Portfolio Management (10%) Flashcards
(216 cards)
1
Q
diversification ratio
A
The ratio of the standard deviation of an equally weighted portfolio to the standard deviation of a randomly selected security.
2
Q
investment policy statement (IPS)
A
A written planning document that describes a client’s investment objectives and risk tolerance over a relevant time horizon, along with the constraints that apply to the client’s portfolio.
2
Q
definition:
modern portfolio theory
A
the analysis of rational portfolio choices based on the efficient use of risk.
3
Q
big picture of:
modern portfolio theory
A
The main conclusion of MPT is that investors should not only hold portfolios but should also focus on how individual securities in the portfolios are related to one another.
4
Q
Portfolio Management Process:
3 Steps
A
- Planning
- Execution
- Feedback
5
Q
Portfolio Management Process:
(1) Planning Step
A
- Understanding the client’s needs
- Preparation of an investment policy statement (IPS)
6
Q
Portfolio Management Process:
(2) Execution Step
A
1.Asset allocation
2.Security analysis
3.Portfolio construction
7
Q
Portfolio Management Process:
(3) Feedback Step
A
1.Portfolio monitoring and rebalancing
2.Performance measurement and reporting
8
Q
Asset allocation
A
The process of determining how investment funds should be distributed among asset classes.
9
Q
Top-Down Analysis
A
An investment selection approach that begins with consideration of macroeconomic conditions and then evaluates markets and industries based upon such conditions.
10
Q
Bottom-Up Analysis
A
An investment selection approach that focuses on company-specific circumstances rather than emphasizing economic cycles or industry analysis
11
Q
Risk Tolerance:
Endowment vs. Insurance Company
A
endowments shown above are relatively risk tolerant investors.
the majority of the insurance assets are invested in fixed-income investments, typically of high quality.
12
Q
defined contribution pension plans
A
Individual accounts to which an employee and typically the employer makes contributions during their working years and expect to draw on the accumulated funds at retirement. The employee bears the investment and inflation risk of the plan assets.
13
Q
Defined benefit pension plan
A
Plans in which the company promises to pay a certain annual amount (defined benefit) to the employee after retirement. The company bears the investment risk of the plan assets.
14
Q
Endowment:
Typical Goal
A
A typical investment objective of an endowment or a foundation is to maintain the real (inflation-adjusted) capital value of the fund while generating income to fund the objectives of the institution.
15
Q
Endowment:
Typical Asset Class Investment
A
Endowments and foundations typically allocate a sizable portion of their assets in alternative investments
16
Q
Bank:
Typical Asset Class Investment
A
Banks often have excess reserves that are invested in relatively conservative and very short-duration fixed-income investments, with a goal of earning an excess return above interest obligations due to depositors.
17
Q
Bank:
Typical Goal
A
Liquidity is a paramount concern for banks that stand ready to meet depositor requests for withdrawals.
18
Q
Insurance:
Typical Goal
A
Liquidity to meet claims
19
Q
Buy-Side Firm
A
An investment management company or other investor that uses the services of brokers or dealers (i.e., the client of the sell side firms).
20
Q
Sell-Side Firm
A
A broker/dealer that sells securities and provides independent investment research and recommendations to their clients (i.e., buy-side firms).
21
Q
Goal:
Passive Asset Managers
A
passive managers attempt to replicate the returns of a market index
22
Q
Goal:
Active Asset Managers
A
active asset managers generally attempt to outperform either predetermined performance benchmarks, such as the S&P 500, or, for multi-asset class portfolios, a combination of benchmarks.
23
Q
smart beta
A
Involves the use of simple, transparent, rules-based strategies as a basis for investment decisions.
24
Focus:
Traditional Asset Manager
Traditional managers generally focus on long-only equity, fixed-income, and multi-asset investment strategies, generating most of their revenues from asset-based management fees.
25
Focus:
Alternative Asset Manager
Alternative asset managers, however, focus on hedge fund, private equity, and venture capital strategies, among others, while generating revenue from both management and performance fees (or “carried interest”).
26
Company Structure:
Privately-Owned Investment Firms
LLC or Limited Partnerships
27
Robo-Advisors
Robo-advisers represent technology solutions that use automation and investment algorithms to provide several wealth management services—notably, investment planning, asset allocation, tax loss harvesting, and investment strategy selection. Investment and advice services provided by robo-advisers typically reflect an investor’s general investment goals and risk tolerance preferences (often obtained from an investor questionnaire). Robo-adviser platforms range from exclusively digital investment advice platforms to hybrid offerings that offer both digital investment advice and the services of a human financial adviser.
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mutual fund
A comingled investment pool in which investors in the fund each have a pro-rata claim on the income and value of the fund.
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open-end fund
A mutual fund that accepts new investment money and issues additional shares at a value equal to the net asset value of the fund at the time of investment.
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closed-end fund
A mutual fund in which no new investment money is accepted. New investors invest by buying existing shares, and investors in the fund liquidate by selling their shares to other investors.
