Benchmark Investments

The chance that an outcome or investment's actual gains will differ from an expected outcome or return

All investments involve some degree of risk. In finance, risk refers to the degree of uncertainty and/or potential financial loss inherent in an investment decision. In general, as investment risks rise, investors seek higher returns to compensate themselves for taking such risks.

Every saving and investment product has different risks and returns. Differences include: how readily investors can get their money when they need it, how fast their money will grow, and how safe their money will be. In this section, we are going to talk about a number of risks investors face. They include:

Business Risk

With a stock, you are purchasing a piece of ownership in a company. With a bond, you are loaning money to a company. Returns from both of these investments require that that the company stays in business. If a company goes bankrupt and its assets are liquidated, common stockholders are the last in line to share in the proceeds. If there are assets, the company’s bondholders will be paid first, then holders of preferred stock. If you are a common stockholder, you get whatever is left, which may be nothing.

If you are purchasing an annuity make sure you consider the financial strength of the insurance company issuing the annuity. You want to be sure that the company will still be around, and financially sound, during your payout phase.

Volatility Risk

Even when companies aren’t in danger of failing, their stock price may fluctuate up or down. Large company stocks as a group, for example, have lost money on average about one out of every three years. Market fluctuations can be unnerving to some investors. A stock’s price can be affected by factors inside the company, such as a faulty product, or by events the company has no control over, such as political or market events.

Inflation Risk

Inflation is a general upward movement of prices. Inflation reduces purchasing power, which is a risk for investors receiving a fixed rate of interest. The principal concern for individuals investing in cash equivalents is that inflation will erode returns.

Interest Rate Risk

Interest rate changes can affect a bond’s value. If bonds are held to maturity the investor will receive the face value, plus interest. If sold before maturity, the bond may be worth more or less than the face value. Rising interest rates will make newly issued bonds more appealing to investors because the newer bonds will have a higher rate of interest than older ones. To sell an older bond with a lower interest rate, you might have to sell it at a discount.

Liquidity Risk

This refers to the risk that investors won’t find a market for their securities, potentially preventing them from buying or selling when they want. This can be the case with the more complicated investment products. It may also be the case with products that charge a penalty for early withdrawal or liquidation such as a certificate of deposit (CD).

Systematic Risk

• The source of systematic risk is the market or global factors such as rising oil prices, currency movements, changing government policies, and changes in inflation and interest rates.
• Systematic risks cannot be diversified

Unsystematic Risk

• Unsystematic risks, however, are owed to factors unique to a company or an industry. Management and labor relations, increased competition, entry of new players, and customers’ preference for a company’s products are some of the factors that generate unsystematic risk.
• Unsystematic risks can be reduced through Diversification

Systematic Risks + Unsystematic Risks = Total Risk

Some key terms to access the risk

• Standard Deviation
• Downside Deviation
• Beta
• R-Squared
• Covariance

• Standard deviation provides a measure of the volatility of asset prices in comparison to their historical averages in a given time frame.
• Deviation from mean

Standard Deviation Example:

Who is the more consistent?
Who is a safer bet?
The answer is Player A because it’s less deviate

Standard Deviation

• Standard deviation is used to quantify the total risk
• Standard Deviation takes into account both positive as well as negative swings

Standard vs Downside

If the downside deviation is lower than the standard deviation, then it is good because essentially it means that the downside volatility in this return stream is lower than the overall volatility (the combined volatility of negative AND positive months).

If the reverse was true (where the downside deviation was higher than the standard deviation), that would mean that the securities’ negative months are much more volatile than the positive months.

• A beta coefficient can measure the volatility of an individual stock compared to the systematic risk of the entire market. Beta effectively describes the activity of a security's returns as it responds to swings in the market.
• Beta data about an individual stock can only provide an investor with an approximation of how much risk the stock will add to a diversified portfolio.
• Beta itself is not market risk. It just indicates the sensitivity of a stock to the market’s movement
• Beta of a security can be:
  • 1
  • More than 1
  • Less than 1
  • Negative

• R is known as coefficient of Correlation while R- Squared is called Coefficient of Determination
• R squared Ranges from 0 to 1, basically 0% to 100%
• R-squared of 100% means that all movements of a security (or another dependent variable) are completely explained by movements in the index
• If R-squared value 0.3 < r < 0.5 this value is generally considered a weak or low effect size
• If R-squared value 0.5 < r < 0.7 this value is generally considered a Moderate effect size
• If R-squared value r > 0.7 this value is generally considered strong effect size

• Covariance is a statistical tool that is used to determine the relationship between the movement of two asset prices.
• When two stocks tend to move together, they are seen as having a positive covariance; when they move inversely, the covariance is negative.
• Covariance is a significant tool in modern portfolio theory used to ascertain what securities to put in a portfolio. Risk and volatility can be reduced in a portfolio by pairing assets that have a negative covariance.

Covariance VS Correlation

• The covariance measures the directional relationship between two assets,
  
  Where as
• The coefficient of correlation is a more appropriate indicator of this strength of the relationship between the two assets

Risk-Adjusted Returns

Some Key Terms to access the Return

• Sharpe Ratio
• Sortino Ratio
• Treynor Ratio
• Information Ratio
• Jensen’s Alpha

Sharpe Ratio

Formula:

(Fund Return-Risk Free Return) / Standard Deviation of the Fund Return

• Meaning: The additional return generated by the Fund Manager over and above the Risk-Free Return for every unit of Total Risk taken
• Risk Free Return: While no investment is truly risk free, we will be considering the 10 Year GOI Bond Yield to be the Risk Free Return
• Higher the Sharpe Ratio, the Better
• Developed by William F. Sharpe

Fund B is given higher return

Sortino Ratio

Formula:

(Fund Return-Risk Free Return) / Downside Deviation of the Fund Return

• Meaning: The additional return generated by the Fund Manager over and above the Risk-Free Return for every unit of Downside
• Sortino Ratio provides a better view of a portfolio's risk-adjusted performance since positive volatility is a benefit.
• Higher the Sortino Ratio, the Better
• Developed by Frank A. Sortino

Fund A is better choice

Treynor Ratio

Formula:

(Fund Return-Risk Free Return) / Beta of the Fund

• Meaning: The additional return generated by the Fund Manager over and above the Risk Free Return for every unit of Systematic Risk taken
• The rationale of Treynor Ratio is that investors must be compensated for the risk inherent to the portfolio which can not be diversified away
• Higher the Treynor Ratio, the Better
• Developed by Jack Treynor

Fund B is better choice

Information Ratio

Formula:

(Fund Return-Market Return) / Tracking Error of the Fund

• Meaning: The additional return generated by the Fund Manager over and above the Market Return for every unit of Tracking Error observed

What is Tracking Error?

The Tracking Error identifies the level of consistency in which a portfolio "tracks" the performance of an index. A low tracking error means the portfolio is beating or under- performing the index consistently over time. The tracking error is often calculated by using the standard deviation of the difference in returns between a portfolio and the benchmark index.

Information Ratio

• Information Ratio checks for excess returns relative to a benchmark, but it also tries to identify the consistency of the performance by incorporating a tracking error
• Higher the Information Ratio, the Better
• Developed by Fischer Black and Jack Treynor

Fund B is better choice

Jensen’s Alpha

Formula:

Fund Return (-) Expected Return of the Fund

• Meaning: The additional return generated by the Fund Manager over and above the Expected Return given the risks taken
• The Expected Return of the Fund = Risk Free Return + (Market Return - Risk Free Return) * Beta of the Fund
• Higher the Jensen’s Alpha, the Better
• Developed by Michael Jensen

Fund B is better choice

Fund A is better choice

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