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Module 2

Investment Risk,
Return, and
Performance

Craig Kinnunen, MS, CFP®

7721
© 1996, 2002–2018, College for Financial Planning, all rights reserved.
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Table of Contents
Introduction ............................................................................ 1
Chapter 1: Risk ....................................................................... 3
Systematic (Nondiversifiable) Risk ..................................... 6
Unsystematic (Diversifiable) Risk ....................................... 9
Client Attitudes Toward Risk ............................................ 13
Chapter 1 Review ............................................................. 18
Chapter 2: The Risk/Return Relationship ........................... 20
Measuring Risk ................................................................. 20
Risk-Adjusted Returns ...................................................... 28
Chapter 2 Review ............................................................. 34

Chapter 3: Managing Risk in Portfolios .............................. 35


Risk Reduction Through Diversification ........................... 35
Client Time Horizons and Portfolio Risk .......................... 42
Practical Approaches to Creating Client Portfolios ............ 45
Chapter 3 Review ............................................................. 46
Chapter 4: Measuring Investment Performance .................. 47
Excess Return ................................................................... 47
Risk-Adjusted Measures of Return .................................... 48
Performance Benchmarks .................................................. 53
The Importance of Time Periods ....................................... 55
Chapter 4 Review ............................................................. 57

Summary ............................................................................... 58
Chapter Review Answers ...................................................... 59
Chapter 1 ........................................................................... 59
Chapter 2 ........................................................................... 61
Chapter 3 ........................................................................... 63
Chapter 4 ........................................................................... 64
References .............................................................................. 66
About the Author ................................................................... 67
Index ...................................................................................... 68
Introduction

T
he wealth management adviser takes a holistic approach to working with
their high net worth clients, and is often serving in a relationship
management role and may not be the hands-on investment professional
for the client. However, the wealth management adviser must still have a
fundamental understanding of the investment process, and this module considers
several concepts that constitute the very heart of that process. Investment risk is
defined, along with tools to categorize client attitudes toward risk. Systematic
and unsystematic risk are also defined. Betas are reviewed in terms of their ability
to measure risk, both at the individual security level and at the portfolio level. The
capital asset pricing model (CAPM) is introduced as a method of calculating risk-
adjusted return.

Focusing next at the portfolio level, the concept of diversification is explained.


Practical approaches to creating efficient client portfolios are then discussed. Time
horizons are an important factor to be determined in the client assessment process.
All of these aspects of the process serve to educate the client about the relationship
between risk and return. In providing this education, the investment
professional adds value to the client relationship. This module also
demonstrates the use of indexes to account for the performance of investment
professionals. Specifically, portfolio performance is compared using the Jensen,
Treynor, and Sharpe indexes; these indexes allow for risk-adjusted comparisons
to be made between portfolios.

The chapters in this module are:

Risk

The Risk/Return Relationship

Managing Risk in Portfolios

Measuring Investment Performance

Introduction  1
© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Upon completion of this module, you should understand fundamental
concepts of risk and performance measurement principles.

To enable you to reach the goal of this module, material is structured around the
following learning objectives:

2–1 Explain “risk” in terms of investing.

2–2 Calculate the relative risk of stocks or portfolios using betas.

2–3 Calculate the return of a stock or portfolio using the capital asset
pricing model.

2–4 Explain how to achieve risk reduction through diversification.

2–5 Explain the importance of client time horizons to portfolio risk.

2–6 Compare portfolio performance using various performance


measurement tools.

Look for the boxed objectives throughout this module to guide your studies.

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© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Chapter 1: Risk
This chapter contains a general discussion of the subject of risk and how clients
typically react to it. After reading this chapter, you will be able to:

2–1 Explain “risk” in terms of investing.

B
ridget and John Bishop have never set foot inside a brokerage firm—at
least, not until today. They have always thought of brokers as fast-lane
speculators. The total “investing” experience of the Bishops has taken
place within their community bank, where, for years, a customer service clerk has
provided them with information on current bank certificate of deposit (CD) rates.
Until now, their investment decisions have been confined to choices involving CDs
with maturities of six months, one year, two years, and three years.