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no-load fund
A mutual fund in which there is no fee for investing in the fund or for redeeming fund shares, although there is an annual fee based on a percentage of the fund’s net asset value
32
Load funds
A mutual fund in which, in addition to the annual fee, a percentage fee is charged to invest in the fund and/or for redemptions from the fund.
33
Money market funds:
Definition
funds that invest in short-term money market instruments such as treasury bills, certificates of deposit, and commercial paper.
34
Money Market Funds:
Purpose
aim to provide security of principal, high levels of liquidity, and returns in line with money market rates.
35
bond mutual fund:
definition
A bond mutual fund is an investment fund consisting of a portfolio of individual bonds and, occasionally, preferred shares.
36
separately managed account:
definition
An investment portfolio managed exclusively for the benefit of an individual or institution.
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separately managed account:
purpose
SMAs enable asset managers to implement an investment strategy that matches an investor’s specific objectives, portfolio constraints, and tax considerations, where applicable.
38
Exchange-traded funds
investment funds that trade on exchanges (similar to individual stocks) and are generally structured as open-end funds.
39
Exchange-traded funds vs. Mutual Funds:
Dividends
Other key differences between ETFs and mutual funds relate to transaction costs and treatment of dividends and the minimum investment amount. Dividends on ETFs are paid out to the shareholders whereas mutual funds usually reinvest the dividends.
40
Exchange-traded funds vs. Mutual Funds:
Minimum Required Investment
minimum required investment in ETFs is usually smaller than that of mutual funds.
41
Hedge Funds:
definition
Private investment vehicles that may invest in public equities or publicly traded fixed-income assets, private capital, and/or real assets, but they are distinguished by their investment approach rather than by the investments themselves.
42
Hedge Funds:
strategy
typically use leverage, derivatives, and long and short investment strategies.
43
Hedge Funds:
typical management fees
2%
44
private equity funds
A hedge fund that seeks to buy, optimize, and ultimately sell portfolio companies to generate profits. See private equity fund.
45
Hedge Funds:
typical incentive fees
incentive fees of up to 20%
46
venture capital funds
A hedge fund that seeks to buy, optimize, and ultimately sell portfolio companies to generate profits. See venture capital fund
47
hedge fund:
limited partnership agreements
A limited partnership (LP) agreement establishes the final type of partnership from the above list.
It’s also important to note the differences between a limited partnership agreement versus a general partnership agreement. A limited partnership is a partnership between a general partner and a limited partner.
The general partner oversees and runs the business and has unlimited liability for any business debts. The limited partner, also called the silent partner, contributes capital to the partnership but has no role in managing the business — they also have only limited liability up to the amount of their investment.
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hedge fund:
fund manager
the general partner (GP)
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hedge fund:
limited partners
the fund’s investors
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hedge fund:
management fees
Fees are based on committed capital (or sometimes net asset value or invested capital) and typically range from 1–3% annually. Sometimes these fees step down several years into the investment period of a fund.
51
hedge fund:
transaction fees
Fees are paid by portfolio companies to the fund for various corporate and structuring services.
Typically, a percentage of the transaction fee is shared with the LPs by offsetting the management fee.
52
hedge fund:
carried interest
Carried interest is the GP’s share of profits (typically 20%) on sales of portfolio companies.
Most GPs do not earn the incentive fee until LPs have recovered their initial investment.
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hedge fund:
Investment income
Investment income includes profits generated on capital contributed to the fund by the GP.
54
Portfolio planning
The process of creating a plan for building a portfolio that is expected to satisfy a client’s investment objectives.
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investment policy statement (IPS)
The written document governing the "portfolio planning" process.
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investment policy statement (IPS):
periodic review
The IPS should be reviewed on a regular basis to ensure that it remains consistent with the client’s circumstances and requirements.
56
investment policy statement (IPS):
aperiodic review
The IPS should be reviewed if the manager becomes aware of a material change in the client’s circumstances
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investment policy statement (IPS):
Section 1: Introduction
This section describes the client.
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investment policy statement (IPS):
Section 2: Statement of Purpose.
This section states the purpose of the IPS
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investment policy statement (IPS):
Section 3: Statement of Duties and Responsibilities.
This section details the duties and responsibilities of the client, the custodian of the client’s assets, and the investment managers.
60
investment policy statement (IPS):
Section 4: Procedures
This section explains the steps to take to keep the IPS current and the procedures to follow to respond to various contingencies.
61
investment policy statement (IPS):
Section 5: Investment Objectives
This section explains the client’s objectives in investing.
62
investment policy statement (IPS):
Section 6: Investment Constraints
This section presents the factors that constrain the client in seeking to achieve the investment objectives.
The IPS should state clearly the risk tolerance of the client. Risk objectives are specifications for portfolio risk that reflect the client’s risk tolerance.
63
investment policy statement (IPS):
Section 7: Investment Guidelines
This section provides information about how policy should be executed (e.g., on the permissible use of leverage and derivatives) and on specific types of assets excluded from investment, if any.
64
investment policy statement (IPS):
Section 8: Evaluation and Review.
This section provides guidance on obtaining feedback on investment results.
