The initial investment decision-making process involves the valuation and analysis of individual securities. It is necessary to understand the characteristics of the various securities and the factors that affect them and a valuation model is applied to these securities to estimate their price or value. Value is a function of the expected future returns on a security and the risk attached. Both of these parameters must be estimated and then brought together in a model.
It is important to consider the time horizon and the risk of its payments in the valuation of a security. The effects of time are not too difficult to work out; however, corrections of risk are much more important determinants of many securities’ values. The prices of many assets are not easily observed such as potential public or private investment projects, new financial securities, buyout prospects and complex derivatives. We can apply the asset pricing theory to establish what are the prices of these assets.
Asset pricing theory stems from one simple concept: price equals expected discounted payoff. There are two approaches in pricing of assets: absolute pricing and relative pricing. In absolute pricing, we price each asset by reference to its exposure to fundamental sources of macroeconomic risk. The absolute approach is commonly used in which we use asset pricing theory positively to give an economic explanation for why prices are what they are, or in order to predict how prices might change if policy or economic structure changed.
In relative pricing, we can learn about an asset’s value given the prices of some other assets. We do not ask where the prices of the other assets are derived and use as little information about fundamental risk factors as possible. In choosing how much absolute and relative pricing one will do, it depends on the assets in question and the purpose of the calculation. For example, the CAPM and its successor factor models are paradigms of the absolute approach but in application, they price assets “relative” to the market or other risk factors, without answering what determines the market or factor risk premia and betas.
The CAPM is a good measure of risk and helps to explain the fact that some securities such as stocks, portfolios, strategies or equities, earn higher average returns than others. The CAPM states that assets can only earn a high average return if they have a high “beta”, which measures the tendency of the individual asset to move up or down with the market as a whole. Beta drives average returns because beta measures how much adding a bit of the asset to a diversified portfolio increases the volatility of the portfolio. When we analyze investment returns and risks, we are concerned with the total portfolio held by an investor. Individual security returns and risks are important but it is the return and risk to the investor’s total portfolio that ultimately matters because investment opportunities can be enhanced by packaging them together to form portfolios. A security may have large risk if it is held by itself but much less risk when held in a portfolio of securities. As investors are concerned primarily with the risk to his or her wealth, as represented by his or her portfolio, individual securities are risky only to the extent that they add risk to the total portfolio.
There are securities whose average returns cannot be explained by their beta; however, the CAPM multifactor extensions dominate the description, performance attribution and explanation of average returns by associating high average returns with a tendency to move with other risk factors in addition to movements in the market as a whole. This model provides particularly useful insights into analyzing the risk-return characteristics of a portfolio because it allows one to categorize the sources of risk and return into individual and identifiable components. The risk and return of a portfolio can be measured by combining these components and aggregate across individual securities to generate a set of efficient portfolios.
Generally, returns on securities are predictable, in particular to certain variables including the dividend/price ratio and term premium, which can predict substantial amounts of stock return variation. This occurs over business cycle and longer horizons but not daily, weekly and monthly stock returns as it is unpredictable. Bond returns are predictable. The expectation model works well in the long run: though a steeply upward slope yield curve means that expected returns on long-term bonds are higher than on short-term bonds for the next year, these predictions are not guaranteed as there is still substantial risk.
The view that risky asset returns are largely unpredictable or that prices follow “random walks” mean that if stock prices went up, there is no tendency for them to decline today or to continue to rise today because of trend. Any strategy to exploit the price movements for investors’ portfolios for forecasting short-term gains and losses will not do anything over the long run except to rack up their trading costs. The average returns on the market and individual securities do vary over time and that stock returns are predictable at long horizons associating with business cycles and financial distress.
The task of asset pricing is to understand and measure the sources of aggregate or macroeconomic risk that drive asset prices or returns. For examples, expected returns vary across time and across assets in ways that are linked to macroeconomic variables or variables that also forecast macroeconomic events. Most importantly, risk corrections to asset prices should be driven by the co-movement of asset payoffs with marginal utility and hence by the co-movements of asset payoffs with consumption. Other things equal, an asset that does badly in states of nature like a recession, in which the investor feels poor and is consuming little, is less desirable than an asset that does badly in states of nature like a boom in which the investor feels wealthy and is consuming a great deal. The former asset will sell for a lower price; its price will reflect a discount for its “riskiness” and this riskiness depends on a co-movement, not the risk. Most of the theory of asset pricing is about how to go from marginal utility to observable indicators. Consumption is low when marginal utility is high, so consumption may be a useful indicator.
Investors must decide how much to save and how much to consume and what portfolio of securities to hold to maximize the expected returns at a given risk. Many investors are unaware they have a choice between active and passive management strategies. Every investor is different and they will choose a strategy that can maximize their expected returns or utility functions. A passive strategy seeks profits solely from bearing investment risk while an active strategy attempts to profit from identifying mispriced securities. Both strategies are speculative and speculative strategies involved timing or selection of appropriate securities.
