most assets grouped in the moderately positive range.

10 Correlation and Asset Allocation 15% B Expected Return 10% Correlation= -1 Correlation= 0 Correlation= 1 5% A 0% 10% 20% 30% Standard Deviation

11 Asset-Class Correlations Quarterly UK US Europe Stocks Stocks Stocks Property Past performance is no guarantee of future results. This is for UK stocks 1.00 illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. The information, US stocks data, analyses, and opinions contained herein do not constitute investment Europe stocks advice 0.91 offered 0.85 by Morningstar 1.00 and are provided solely for informational purposes Morningstar. All Rights Reserved. 3/1/2010 Gilts Gilts Direct Commodities Inflation Direct Property Commodities Inflation Past performance is no guarantee of future results. Correlation ranges from 1 to 1, with 1 indicating that the returns move perfectly opposite to one another, 0 indicating no relationship, and 1 indicating that the asset classes react exactly the same.

12 Investor Behavior

13 According to a study by Alliance Bernstein, 94% of investors surveyed stated that long-term goals are an important factor in their investment decisions, however, most investors admit that they let current market conditions influence their investment decisions. Source: AllianceBernstein Global Literacy Research Program, 2006

14 Investor Behavior: Short-Term Focus Definition Inappropriately focusing on short-term risk versus long-term risk Implications Many investors talk long term but act short term Overly sensitive to interim volatility regardless of time horizon May tend to behave as though their time horizon is far shorter than it truly is

15 50% Probability Short-Term Focus: Coping with Near-Term Fluctuations Probability of losing money in the stock market % 40 45% 30 41% 32% Daily Monthly Quarterly Annually Past performance is no guarantee of future results.

16 Why Not Market Time? Market timing can lead to: High portfolio turnover Exposure to more risk Must believe in past trends repeating Be aware of concentrated returns

17 Risk of missing the best days in the market % Return 8 9.1% % 3.0% 0.9% Invested for all 5,043 trading days 1.0% 2.7% 10 best days missed 20 best days missed 30 best days missed 40 best days missed 50 best days missed 10% Return Daily returns for all 5,043 trading days Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index

18 Asset-Class Winners and Losers Past performance is no guarantee of future results. Highest return Lowest return Small stocks Large stocks International stocks Long-term government bonds Treasury bills Diversified portfolio

19 What is Asset Allocation?

20 What is Asset Allocation? Asset allocation is the strategic approach of combining asset classes such as stocks, bonds, and cash in a portfolio in order to meet the investor s goals. Stocks Cash Bonds

21 Tactical Asset Allocation Goal is to take advantage of potential short-term opportunities in the market and deviating from the strategic asset allocation Programs may include valuation techniques or momentum techniques

22 The Asset Allocation Decision Three factors determine the appropriate asset allocation over an individual s life-cycle: Risk-return tradeoff among asset classes Investor s risk preference (short-term risk aversion) Investor s risk capacity (human capital)

23 14% Return Risk Versus Return Stocks, gilts, and cash Europe stocks US stocks 10 Gilts 8 Cash UK stocks Past performance is no guarantee of future results. 0 0% Risk

24 Risk Tolerance Questionnaire Goal Guide clients to an appropriate strategic asset allocation Process Gather information Assess the client s investment profile Identify an investment strategy

25 Human Capital Human Capital Human capital is the actuarial PV of future labor income Directly affects one s capacity to take on risk with one s financial capital Human capital is used to fund: Current expenses Retirement savings Direct contributions to portfolio Defined contribution (match) Defined benefit State Pensions PV=Present Value

26 Melting Pot: Portfolio is Greater than the Sum of its Parts Risk and Return Characteristics US stocks Return: Risk: 12.0% 20.3% UK stocks Return: Risk: 8.5% 15.1% Total portfolio Return: 10.7% Risk: 10.7% Cash (90 Day) Return: Risk: 8.1% 4.1% Europe stocks Return: 12.4% Risk: 18.6% Gilts Return: Risk: 10.1% 9.7% Past performance is no guarantee of future results.

27 Asset Allocation Best Practices

28 Developing Asset Class Inputs: Overview of Building Blocks Method What does the market expect today? Incorporates relevant historical data and current expectations How much compensation do investors require for bearing additional risk? Risk premia reflected through supply side analysis What can we learn from historical experience? What historical relationships can we uncover among the asset classes

29 The Traditional Markowitz Mean-Variance Framework Expected Return MVO MVO Inputs Inputs Mean-Variance MVO Optimizer Optimizer MVO Efficient Frontier Individual Assets Standard Deviation de Finetti / Markowitz Mean-Variance Optimization (de Finetti [1940], Markowitz [1952, 1959]) Capital Market Assumptions Expected Returns Standard Deviations (Risk) Correlations

30 Mean Conditional Value-at-Risk Optimization Mean-CVaR MVO Inputs Inputs Mean-CVaR MVO Optimizer Optimizer Mean-CVaR Efficient Frontier Capital Market Assumptions Expected Returns Standard Deviations (Risk) Correlations Skewness Kurtosis Expected Return Individual Assets Conditional Value-at-Risk

31 Building Efficient Portfolios Analyze risk and return characteristics of asset classes Correlation is the key Building the efficient frontier Selecting the appropriate portfolio

32 Selecting An Appropriate Portfolio Which efficient portfolio is appropriate? Appropriate for investor s risk tolerance Matches investor s behavioral attitude towards risk Consistent with investor s time horizon Use risk tolerance questionnaire and other tools as a guide