65
investment policy statement (IPS):
Appendices
(A) Strategic Asset Allocation and
(B) Rebalancing Policy.
Many investors specify a strategic asset allocation (SAA), also known as the policy portfolio, which is the baseline allocation of portfolio assets to asset classes in view of the investor’s investment objectives and the investor’s policy with respect to rebalancing asset class weights.
This SAA may include a statement of policy concerning hedging risks such as currency risk and interest rate risk.
66
responsible investing
non-financial considerations when formulating their investment policies
67
value at risk
A money measure of the minimum value of losses expected during a specified time period at a given level of probability.
68
relative risk objectives:
definition
risk objectives that relate risk relative to one or more benchmarks perceived to represent appropriate risk standards.
For example,
investments in large-cap UK equities could be benchmarked to an equity market index, such as the FTSE 100 Index.
The S&P 500 Index could be used as a benchmark for large-cap US equities;
for investments with cash-like characteristics, the benchmark could be an interest rate such as Treasury bill rate.
69
relative risk objectives:
tracking error or tracking risk
The standard deviation of the differences between a portfolio’s returns and its benchmarks returns. Also called tracking error.
70
liability-driven investment (LDI):
definition
An investment industry term that generally encompasses asset allocation that is focused on funding an investor’s liabilities in institutional contexts.
71
liability-driven investment (LDI):
client examples
Examples of LDI include life insurance companies, defined benefit pension plans or an individual’s budget after retirement. For example, a pension plan must meet the pension payments as they come due, and the risk objective will be to minimize the probability that it will fail to do so.
72
liability-driven investment (LDI):
objective (goal) examples
A related return objective might be to outperform the discount rate used in finding the present value of liabilities over a multi-year time horizon.
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policy portfolio:
definition
a specified set of long-term asset class weightings and hedge ratios
74
policy portfolio:
objective (goal) examples
the risk objective may be expressed as a desire for the portfolio return to be within a band of plus or minus X% of the benchmark return calculated by assigning an index or benchmark to represent each asset class present in the policy portfolio.
75
Example:
A Japanese institutional investor has a portfolio valued at ¥10 billion. The investor expresses her first risk objective as a desire not to lose more than ¥1 billion in the coming 12-month period. She specifies a second risk objective of achieving returns within 4% of the return to the TOPIX stock market index, which is her benchmark
1A. Characterize the first risk objective as absolute or relative.
1B. Give an example of how the risk objective could be restated in a practical manner.
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2A. Characterize the second risk objective as absolute or relative.
2B. Identify a measure for quantifying the risk objective.
1A. This is an absolute risk objective.
1B. This risk objective could be restated in a practical manner by specifying that the 12-month 95% value at risk of the portfolio must be no more than ¥1 billion.
2A. This is a relative risk objective.
2B. This risk objective could be quantified using the tracking risk as a measure. For example, assuming returns follow a normal distribution, an expected tracking risk of 2% would imply a return within 4% of the index return approximately 95% of the time. Remember that tracking risk is stated as a one standard deviation measure.
76
tracking risk:
units
tracking risk is stated as a one standard deviation measure.
77
two components of risk tolerance
1. ability to bear risk
2. willingness to take risk
78
ability to bear risk:
how is it measured
The ability to bear risk is measured mainly in terms of objective factors, such as:
1. time horizon
2. expected income
3. level of wealth relative to liabilities.
For example, an investor with a 20-year time horizon can be considered to have a greater ability to bear risk, other things being equal, than an investor with a 2-year horizon. This difference is because over 20 years, there is more scope for losses to be recovered or other adjustments made to circumstances than there is over 2 years.
79
willingness to bear risk:
definition
The willingness to take risk, or risk attitude, is a more subjective factor based on the client’s psychology and perhaps also his current circumstances.
Although the list of factors related to an individual’s risk attitude remains open to debate, it is believed that some psychological factors, such as personality type, self-esteem, and inclination to independent thinking, are correlated with risk attitude.
Some individuals are comfortable taking financial and investment risk, whereas others find it distressing.
80
willingness to bear risk:
how is it measured
psychometric questionnaire.
Although there is no single agreed-upon method for measuring risk tolerance, a willingness to take risk may be gauged by discussing risk with the client or by asking the client to complete a psychometric questionnaire.
81
what must a manager do when an investors (1) ability to take risk and (2) willingness to take risk are in conflict?
The prudent approach is to reach a conclusion about risk tolerance consistent with the lower of the two factors (ability and willingness) and to document the decisions made.
The investment adviser, however, should not aim to change a client’s willingness to take risk that is not a result of a miscalculation or misperception. Modification of elements of personality is not within the purview of the investment adviser’s role.
82
nominal return:
definition
the amount of money generated by an investment before factoring in expenses such as taxes, investment fees, and inflation
83
real return:
definition
inflation-adjusted, which usually relates better to the objective
84
Portfolio Manager's duty when a client has unrealistic return expectations
When a client has unrealistic return expectations, the manager or adviser will need to counsel her about what is achievable in the current market environment and within the client’s tolerance for risk.