Bridget and John have come to the brokerage firm because their bank’s CD rates
have dropped into the cellar. They know that they must obtain higher returns on
their funds if they intend to meet their long-term financial goals, and they appear
to be psychologically prepared, at least on the surface, to deal with the added
risks they associate with the brokerage office they have freely entered. But will
Bridget and John be able to live with the added risks of market investing? Will
they invest their funds if their new investment professional explains the facts
about risks and investment returns? Will they bolt at the first fluctuation in the
market value of their investments?

Helping clients like the Bishops to make the transition from cautious savers to
decisive investors is one of the greater challenges of the investment professional.
Success in that effort usually begins with a process of education about risk and
its relationship to return. Risk is often taken to mean the degree of uncertainty
associated with the return of an asset. The uncertainties of return that cause
investors to worry and to hesitate include the extent to which the price behavior
of a market security, such as a stock or bond, cannot be predicted, or the chance
that a bond issuer will default.

Chapter 1: Risk  3
© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Another way of looking at risk is in terms of volatility. A stock whose price
fluctuates wildly up and down is considered riskier than another stock, whose
price stays on an even keel, even if the two stocks end up delivering the same
return after a number of years.

A third way to look at risk is what is the possibility of losing money in this
investment? This is the first way many clients view risk and such a view has
merit. For example, if a stock falls 50%, it takes a 100% return to get back to
even. If a stock falls 75% (like some stocks in 2008), it takes a return of 300% to
get back to even, which could take years. This is why it is critically important for
an investor to avoid large losses. Conservative clients are especially sensitive to
the possibility of loss. In these situations, bank CDs have great appeal because
they are fully insured (up to FDIC limits) by the government. Stocks, on the
other hand, have the real possibility of losing money for a client.

This, however, is not the total picture. CDs do have risk—purchasing power
risk—because their interest and the return of principal are paid in fixed dollar
amounts. In contrast, over time, stocks have provided an excellent counter to
inflation. Long-term studies of asset returns indicate U.S. large company stocks
returned a compound rate of return of about 10% during which inflation
increased slightly more than 3%. Two lessons from this are:

1. there is risk in every investment (even insured CDs have purchasing power
risk); and

2. there is a short-term risk of being in securities that fluctuate, especially


stocks; and a long-term risk of being too conservative, such as being totally
invested in CDs.

In this sense, the time frame within which the investment will be held has a direct
relationship to risk.

The degree of risk in owning a security is often given little thought by investors;
they instead usually concentrate on the return of an investment. As an example,
in 2006 and 2007, investors bought collateralized debt obligations (CDOs) that

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© 1996, 2002–2018, College for Financial Planning, all rights reserved.
contained subprime mortgages. When these mortgages began to experience rising
default rates, investors sold their CDOs (and anything else they perceived as
being risky) and reinvested in Treasury securities as a safe haven for their money.
The cash flow into Treasuries was highlighted on August 20, 2007, when
investors aggressively bought three-month Treasury bills. This flood of investors
pushed the three-month Treasury bill yield from a start of about 3.90% down to
2.51% at one point; ending the day at 3.04%. This was the largest yield drop for
the Treasury bill in almost 19 years. In a flight to safety, by 2008 T-bills were
yielding just a few basis points or less than 1%. Clearly, investors had changed
focus from earning a return to safety of principal.

How do you deal with risk and the investment process? What can you tell a
couple like the Bishops about risks and the greater returns they hope to achieve?

Before we can explain anything to clients like the Bishops, we need to first
understand the two broad types of risk that exist in investing: systematic and
unsystematic risk. Together, systematic risk and unsystematic risk comprise total
risk, which is measured by standard deviation (which measures variability).
Systematic risk, as we will see later on, is measured by beta (which measures
volatility).