33 Stochastic Modelling

34 Stochastic Modelling for Investors Stochastic Modelling (aka Monte Carlo analysis): randomly generating data using sampling distributions Two types of data used in financial market studies Real: observed in the real world Simulated: lab generated to simulate the real world

35 Stochastic Modelling for Investors Illustrates market impact on investment strategy Creates many scenarios Each scenario is a possible future return path The Approach Generate many possible random return scenarios Project the investor s wealth Summarise and present outcomes

36 Wealth Forecasting Without Cashflows Year Return Wealth Return Wealth 0-1,000,000-1,000, % 1,250,000-20% 800, % 1,000,000 25% 1,000,000

37 Wealth Forecasting Without Cashflows Wealth ( ) 4 95th Percentile Expected Value 5th Percentile 1 Dec 2010 Dec 2015 Dec 2020 Dec 2025 Dec 2030 Time

38 Wealth Forecasting With Cashflows Year Return Wealth Return Wealth 0-1,000,000-1,000, % 1,250,000 cashflow - 500,000-20% 800, , % 600,000 25% 375,000

39 Wealth Forecasting With Cashflows: Deterministic Method 3,000,000 2,500,000 Portfolio Income 2,000,000 1,500,000 1,000, ,000 Portfolio Balance Years

40 Wealth Forecasting With Cashflows: Deterministic Method 130,000 65,000 Portfolio Income in real terms Age

41 Why Stochastic Modelling? Typically used when there is no analytical solution Wealth forecasting with cashflows Individual wealth forecasting & asset-liability analysis Used to personalise or illustrate the uncertainty in the market Flexibility Single-period vs. multi-period Alternative objectives: Probability of short-fall

42 Case Profile: Couple Age 65 Pre-Retirement Income 100,000/year Target Retirement Income 75,000/year Pension Benefit 25,000/year Portfolio Size 1,000,000 60/40 equity/fixed income 8.8% compound return 13.2% standard deviation 3% inflation

43 Deterministic Forecast Wealth Today s Pound Sterling 1,000, ,000 10,000 Income Today s Pound Sterling 80,000 60,000 40,000 20,000 0 Pensions Longevity Chance of living longer Age in 10 3 in 4 1 in 2 1 in 4 1 in 10

44 How Stochastic Modelling Works

45 How Stochastic Modelling Works

46 today tomorrow How Stochastic Modelling Works

47 today tomorrow How Stochastic Modelling Works

48 today tomorrow How Stochastic Modelling Works

49 How Stochastic Modelling Works We draw from parameters calculated by the historical data, not from the historical data itself $ today tomorrow

50 Types of Stochastic Modelling Non-parametric (Bootstrapping) Parametric Simulation based on historical data No distribution parameter assumption made Simulation based on specific distribution assumptions (e.g., normal, lognormal, etc.) Advanced modelling with more parameters (e.g. serial correlation)

51 Case Profile: Investor at Age 45, Retirement Age 65 Pre-Retirement Income 100,000/year Savings (inflation adjusted) 10,000/year Target Retirement Income 75,000/year Pension Benefit 25,000/year Portfolio Size 300,000 60/40 equity/fixed income 8.8% compound return 13.2% standard deviation 3% inflation

52 Illustration with Conventional Approach Wealth Today s Pound Sterling Age ,000, , ,000 10,000 Income Today s Pound Sterling 80,000 60,000 40,000 20,000 0 Pensions

53 Illustration with Stochastic Modelling Wealth Today s Pound Sterling 1,000, ,156 1 in 2 100,000 Market Risk Chance of this scenario: 1 in 2 10,000 Income Today s Pound Sterling 80,000 60,000 1 in 2 40,000 20,000 0 Pensions Age

54 Illustration with Stochastic Modelling Wealth Today s Pound Sterling 1,000, ,156 1 in 2 100,000 10,000 1 in 10 Market Risk Chance of this scenario: 1 in 2 1 in 10 Income Today s Pound Sterling 80,000 60,000 1 in 2 40,000 20, in 10 Pensions Age

55 Illustration with Stochastic Modelling Wealth Today s Pound Sterling 1,000, ,156 1 in 2 100,000 10,000 1 in 10 1 in 4 Market Risk Chance of this scenario: 1 in 2 1 in 4 1 in 10 Income Today s Pound Sterling 80,000 60,000 1 in 2 40,000 20, in 10 1 in 4 Pensions Age

56 Stochastic Modelling General Rules Assumptions Simulations are only as good as what goes into the process Individual Securities Beware of any long-term illustrations that go beyond asset classes

57 The Interpretive Material Key Points An Investment Analysis Tool Produces simulations and statistical analyses that present the likelihood of various investment outcomes if certain investments are made or certain investment strategies or styles are undertaken Serves as an investor resource to evaluate potential risks and returns of investment choices

58 The Interpretive Material Key Points Advisor should Describe the methodology and criteria used, including the tool s limitations and key assumptions Explain that results may vary with each use and over time Describe the investment universe considered in the analysis Disclose that the outcomes are hypothetical and do not reflect actual investment results

59 Summary Mitigate risk by diversification across investment securities and asset classes Utilizing correlation: the portfolio may be greater than the sum of its parts Avoid the pitfalls of market timing and chasing performance If using tactical asset allocation, understand the methodology Select the asset allocation portfolio that suits the investor s risk tolerance and time horizon Asset allocation is the strategic mix of asset classes designed to meet the investor s goals

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