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investment policy statement (IPS):
Liquidity Requirements for Clients
The IPS should state what the likely requirements are to withdraw funds from the portfolio.
Examples for an individual investor would be outlays for covering healthcare payments or tuition fees. For institutions, it could be spending rules and requirements for endowment funds, the existence of claims coming due in the case of property and casualty insurance, or benefit payments for pension funds and life insurance companies.
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investment policy statement (IPS):
Liquidity Requirements for Portfolio
manager should allocate part of the portfolio to cover the liability.
This part of the portfolio will be invested in assets that are liquid—that is, easily converted to cash—and have low risk when the liquidity need is actually present (e.g., a bond maturing at the time when private education expenses will be incurred), so that their value is known with reasonable certainty
87
investment policy statement (IPS):
Time Horizon
The IPS should state the time horizon over which the investor is investing.
It may be the period over which the portfolio is accumulating before any assets need to be withdrawn; it could also be the period until the client’s circumstances are likely to change.
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investment policy statement (IPS):
Tax Concerns
portfolio should reflect the tax status of the client.
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investment policy statement (IPS):
Legal & Regulatory Factors
The IPS should state any legal and regulatory restrictions that constrain how the portfolio is invested.
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self-investment limits
With respect to investment limitations applying to pension plans, restrictions on the percentage of assets that can be invested in securities issued by the pension plan sponsor.
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ESG:
Negative screening
Excluding companies or sectors based on business activities or environmental or social concerns
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ESG:
Positive screening
Including sectors or companies based on specific ESG criteria, typically ESG performance relative to industry peers;
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ESG:
ESG integration
Systematic consideration of material ESG factors in asset allocation, security selection, and portfolio construction decisions
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ESG:
Thematic investing
Investing in themes or assets related to ESG factors
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ESG:
Engagement/active ownership:
Using shareholder power to influence corporate behavior to achieve targeted ESG objectives along with financial returns
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ESG:
Impact investing
Investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return.
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investment policy statement (IPS):
exercise in fact finding about the customer
should take place at the beginning of the client relationship.
This process will involve gathering information about the client’s circumstances as well as discussing the client’s objectives and requirements.
Important data to gather from a client should cover family and employment situation as well as financial information. If the client is an individual, it may also be necessary to know about the situation and requirements of the client’s spouse or other family members. The health of the client and her dependents is also relevant information. In an institutional relationship, it will be important to know about key stakeholders in the organization and what their perspective and requirements are. Information gathering may be done in an informal way or may involve structured interviews, questionnaires, or analysis of data. Many advisers will capture data electronically and use special systems that record data and produce customized reports.
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asset class
A group of assets that have similar characteristics, attributes, and risk–return relationships.
99
Strategic asset allocation:
definition
Strategic asset allocation is an investment strategy premised on long-term asset allocation. This strategy only rebalances its portfolio when the asset mix represents significant deviation from the original or targeted allocation mix.
100
Strategic asset allocation and its relationship to the IPS
The strategic asset allocation (SAA) is the set of exposures to IPS-permissible asset classes that is expected to achieve the client’s long-term objectives given the client’s risk profile and investment constraints.
101
Strategic asset allocation:
hedging
An SAA could include a policy of hedging portfolio risks not explicitly covered by asset class weights. The obvious examples are hedge ratios for foreign currency exposure, or the management of interest rate risk resulting from asset-liability mismatch, and the hedging of inflation risk.
101
Systematic risk
Risk that affects the entire market or economy; it cannot be avoided and is inherent in the overall market. Systematic risk is also known as non-diversifiable or market risk.
102
nonsystematic risk
Unique risk that is local or limited to a particular asset or industry that need not affect assets outside of that asset class.
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Capital market expectations
Expectations concerning the risk and return prospects of asset classes.
104
alternative investments
hedge funds,
private equity,
art,
intellectual property
105
ESG:
best-in-class policy
An ESG implementation approach that seeks to identify the most favorable companies and sectors based on ESG considerations. Also called positive screening.
106
risk budgeting
The establishment of objectives for individuals, groups, or divisions of an organization that takes into account the allocation of an acceptable level of risk.
107
Tactical asset allocation
Asset allocation that involves making short-term adjustments to asset class weights based on short-term predictions of relative performance among asset classes.
108
Security selection
The process of selecting individual securities; typically, security selection has the objective of generating superior risk-adjusted returns relative to a portfolio’s benchmark.
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efficient market
market in which prices, on average, very quickly reflect newly available information
110
drift
eights of the asset classes will gradually deviate from the policy weights in the strategic asset allocation
111
rebalancing policy
The set of rules that guide the process of restoring a portfolio’s asset class weights to those specified in the strategic asset allocation
112
ETFs
funds that track the performance of an asset class index or sub-index, are easily tradable, and are relatively cheap compared with actively managed funds or managed accounts.
113
Shareholder engagement
Shareholder engagement reflects active ownership by investors in which the investor seeks to influence a corporation’s decisions on ESG matters, either through dialogue with corporate officers or votes at a shareholder assembly (in the case of equity).