Figure 1: Types of Risk

Total Risk
Standard Deviation (Variability)

Systematic Risk
Unsystematic Risk
Beta (Volatility)

Chapter 1: Risk  5
© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Systematic (Nondiversifiable) Risk
Systematic risk is the uncertainty of return inherent in the “system” of which any
asset is a part. It exists anytime there is an unknown element in an investment.
For example, a share of Intel common is part of a larger system of events and
relationships that have an effect on Intel shares in spite of anything the
management of Intel Corporation may do. It is the risk of the investment
environment that exists outside of Intel. To varying degrees, systematic risk is
found in nearly all securities because comparable securities generally move
together in a systematic manner. For this reason, it is also called
“nondiversifiable” risk.

Systematic risk includes the following types, and can be remembered with the
acronym “PRIME”:

 Purchasing power risk

 Reinvestment risk

 Interest rate risk

 Market risk

 Exchange rate risk

Purchasing power (inflation) risk. This risk is the risk of one’s purchasing
power decreasing as a result of an increase in inflation. At times, like in 2008
when the Consumer Price Index from December 2007 to December 2008
increased only 0.1%, inflation can be very subtle. However, even with a low
overall rate, in certain segments of the economy such as health care and higher
education, inflation can be much higher. Inflation has a corrosive effect on the
investor’s principal and return, robbing both of purchasing power. For example,
assuming an inflation rate of 3%, something costing $10,000 at the beginning of
the year1990 would cost $22,213 at by the beginning of year 2017. Inflation is
most devastating to bond prices since the interest and principal are usually fixed
in terms of dollar amounts. Just the hint or expectation of an increase in inflation

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© 1996, 2002–2018, College for Financial Planning, all rights reserved.
will send bond prices downward. Since 1926, inflation has grown at a compound
rate of just over 2.9% annually. The inflation rate is pro-cyclical, meaning that
inflation moves in the same direction as the economy as a whole, but will often
lag by a year or more.

Reinvestment risk. Sometimes called reinvestment rate risk, this is the risk that
market interest rates have decreased at the time payments from an investment are
received. An investor is forced to reinvest his or her payment amount at a time
when rates are not as favorable as they may have been previously. Investors who
need a fixed amount of income should pay special attention to this risk. Another
investor who has significant exposure to this risk is the person who has a large
amount of bond principal coming due on one day. For example, a person with
$500,000 worth of bonds maturing at one time is taking the risk that interest rates
will be low when that newly paid out bond principal needs to be reinvested.

Interest rate risk. The market values of most securities, and fixed-income
securities in particular, move inversely with changes in interest rates. When
market interest rates go up, the value of outstanding bonds goes down. Even
stock prices can be hurt by rising interest rates as bond yields become more
attractive to investors and corporate earnings are reduced by higher borrowing
costs. Residential real estate values are likewise affected as higher mortgage rates
make home ownership less affordable. Again, interest rate risk is systematic;
even the most solid bond, such as U.S. Treasury securities, will drop in market
value when market interest rates rise. The safety of Treasury securities is in terms
of payments due (creditworthiness), not in terms of price while the bonds are
outstanding. In addition, buying several more bond issues (diversification) will
not eliminate interest rate risk, which is what makes it a systematic risk.

Market risk. “A rising tide lifts all boats” is a time-honored maxim of Wall
Street, and likely the converse is also true. Market risk stems from factors
independent of any particular security. These factors include political events,
broad economic and social changes, and the mood of the investing public. It is
“systematic” in the sense that the price of any security can rise or fall in reaction
to these larger events. Thus, if the stock market is seized by a temporary selling
panic, many securities will suffer short-term losses, regardless of each company’s

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© 1996, 2002–2018, College for Financial Planning, all rights reserved.
financial condition. Market risk was clearly demonstrated on “Black Monday,”
October 19, 1987, when the Dow Jones Industrial Average fell over 500 points
(the DJIA was around 2,000 at that time) and again in 2008 when the S&P 500
stock index dropped approximately 37% that year.