All investors must determine a portfolio asset allocation that provides them with the best mix of risk and return. Passive investors make this decision in the belief that the expected returns on different asset classes are fair given the risk of each asset class while active investors will attempt to identify periods when, say, stocks are overvalued or undervalued relative to other asset classes. When they believe an asset class is overvalued, they underweight or hold less than they would normally do in the asset class in their portfolios or when they believe an asset is undervalued, they overweight the asset class. The decision to pursue an active or passive strategy depends largely on market efficiency. Securities that are actively traded in major financial markets are most likely efficiently priced and other securities such as those traded in emerging markets might not be properly priced and require an active management approach. The decision to use an active versus a passive approach to manage an investment portfolio depends on the types of securities to be owned and the investor’s knowledge.
4. Portfolio Construction
The next investment decision requires determining an appropriate asset allocation for the portfolio. The construction of an appropriate portfolio involves asset allocation by determining the proportions of the investor’s wealth to put in each asset. Asset allocation is probably the important decision the investor will make and his or her decision affects both short and long-term investment performance of the securities selected. Asset allocation is a major determinant of the risk and future returns of diversified portfolios and the asset allocation of a diversified portfolio is considerably more important than the individual securities held. Security investment is risky and some asset classes have relatively little risk while others have considerable risk. The most difficult aspect of the asset allocation decision is to determine how to balance the fund’s need for long-term growth against the investor’s need to achieve investment results within shorter time frames.
Leibowitz and Krasker (1988) introduced a model to compare the investment performance of stocks and bonds. Both stock and bond returns are very volatile in Year 1 to 2 but the range of returns shrinks quite rapidly over time. In fact, there is a 36% chance that stocks will underperform bonds over a 5-year horizon and even a 24% chance over 20 years. The fact that stocks can greatly underperform in both the short and long term may cause many investors to seek a safer route than a 100% stock portfolio. Over a 1-year investment horizon, the choice between stocks and bonds reflects a standard risk-return trade-off. Over a 10-year horizon, the benefits of diversification start to emerge.
The mean-variance model of modern portfolio theory provides a rigorous approach for managing risk and return. Modern portfolio theory works best over short investment horizons and it may fail to address the concerns of investors with long-term investment horizons. As the investment horizon lengthens, the distribution of portfolio values becomes increasingly asymmetric and loses its value as complete measure of risk. To manage investment performance over planning horizons of 10 years or longer, we must sharpen our understanding of risk. Risk is decomposed into systematic and non-systematic risk. Non-systematic risk can be eliminated through diversification while systematic risk remains and cannot be diversified. To achieve a high expected return on investment while limiting risk exposure, an optimal asset mix will maximize the overall return while minimizing risk.
The optimal asset mix that maximizes overall return while minimizing risk depends on the assumed individual asset returns and their volatility over some extended period of time. Diversifying among multiple asset allocation may reduce risk while adding value to performance. Tactical asset allocation uses asset pricing models that forecast the relative returns of various asset categories and structure their portfolios so as to benefit from expected return differentials. The benefits of diversification among asset allocations are similar to the benefits of diversification among stocks and bonds. The expected return to the investor splitting their investment equally between two assets falls midway between the expected returns of the two asset portfolios. The risk borne by the investor nevertheless is lower than the midpoint between the risks of the two asset portfolios unless the returns of the portfolio are perfectly correlated.
Empirical evidence shows that investors who invest completely with macroeconomic risk factor can expect a higher return with higher risk than an asset group without it. Investors who diversify among asset group that contain equal amounts of information reduces risk without reducing expected return as return is moved from one asset group with much information into the other asset group with little information. Investors should examine the available combinations of expected return and risk and choose a combination that gives the highest return according to risk preferences. The expected equity return will be different from period to period as the market’s information set changes over time. In short, transitory deviations of expected returns from mean returns are consistent with the time horizon and risk premiums. As economic conditions change, the investor’s attitude toward risk tolerance may change as well. Investors may be more risk-averse in periods of economic recession than in periods of economic expansion. Moreover, a change in investor’s perception of future uncertainties in inflation or economic growth will certainly change desired returns.
Portfolio selection is a decision-making process under uncertainty, that begins with the determination of the investor’s investment horizon and specific investment goals. The return of an investment is generally regarded as an important determinant of the portfolio. In an uncertain environment, most investors display the common trait of risk-aversion. The traditional approach, generally, has to incorporate other investment goals to accommodate the specific needs of the individual investor, such as a low downside risk, etc. When choosing a portfolio, it is important to recognize the degree of co-movement in the returns of the individual securities than their individual risks.