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investment policy statement (IPS):
unique circumstances section
The unique circumstances section of the IPS should cover any other aspect of a client’s circumstances that is likely to have a material impact on portfolio composition.
115
starting point of the portfolio management process
investment policy statement (IPS)
116
cognitive errors:
definition
Behavioral biases resulting from faulty reasoning; cognitive errors stem from basic statistical, information-processing, or memory errors.
117
emotional biases:
definition
Behavioral biases resulting from reasoning influenced by feelings; emotional biases stem from impulse or intuition.
118
cognitive errors:
ways to eliminate
Cognitive errors can often be corrected or eliminated through better information, education, and advice.
119
emotional biases:
ways to eliminate
harder to correct because they stem from impulses and intuitions. They arise spontaneously rather than through conscious effort and may even be undesired to the individual feeling them. Thus, it is often possible only to recognize an emotional bias and adapt to it.
120
belief perseverance biases:
definition
Belief perseverance is the tendency to cling to one’s previously held beliefs by committing statistical, information-processing, or memory errors. The belief perseverance biases discussed are conservatism, confirmation, representativeness, illusion of control, and hindsight.
121
processing errors:
definition
Processing errors describe how information may be processed and used illogically or irrationally in financial decision making
122
Belief perseverance biases:
definition
Belief perseverance biases result from the mental discomfort that occurs when new information conflicts with previously held beliefs or cognitions, known as cognitive dissonance. To resolve this discomfort, people may ignore or modify conflicting information and consider only information that confirms their existing beliefs or thoughts.
123
Conservatism bias:
definition
Conservatism bias is a belief perseverance bias in which people maintain their prior views or forecasts by inadequately incorporating new, conflicting information. In Bayesian terms, they tend to overweight their prior probability of the event and underweight the new information, resulting in revised beliefs about probabilities and outcomes that underreact to the new information.
124
Conservatism bias:
consequences
1. Maintain or be slow to update a view or a forecast, even when presented with new information; and
2.Maintain a prior belief rather than deal with the mental stress of updating beliefs given complex data. This behavior relates to an underlying difficulty in processing new information.
125
Conservatism bias:
how to fix
1. be aware that a bias exists
2. by properly analyzing and weighting new information.
3.If information is difficult to interpret or understand, FMPs should seek guidance from someone who can either explain how to interpret the information or can explain its implications.
126
cognitive cost:
definition
The effort involved in processing new information and updating beliefs.
127
Confirmation bias:
definition
refers to the tendency to look for and notice what confirms prior beliefs and to ignore or undervalue whatever contradicts them.
A response to cognitive dissonance, confirmation bias reflects a predisposition to justify to ourselves what we want to believe.
128
Confirmation bias:
consequences
1. Consider only the positive information about an existing investment while ignoring any negative information about the investment.
2.Develop screening criteria while ignoring information that either refutes the validity of the criteria or supports other criteria. As a result, some good investments that do not meet the screening criteria may be ignored, and conversely, some bad investments that do meet the screening criteria may be made.
3. Under-diversify portfolios. FMPs may become convinced of the value of a single company’s stock. They ignore negative news, and they gather and process only information confirming that the company is a good investment. They build a larger position than appropriate and hold an under-diversified portfolio.
129
Confirmation bias:
how to fix
1. actively seeking out information that challenges existing beliefs.
2. corroborate an investment decision
130
Representativeness bias:
definition
A belief perseverance bias in which people tend to classify new information based on past experiences and classifications.
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base-rate neglect:
definitions
phenomenon’s rate of incidence in a larger population—its base rate—is neglected in favor of specific information.
132
sample-size neglect:
definitions
incorrectly assume that small sample sizes are representative of populations
133
sample-size neglect:
implications
Individuals prone to sample-size neglect are quick to treat properties reflected in small samples as properties that accurately describe large pools of data, overweighting the information in the small sample.
134
Representativeness Bias:
consequences
1.Adopt a view or a forecast based almost exclusively on individual, specific information or a small sample; and
2.Update beliefs using simple classifications rather than deal with the mental stress of updating beliefs given the high cognitive costs of complex data.
135
Illusion of Control Bias:
definition
people tend to believe that they can control or influence outcomes when, in fact, they cannot.
136
Illusion of Control Bias:
consequences
Inadequately diversify portfolios.
Trade more than is prudent.
Construct financial models and forecasts that are overly detailed.
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Illusion of Control Bias:
how to fix
1. recognize is that investing is a probabilistic activity
2. it is advisable to seek contrary viewpoints.
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Hindsight Bias:
definition
A bias with selective perception and retention aspects in which people may see past events as having been predictable and reasonable to expect.
139
Hindsight Bias:
consequences
1. Overestimate the degree to which they correctly predicted an investment outcome, or the predictability of an outcome generally. This bias is closely related to overconfidence bias, which is discussed later in the reading.
2. Unfairly assess money manager or security performance. Based on the ability to look back at what has taken place in securities markets, performance is compared against what has happened as opposed to expectations at the time the investment was made.