Exchange rate risk (also called currency risk). When U.S. investors buy assets
denominated in foreign currencies, they face the risk of having both their
principal and their return diminished by changes in the relative values of U.S.
and foreign currencies. For example, the American purchaser of shares in a fund
of British bonds is subject to changes in the U.S. dollar/British pound exchange
rate. If this exchange rate changes in favor of the British pound—that is, if the
pound strengthens against the dollar—the investor will find his or her return
enhanced as he or she will receive more dollars after pounds are converted into
dollars. A weakening in the British currency relative to the dollar, however, will
have just the opposite effect.

To illustrate this principle, let us consider an American investor whose British


bond pays interest at the rate of 10 pounds per year. If the current exchange rate
is £1.00 equals $1.60, the interest payment in U.S. currency is $16.00. But what
if the British pound weakens against the dollar to the point that £1.00 equals
$1.20? If the bond continues to pay interest of 10 pounds annually, the U.S.
investor will be receiving $12.00 of interest instead of $16.00. In this situation,
the pound is said to have weakened against the U.S. dollar because one pound
buys less U.S. currency. In other words, previously your pound sterling bought
you $1.60, but now will only buy you $1.20 (as the pound weakens). Another
way of saying this is that the U.S. dollar has strengthened or appreciated against
the British pound because only $1.20, instead of $1.60, is needed to buy one
pound. As can be seen in this example, a strengthening of the U.S. dollar relative
to foreign currencies is disadvantageous to U.S. investors when owning foreign
securities or international mutual funds because U.S. investors receive fewer U.S.
dollars after conversion. On the other hand, a weak dollar is advantageous to U.S.
investors owning foreign securities or international mutual funds.

Exchange rate risk is considered to be systematic risk in that it originates as an


unknown element within the investment system and is beyond the influence of

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© 1996, 2002–2018, College for Financial Planning, all rights reserved.
any particular firm or firms. That is, in the example above, the conversion process
would apply to all British bonds. One very important rule to remember when dealing
with exchange rate risk is “who changes the currency assumes the risk.”

Exchange rate risk is not restricted to securities issued by foreign corporations.


This form of risk can also affect the earnings of America’s corporations that do
business overseas, and therefore those who own these corporations’ securities are
indirectly affected by exchange rates. As more and more business activities cross
national borders, earnings are more subject to exchange rate risk (unless
businesses hedge this risk, a topic beyond the scope of this course). General
Electric, Coca-Cola, ExxonMobil, Caterpillar, and many other companies are
heavily dependent on non-U.S. business activities.

Systematic Risk Cannot Be Eliminated


The systematic risks just described have their origins in broad economic,
political, and international events, as well as in the collective mood of investors.
Some securities may be more sensitive to these risks than others, but none can
escape them entirely. For example, if a person has 10 bonds and buys another 10
bonds, he or she will still have interest rate risk. Or if an investor owns 15
different common stocks, buying 10 more different stocks will not eliminate
market risk. Therefore, systematic risk cannot be eliminated. As we will see later,
the beta coefficient (or simply beta) is the measure of systematic risk for a
security or portfolio.

Unsystematic (Diversifiable) Risk


Some forms of risk are directly associated with particular securities, and the risk
involved in these, as we will see, can be reduced through diversification.
Unsystematic risk depends on factors unique to a particular asset, firm, or
security. Factors such as management capabilities and actions, technological
changes, and the competitiveness of a firm’s service or product result in the
uncertainty of return. These uncertainties are independent of factors affecting
other firms, industries, or securities markets; that is, the factors causing

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© 1996, 2002–2018, College for Financial Planning, all rights reserved.
uncertainty are specific to an individual firm. Some of the most common forms
of unsystematic risk are described in the following.

Business risk. Every business has a set of income flows that are unique and
related to the nature of its operations and products. Depending upon the business,
these income flows can be steady or volatile. Steady and dependable income
flows mean greater certainty of returns—that is, less risk. Firms with highly volatile
income flows are viewed as risky because plunging income flows threaten a firm’s
ability to pursue its strategic plans, meet payrolls, or pay dividends.