5. Practical implications on asset pricing theory
Asset pricing theory provides a good description of why average returns on some stocks, portfolios, funds or strategies were higher than others. They attempt to define risk and explain the market value or expected return of any asset. Both have implications for an investor’s decision on strategic asset allocation.
In the Capital Asset Pricing Model, the optimal portfolio of risky assets for any investor implies investors should own all risky assets in proportions to the market. Once such a risky asset is acquired, no diversification is gained. If it is too risky, it can be held in combinations with risk-free asset. If it is not risky enough, investor can borrow and invest. In short, the optimal risky asset portfolio is the market portfolio of all risky assets. Although the CAPM is a conceptual tool, its practical implications should not be interpreted rigidity – the CAPM relies on the observation of the market portfolio, which in actuality, cannot be observed. On the other hand, the CAPM multifactor extension offers no clues as to the identity of the factors that are priced in the factor structure. Neither model has been proven superior as both rely on expectations that are not directly observable. Additionally, investors have differing investment horizons, tax rates, transaction costs and each causing different optimal asset mixes. The optimal allocation of different classes of assets must consider the unique needs of each portfolio. The CAPM should be used only as a theoretical guide from which actual portfolios are created that better achieved investor’s objectives.
6. Concluding remarks
The traditional investment advice is to understand investor’s risk-return trade-off characteristics before assembling classes of assets in an asset allocation for inclusion in a portfolio. A sensible investment advice is that the average investor must hold the market portfolio; thus, the multiple factors and return predictability cannot have any portfolio implications for the average investor. Investors should follow a value strategy or time the market for the extra returns offered by those extra risks and this works if it involves buying stocks when nobody wants and selling them when everybody wants them. Every investor is still faced with the choice between pursuing an active or a passive investment strategy or some combination thereof. Making this choice depends heavily upon what the investor believes about efficient markets. When the market is informational efficient, investors are unable to earn abnormal profits (returns beyond those warranted by the amount of risk) by using that information set in their investing decisions.
References
1. John H. Cochrane, ‘Portfolio Advice for a Multifactor World’, Economic Perspectives, Federal Reserve Bank of Chicago, pp. 59-74.
2. John H. Cochrane, ‘New Facts in Finance’, Economic Perspectives, Federal Reserve Bank of Chicago, pp. 36-56.
3. John H. Cochrane, ‘Asset Pricing Theory’, Research Paper, pp.1-50.
4. William F. Sharpe/Gordon J. Alexander, Investments, Fourth Edition, Prentice Hall.
5. Charles P. Jones, Investments Analysis and Management, Eighth Edition, John Wiley & Sons, Inc.
6. Martin L. Leibowitz and Terence C. Langetieg, ‘Shortfall risk and the asset allocation decision: A simulation analysis of stock and bond risk profiles’, The Journal of Portfolio Management, Fall 1989, pg. 61-68.
7. Haim Levy, ‘The CAPM and the investment horizon’, The Journal of Portfolio Management, Winter 1981, pg 32-40.
8. Edward C. Franks, ‘Should investors concentrate their investments in the hands of one asset group or should they diversify among several asset group’, The Journal of Portfolio Management, Spring 1990, pg 60-69.
John H Cochrane shows that over the last 50 years U.S. stocks have given a real return of about 9% on average. Of this, only about 1% is due to interest rates; the remaining 8% is a premium earned for holding risk. (2001, Article on Asset Pricing, pg xiii).
John H Cochrane follows that the asset’s price should equal the expected discounted value of the asset’s payoff, using the investor’s marginal utility to discount the payoff. (2001, Article on Asset Pricing, pg 5).
In the volatility tests by Shiller (1981) and LeRoy and Porter (1981) on long horizon return predictability found that stock prices vary and expected returns must account for variation in stock prices. (Cochrane, New facts in finance, pg 44).
Leibowitz (1988), the stimulation starts with a model for single-period returns based on the best estimate of expected returns, risk premiums, volatilities and correlations. The multi-period is calculated from a compounded sequence of single-period returns (The Journal of Portfolio Management, Fall 1989, pg 61-67).
Refer to Martin L. Leibowitz (1998), the article on shortfall risk and the asset allocation for details on the simulation of stock and bond returns on a single-period and multi-period returns (The Journal of Portfolio Management, Fall 1989, pg 62-65).
Leibowitz (1988) study shows diversification works when the 30% stock/70% bond allocation dominates the 100% bond allocation over a 20-year investment horizon (The Journal of Portfolio Management, Fall 1989, pg 66-67).
For more details, read the article ‘should investors concentrate their investments in the hands of one asset group or should they diversify among several asset group’ in the Journal of Portfolio Management, Spring 1990.
See Ferson and Merrick (1987) for details
See Copeland (1982) for details.