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Hindsight Bias:
how to fix
record their investment decisions and key reasons for making those decisions in writing at or around the time the decision is made.
Consulting these written records rather than memory will often produce a far more accurate examination of past decisions.
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Processing Errors:
definition
Processing errors refer to information being processed and used illogically or irrationally.
relate more closely to flaws in how information itself is processed.
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Anchoring and adjustment bias:
definition
An information-processing bias in which the use of a psychological heuristic influences the way people estimate probabilities.
143
Anchoring and adjustment bias:
consequences
FMPs may stick too closely to their original estimates when learning new information. This mindset is not limited to downside adjustments; the same phenomenon occurs with upside adjustments as well.
144
Mental accounting bias:
definition
An information-processing bias in which people treat one sum of money differently from another equal-sized sum based on which mental account the money is assigned to.
145
Mental accounting bias:
consequences
1. Irrationally bifurcate wealth or a portfolio into investment principal and investment returns.
2. Irrationally distinguish between returns derived from income and those derived from capital appreciation. Although many investors feel the need to preserve principal, they focus on the idea of spending income that the principal generates.
146
Mental accounting bias:
how to fix
FMPs should go through the exercise of combining all of their assets onto one spreadsheet (without headings or account labels) to see the holistic asset allocation.
This exercise often produces information that is surprising when seen as a whole, such as higher cash balances than expected.
147
Framing bias
An information-processing bias in which a person answers a question differently based on the way in which it is asked (framed).
148
Narrow framing
occurs when people evaluate information based on a narrow frame of reference—that is, losing sight of the big picture in favor of one or two specific points.
For example, an investor might focus solely on a company’s executive management team, overlooking or even dismissing other important properties such as industry characteristics, fundamental performance, and valuation.
149
Availability Bias:
definition
an information-processing bias in which people estimate the probability of an outcome or the importance of a phenomenon based on how easily information is recalled
150
Loss-aversion bias:
definition
A bias in which people tend to strongly prefer avoiding losses as opposed to achieving gains
151
Loss-aversion bias:
consequences
hold their losers to avoid recognizing losses and sell their winners to lock in profits.
The resulting portfolio may be riskier than the optimal portfolio based on the investor’s risk–return objectives.
152
disposition effect
As a result of loss aversion, an emotional bias whereby investors are reluctant to dispose of losers. This results in an inefficient and gradual adjustment to deterioration in fundamental value.
153
Loss-aversion bias:
overcoming
A disciplined approach to investment is a good way to alleviate the impact of the loss-aversion bias
154
Overconfidence bias:
definition
bias in which people demonstrate unwarranted faith in their own abilities
155
self-attribution bias
A bias in which people take too much credit for successes (self-enhancing) and assign responsibility to others for failures (self-protecting).
156
Overconfidence bias:
consequences
Underestimate risks and overestimate expected returns.
Hold poorly diversified portfolios, which may result in significant downside risk.
157
Self-control bias:
definition
a bias in which people fail to act in pursuit of their long-term, overarching goals in favor of short-term satisfaction.
158
Self-control bias:
consequences
Save insufficiently for the future, which may, in turn, result in accepting too much risk in portfolios in an attempt to generate higher returns.
Borrow excessively to finance present consumption.
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Status quo bias:
definition
An emotional bias in which people do nothing (i.e., maintain the status quo) instead of making a change.
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Status quo bias:
consequences
Unknowingly maintain portfolios with risk characteristics that are inappropriate for their circumstances.
Fail to explore other opportunities.
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Endowment bias:
definition
an emotional bias in which people value an asset more when they own it than when they do not.
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Endowment bias:
consequences
Fail to sell certain assets and replace them with other assets.
Continue to hold classes of assets with which they are familiar. FMPs may believe they understand the characteristics of the investments they already own and may be reluctant to purchase assets with which they have less experience. Familiarity adds to owners’ perceived value of a security.
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Regret-aversion bias:
definition
an emotional bias in which people tend to avoid making decisions out of fear that the decision will turn out poorly
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Regret-aversion bias:
consequences
Be too conservative in their investment choices
Engage in herding behavior. FMPs may feel safer in popular investments in order to limit potential future regret. It seems safe to be with the crowd, and a reduction in potential emotional pain is perceived.
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Market Anomalies
apparent deviations from the efficient market hypothesis, identified by persistent abnormal returns that differ from zero and are predictable in direction
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Momentum
future price behavior correlates with that of the recent past
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Regret
feeling that an opportunity has been missed and is typically an expression of hindsight bias, which reflects the human tendency to see past events as having been predictable.
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Value stocks
typically characterized by low price-to-earnings ratios, high book-to-market equity, and low price-to-dividend ratios.
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Growth stock
characterized by low book-to-market equity, high price-to-earnings ratios, and high price-to-dividend ratios.
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Home Bias
A preference for securities listed on the exchanges of one’s home country.
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Risk
exposure to uncertainty.
risk is about the chance of a loss or adverse outcome as a result of an action, inaction, or external event.