On another level, business risk is associated with the unique nature of the firm’s
operations, management, and it’s the firm’s position in its industry. An
established company with competitive products and established customers has far
less business risk than does a start-up venture whose product has neither patents
nor customers and is still under development. This level of business risk, of
course, is mirrored in the patterns of income flows mentioned above.

Financial risk. Financial risk is the degree to which a company utilizes debt to
finance its operations. Assume EFG Corporation is entirely financed by equity—
that is, all of its assets are paid for, and it has no debts. XYZ Inc., on the other
hand, is a highly “leveraged” firm. For every dollar of assets it owns, 75 cents is
owed to creditors. Because a firm is under a legal obligation to repay the interest
and principal of its debts, high debt levels increase the risk that shareholders will
not receive dividends. Heavy debt obligations also increase the risk to
bondholders that the firm will not generate sufficient funds to meet its obligations to
repay either interest or principal—or both. The common stock price of a highly
leveraged company having difficulty meeting its debt service will likely decline.

Default risk. Default is a condition in which an entity cannot repay its debt
obligations. The best-known obligation of a bond issue is the obligation to make
payments of interest when due and principal at maturity. The U.S. government is
viewed as being free from default risk because of its ability to raise taxes and
print money, with which to pay its debts. State and municipal securities have no
abilities to print money, but (within limits) they can raise taxes to generate the
income needed to meet their obligations. The degree of a company’s or

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© 1996, 2002–2018, College for Financial Planning, all rights reserved.
municipality’s default risk is reflected in its credit rating, as determined by major
credit rating companies (i.e., Moody’s or Standard & Poor’s) for those issuers that
choose to have their issues rated. In general, corporate bonds have more default risk
than municipal bonds because corporations have more business and financial risk.

Credit risk. This risk is closely related to default risk. A lowering or expected
lowering of the credit rating on an issuer’s debt can cause the market price of that
debt to fall. Often these price declines occur before credit agencies actually
downgrade issues as bond investors recognize deteriorating financial conditions
and therefore anticipate the downgrading. The prices of all corporate or
municipal debt issues can also be affected if the risk premium demanded by
investors for a given credit rating changes.

Liquidity risk. Every investment has some amount of “liquidity risk.” This is
related to the ability to transform the investment into cash in a short period of
time with little or no change in price. A share of a blue-chip company trading on
the NYSE, for example, has little liquidity risk because there are always plenty of
buyers and sellers, a situation that keeps bid and ask prices fairly close together.
A partnership interest in a local shopping mall, on the other extreme, has a great
deal of liquidity risk. The sale of the shopping mall partnership interest could
take months to consummate unless a substantial price concession is made to
facilitate a quick sale. For an investment to be considered liquid, there must also
be an active market for the investment.

Event risk. Event risk is the possibility that a bond or stock holder will be
negatively affected by an unanticipated and damaging event. The event may take
the form of a major tax or regulatory change; a change in a company’s capital
structure due to a merger or buyout; disclosure of fraud or other significant
misdeeds; negative media attention to a particular product; or some other major,
unexpected event. Municipal bonds can experience event risk as well. For
example, in July of 2013 the city of Detroit defaulted on $600 million of general
obligation municipal bonds, and in 1993 and 1994 the treasurer of Orange
County, California invested in derivative securities, which eventually caused
large, unexpected losses. This, in turn, caused a large selloff of the county’s
bonds due to serious questions about the county’s ability to make bond payments

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© 1996, 2002–2018, College for Financial Planning, all rights reserved.
(the county declared bankruptcy on December 6, 1994, due to $1.7 billion of
losses from these derivatives).

Another example would be when a company unexpectedly issues a large amount


of debt, causing the prices of existing bonds to fall. Reasons a company might do
this are to finance the acquisition of another company, to buy back shares, or to
pay special dividends. In 2006 and 2007, some private-equity firms had been
acquiring companies and loading those acquired companies with debt in order to
pay the generous dividends and fees of those private-equity firms. The result is
that the acquired company suddenly had much more debt, causing the price of its
bonds that were issued before the private acquisition to fall in price. When these
intentions become public, this would likely cause existing bonds to be downgraded
with a corresponding fall in price because of the increased debt load.