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Risk exposure
The state of being exposed or vulnerable to a risk.
The extent to which an organization is sensitive to underlying risks.
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Risk management
the process by which an organization or individual defines the level of risk to be taken, measures the level of risk being taken, and adjusts the latter toward the former, with the goal of maximizing the company’s or portfolio’s value or the individual’s overall satisfaction, or utility.
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risk management framework
The infrastructure, process, and analytics needed to support effective risk management in an organization.
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Risk governance:
definition
The top-down process and guidance that directs risk management activities to align with and support the overall enterprise.
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Risk governance:
good governance
Good governance should include defining an organization’s risk tolerance and providing risk oversight.
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Enterprise risk management
an overarching governance approach applied throughout the organization and consistent with its strategy, guiding the risk management framework to focus risk activities on the objectives, health, and value of the entire organization.
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Risk identification and measurement
the main quantitative core of risk management; but more than that, it must include the qualitative assessment and evaluation of all potential sources of risk and the organization’s risk exposures
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Risk infrastructure
the people and systems required to track risk exposures and perform most of the quantitative risk analysis to allow an assessment of the organization’s risk profile
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Which of the following is not a goal of risk management?
A.Measuring risk exposures
B.Minimizing exposure to risk
C.Defining the level of risk appetite
B is correct. The definition of risk management includes both defining the level of risk desired and measuring the level of risk taken. Risk management means taking risks actively and in the best, most value-added way possible and is not about minimizing risks.
181
Which element of a risk management framework sets the overall context for risk management in an organization?
A.Governance
B.Risk infrastructure
C.Policies and processes
A is correct. Governance is the element of the risk management framework that is the top-level foundation for risk management. Although policies, procedures, and infrastructure are necessary to implement a risk management framework, it is governance that provides the overall context for an organization’s risk management.
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Which element of risk management makes up the analytical component of the process?
A. Communication
B. Risk governance
C. Risk identification and measurement
C is correct. Risk identification and measurement is the quantitative part of the process. It involves identifying the risks and summarizing their potential quantitative impact. Communication and risk governance are largely qualitative.
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Which element of risk management involves action when risk exposures are found to be out of line with risk tolerance?
A. Risk governance
B. Risk identification and measurement
C. Risk monitoring, mitigation, and management
C is correct. Risk monitoring, mitigation, and management require recognizing and taking action when these (risk exposure and risk tolerance) are not in line, as shown in the middle of Exhibit 1. Risk governance involves setting the risk tolerance. Risk identification and measurement involves identifying and measuring the risk exposures.
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human capital
The accumulated knowledge and skill that workers acquire from education, training, or life experience and the corresponding present value of future earnings to be generated by said skilled individual.
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chief risk officer (CRO)
This officer should be responsible for building and implementing the risk framework for the enterprise and managing the many activities therein. In the same manner that risks are inextricably linked with the core business activities, the CRO is likewise a key participant in the strategic decisions of the enterprise—this position is not solely a policing role. Although the chief executive is responsible for risk as well as all other aspects of an enterprise, it makes no more sense for the CEO to perform the role of the CRO than it would be for the CEO to perform the role of the CFO.
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risk tolerance
The amount of risk an investor is willing and able to bear to achieve an investment goal.
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Risk budgeting
The establishment of objectives for individuals, groups, or divisions of an organization that takes into account the allocation of an acceptable level of risk.
Risk budgeting quantifies and allocates the tolerable risk by specific metrics; it extends and guides implementation of the risk tolerance decision.
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Which of the following approaches is most consistent with an enterprise view of risk governance?
A.Separate strategic planning processes for each part of the enterprise
B.Considering an organization’s risk tolerance when developing its asset allocation
C.Trying to achieve the highest possible risk-adjusted return on a company’s pension fund’s assets
B is correct. The enterprise view is characterized by a focus on the organization as a whole—its goals, value, and risk tolerance. It is not about strategies or risks at the individual business line level.
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Which of the following statements about risk tolerance is most accurate?
A. Risk tolerance is best discussed after a crisis, when awareness of risk is heightened.
B.The risk tolerance discussion is about the actions management will take to minimize losses.
C.The organization’s risk tolerance describes the extent to which the organization is willing to experience losses.
C is correct. Risk tolerance identifies the extent to which the organization is willing to experience losses or opportunity costs and fail in meeting its objectives. It is best discussed before a crisis and is primarily a risk governance or oversight issue at the board level, not a management or tactical one.
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Which of the following is not consistent with a risk-budgeting approach to portfolio management?
A.Limiting the beta of the portfolio to 0.75
B.Allocating investments by their amount of underlying risk sources or factors
C.Limiting the amount of money available to be spent on hedging strategies by each portfolio manager
C is correct. Risk budgeting is any means of allocating a portfolio by some risk characteristics of the investments. This approach could be a strict limit on beta or some other risk measure or an approach that uses risk classes or factors to allocate investments. Risk budgeting does not require nor prohibit hedging, although hedging is available as an implementation tool to support risk budgeting and overall risk governance.
191
Who would be the least appropriate for controlling the risk management function in a large organization?