Yet another example is the April 2010 oil leak in the Gulf of Mexico from a well
owned by BP, the large British oil company. Certainly this was an unexpected
event that had a huge effect on BP, as it had to spend billions of dollars to cover
the damage caused by the leak. The total cost of this event is still unknown, and
could be billions of dollars more than already calculated. This can have a major
impact on BP’s corporate reputation. In the two months after the oil leak, BP stock
price fell 50%, along with a dividend suspension, as the cost of this event climbed.

Call risk. Call risk is the possibility that a debt security will be called in by its
issuer prior to maturity. This option is a feature of most municipal and corporate
bond issues, making it possible for the issuers to pay off existing high-coupon
bond issues with new ones that have lower coupon rates. Therefore, calling a
bond is advantageous for the issuer but disadvantageous for the bondholder. Call
risk increases when interest rates decline. When investors receive their principal
from called bonds, they find that they are able to reinvest the funds only at a
lower rate (thereby encountering reinvestment risk). Call dates indicate the first
and successive dates on which bonds may be called, and call premium is the
amount above par value to be paid if the issue is called.

Political risk and country risk. Political risk captures the risk of a nation-state
defaulting on its commercial debt obligations due to potential government

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instability or overthrow, while country risk covers the downside of a country’s
business environment including legal environment, levels of corruption, and
socioeconomic variables such as income disparity. The less stable the political
circumstances, the greater the political risk. The less stable the economic, or
social structure of a country, the greater the country risk. These risks could be
manifested in the expropriation of assets, exchange control laws, the overthrow
of governments, war, corruption, riots, and so forth. An example of political risk
was the crisis in Egypt that began in late January 2011 as Egyptian citizens
demanded the resignation of its president. The Egyptian stock market fell about
21% during that time; falling roughly 17% in just two of those days.

In nations with both high country and high political risk, there are risks caused
by less available public information about the issuers of securities, less stringent
regulatory standards, and lack of uniform accounting, auditing, and financial
reporting standards. A security or portfolio of securities from emerging market
countries would, of course, have more political risk and country risk than securities
from developed countries. The United States is considered to be the most stable
country in the world for investment. When uncertainty exists in the world,
investment funds tend to flow into the United States as a safe haven for wealth.

Client Attitudes Toward Risk


The scholarly definition of risk given earlier as “the degree of uncertainty
associated with the return of an asset” encompasses equally the uncertainty
associated with an increase in the price of an asset and the uncertainty associated
with a decline in the price of an asset. Obviously, it is the “not knowing” what
will happen that matters in this definition.

Clients, however, do not lose sleep worrying about the “risk” of an asset
producing an increase in a given year; on the other hand, they worry considerably
about a loss. In an article on the attitude of individual investors to risk, Owen M.
Quattlebaum remarked that, “there is something in the human mind that so
abhors a loss that giving up a quantity of money is rarely fully offset by an
equivalent gain.” Other studies in the field of behavioral finance have confirmed

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© 1996, 2002–2018, College for Financial Planning, all rights reserved.
this statement. Said another way, people dislike losing money more than they like
making the same amount.

The Barnewall study. The field of investments is abundant with research studies
on market performance, price behaviors of various instruments, and other
quantitative measures. Much less attention has been given to the human
behaviors that underlie the investment process. Fortunately, Marilyn MacGruder-
Barnewall conducted a very comprehensive study that contributes greatly to our
understanding of clients and risk.

Barnewall conducted focus group interviews with 2,000 affluent individuals over
a 13-year period ending in the mid-1980s. Her goal, which remains relevant
today, was to determine the extent to which individuals in the different
occupation/professional groups targeted by financial services firms were either
active or passive investors and, by extension, the risk tolerance of these same
individuals. The individuals studied by Barnewall are categorized by
occupation/profession in Table 1.

Table 1: Occupations/Professions Represented in Barnewall Focus Groups


Health care professionals, surgeons CPAs, Big 4
Health care professionals, non-surgeons CPAs, independent
Corporate executives Lawyers, large regional firms
Small business owners Lawyers, small independent firms
Entrepreneurs (no other occupations) Dentists, surgeons
Inherited wealth Dentists, non-surgeons
Miscellaneous categories
Source: Adapted with permission, from the Asset Allocation for the Individual Investor seminar
proceedings. © 1987, The Institute of Chartered Financial Analysts, Charlottesville, VA. All
rights reserved.

Barnewall concluded from her research that members of some occupational


groups are measurably more risk averse and security oriented. These groups
include the following:
 corporate executives

 lawyers in large regional firms

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 CPAs of Big 4 firms

 non-surgeons (both medical and dental)

 individuals with inherited wealth

 small business owners who inherited their businesses

Barnewall categorized members of this group as, by and large, passive


investors—individuals whose wealth has been obtained passively, either through
inheritance or through risking the capital of others. Further, the fewer economic
resources these individuals have, the more risk averse they are. Passive investors
tend to direct 70% of their investable funds into a secure mix of products; only
30% is available for investments perceived as risky.

In contrast to passive investors, members of some occupational groups were


measurably less risk averse. These included the following:

 small business owners who started their firms

 surgeons (medical and dental)

 independent CPAs and lawyers

 entrepreneurs

Barnewall described these groups as active investors, who, in her definition, are
“... those individuals who have earned their own wealth in their lifetimes. They
have been actively involved in wealth creation and they have risked their own
capital in achieving their wealth objectives.”

These investors, according to Barnewall, have a higher risk tolerance, stemming


partly from their insistence on maintaining control of their investments. As long
as they are in control, they perceive their investments as being less risky. Their
perception of risk in an investment increases as control is kept from them. Thus,
an “active” investor would likely view the typical syndicated real estate limited
partnership in residential apartments as very risky, whereas an investment in a

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© 1996, 2002–2018, College for Financial Planning, all rights reserved.
local residential apartment building by this same investor and two or three other
local businesspeople would be perceived as less risky.

The difference here is the investor’s access to information and decision making—
that is, to control. As Barnewall put it, “By their involvement and control, they
feel they reduce the risk to an acceptable level.” In general, their investments are
70% in the risky category and only 30% in the secure products favored by
passive investors.

Implications for investment professionals. There are two important explicit


implications of the Barnewall study for the investment professional:

1. Active clients are candidates for your firm’s more complex and risky
investment opportunities, but they will demand information and may end up
knowing more about the particular investment than you do. They have
tremendous confidence in their own judgment and are unlikely to defer to
yours.

2. Passive investors are poor candidates for your firm’s more complex and risky
investment opportunities—at least not until they have reached a stage in life
that their lifestyle requirements are very secure. They are generally better
candidates for managed investments and are more likely to defer to your
recommendations.

A word of caution: Even with this study as evidence, do not be too quick to
classify an individual until you get to know him or her well.

“There Is No Such Thing…”


Some investment professionals have little reminders taped to their telephones,
like “Did You Ask for a Referral?” We would suggest this one as being just as
important:

There is no such thing as a no-risk investment.

16  Investment Risk, Return, and Performance


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Hopefully, the previous discussion has made this clear. In 2001, Enron bonds
were rated AAA just a few months before the company’s collapse. At one time,
General Motors stock was considered “blue chip,” backed by the earning power
of the largest automobile maker in the world. Widows and orphans could depend
on the GM dividend associated with this “safe” investment. By early 2009, GM
was on the brink of bankruptcy and dependent on a government bailout to
provide funds to keep operating. Banking giant Citigroup was regarded in a
similar manner until taking too much risk that by 2008 resulted in also requiring
a government bailout.