A. Chief risk officer
B. Chief financial officer
C. Risk management committee
B is correct. A chief risk officer or a risk management committee is an individual or group that specializes in risk management. A chief financial officer may have considerable knowledge of risk management, may supervise a CRO, and would likely have some involvement in a risk management committee, but a CFO has broader responsibilities and cannot provide the specialization and attention to risk management that is necessary in a large organization.
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financial risks
The risk arising from a company’s capital structure and, specifically, from the level of debt and debt-like obligations.
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non-financial risks
Risks that arise from sources other than changes in the external financial markets, such as changes in accounting rules, legal environment, or tax rates.
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financial risk:
market risk
The risk that arises from movements in interest rates, stock prices, exchange rates, and commodity prices.
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financial risk:
credit risk
The expected economic loss under a potential borrower default over the life of the contract
196
financial risk:
liquidity risk
A divergence in the cash flow timing of a derivative versus that of an underlying transaction
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Operational risk
The risk that arises from inadequate or failed people, systems, and internal policies, procedures, and processes, as well as from external events that are beyond the control of the organization but that affect its operations.
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solvency risk
The risk that an organization does not survive or succeed because it runs out of cash, even though it might otherwise be solvent.
199
Which of the following is not a financial risk?
A.Credit risk
B.Market risk
C.Operational risk
C is correct. Operational risk is the only risk listed that is considered non-financial, even though it may have financial consequences. Credit and market risks derive from the possibility of default and market movements, respectively, and along with liquidity risk, are considered financial risks.
200
Which of the following best describes an example of interactions among risks?
A. A stock in Russia declines at the same time as a stock in Japan declines.
B.Political events cause a decline in economic conditions and an increase in credit spreads.
C.A market decline makes a derivative counterparty less creditworthy while causing it to owe more money on that derivative contract.
C is correct. Although most risks are likely to be interconnected in some way, in some cases the risks an organization is exposed to will interact in such a way that a loss (or gain) in one exposure will lead directly to a loss in a different exposure as well, such as with many counterparty contracts. Conditions in A and B are much more directly linked in that market participants fully expect what follows—for example, in B, an outbreak of war in one region of the world could well cause widespread uncertainty; a flight to quality, such as to government-backed securities; and a widening in spreads for credit-risky securities. In C, in contrast, the reduction in creditworthiness following the market decline may be expected, but owing more money on an already existing contract as a result comes from the interaction of risks.
201
Which of the following best describes a financial risk?
A. The risk of an increase in interest rates.
B.The risk that regulations will make a transaction illegal.
C.The risk of an individual trading without limits or controls.
A is correct because this risk arises from the financial markets.
202
Which of the following is not an example of model risk?
A. Assuming the tails of a returns distribution are thin when they are, in fact, fat.
B.Using standard deviation to measure risk when the returns distribution is asymmetric.
C.Using the one-year risk-free rate to discount the face value of a one-year government bond
C is correct. The risk-free rate is generally the appropriate rate to use in discounting government bonds. Although government bonds are generally default free, their returns are certainly risky. Assuming a returns distribution has thin tails when it does not and assuming symmetry in an asymmetric distribution are both forms of model risk.
203
Which of the following is the risk that arises when it becomes difficult to sell a security in a highly stressed market?
A.Liquidity risk
B.Systemic risk
C.Wrong-way risk
A is correct. Securities vary highly in how liquid they are. Those with low liquidity are those for which either the number of agents willing to invest or the amount of capital these agents are willing to invest is limited. When markets are stressed, these limited number of investors or small amount of capital dry up, leading to the inability to sell the security at any price the seller feels is reasonable. Systemic risk is the risk of failure of the entire financial system and a much broader risk than liquidity risk. Wrong-way risk is the extent to which one’s exposure to a counterparty is positively related to the counterparty’s credit risk.
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model risk
the risk of a valuation error from improperly using a model. This risk arises when an organization uses the wrong model or uses the right model incorrectly.
205
extreme value theory
A branch of statistics that focuses primarily on extreme outcomes.
206
scenario analysis
A technique for exploring the performance and risk of investment strategies in different structural regimes
207
stress testing
A specific type of scenario analysis that estimates losses in rare and extremely unfavorable combinations of events or scenarios.
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Risk Prevention and Avoidance
Take steps to avoid risks entirely or reduce them significantly. This often involves a trade-off between the cost of avoidance and the benefits of taking the risk.
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Risk Acceptance (Self-Insurance and Diversification)
Accepting risk either by bearing it directly or through diversification to spread the risk efficiently. Self-insurance involves setting aside reserves to cover potential losses.
210
Risk Transfer
Transfer the risk to another party, such as through insurance
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Risk Shifting
Changing the distribution of risk outcomes, often using derivatives.
Example: Hedging currency risk by using forward contracts or options to manage exchange rate exposure.
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Surety Bonds
Promise payment if a third party fails to fulfill obligations, similar to insurance but with a focus on non-performance risks.
213
Risk Mitigation
risk can be mitigated through self-insurance or diversification.