And more than a few investment professionals have encountered the elderly
person who invested his or her life savings in U.S. Treasury bonds because they
were “government guaranteed,” only to see their market value plunge to 75 cents
on the dollar due to rising interest rates. And, as mentioned before, even
government-insured certificates of deposit, which do not fluctuate in value, have
purchasing power risk.

Chapter 1: Risk  17
© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Chapter 1 Review
1. Define risk in terms of investing.
Go to answer.

2. Define the following types of systematic risk.


a. market risk
Go to answer.
b. interest rate risk
Go to answer.

c. reinvestment risk
Go to answer.

d. purchasing power risk


Go to answer.

e. exchange rate risk


Go to answer.

3. Define the following types of unsystematic risk.


a. business risk
Go to answer.

b. financial risk

Go to answer.

c. default risk

Go to answer.

18  Investment Risk, Return, and Performance


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
d. credit risk

Go to answer.

e. liquidity risk

Go to answer.

f. event risk

Go to answer.

g. call risk

Go to answer.

h. political risk

Go to answer.

Chapter 1: Risk  19
© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Chapter 2: The Risk/Return
Relationship

A
ssume you have the option of choosing one of two investments.
Investment A has an expected return of 12% while Investment B has an
expected return of 9%. Which investment would your clients choose?
Of course, every client would select Investment A. However, let’s add some
more information. Investment A is stock in foreign gold mines and Investment B
is U.S. Treasury bonds. Would this change the selection of your clients? Very
likely it would, because instead of just return, the element of risk has been
introduced. And a 3% difference in expected return would not be enough to
compensate an investor for the additional risk taken. This example illustrates the
importance of considering both the risk and the expected return, and not just
simply the return, of an investment.

Most people with any level of experience intuitively understand that investments
touted as being “high profit, no risk” are generally too good to be true—and
invariably they turn out to be not true. Yet many ignore their intuition when
faced with the promise of a very high return and, unfortunately, end up losing
money, sometimes all they have. In fact, fraudulent investment sales are based upon
exaggerated returns promised to investors. The essence of investing is balancing risk
and return. Both subjects will be addressed in this course, starting with risk.

Measuring Risk
This chapter examines risk with greater precision, and offers quantitative tools
you can use in the course of serving your customers. After completing this
chapter, you will be able to:

2–2 Calculate the relative risk of stocks or portfolios using betas.

Sarah Wilson purchased QRS stock in January 2007. Over a holding period of 10
years, her stock produced an average annual return of 12%.

20  Investment Risk, Return, and Performance


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Sarah’s brother, Nathan, purchased TUV stock in January 2007. By coincidence,
his stock also averaged a 12% return during that same period. While both stocks
“averaged” the same yearly return, Sarah’s QRS annual stock returns did not
deviate very much from that average. The annual returns of Nathan’s TUV stock,
on the other hand, varied widely. Figure 2 illustrates the annual returns of the
individual stocks plotted against the average annual return of 12%.

Figure 2: Stock Return Movements

Average
QRS Stock
Annual
Return
12%

Year 1 2 3 4 5 6 7 8 9 10

Average TUV Stock


Annual
Return
12%

Year 1 2 3 4 5 6 7 8 9 10

The data points represent the variability, or dispersion, of stock returns from the
average return for each stock. For QRS, the data points indicate that yearly
returns did not vary a great deal from the average for the 10-year period. For
TUV, however, annual returns varied greatly over the period. Both stocks may
have had the same total return over 10 years, but did they have the same level of
risk? QRS exhibited a low level of variability relative to its average return; TUV,
by contrast, had a relatively high level of variability.

So, who cares? If one investment has the same long-term return as another, but
its value fluctuates dramatically, does it matter? Ask your clients. If the client did

Chapter 2: The Risk/Return Relationship  21


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
not intend to sell during the period of the fluctuations, or if the client did not
bother to read the monthly account statements or the financial pages, it might not
matter. For most clients, however, the wild ride adds no value to the eventual
outcome. In fact, it diminishes the investment’s appeal, even to the point of panic
selling.

Standard deviation. One measure of variability is standard deviation, which can


be thought of as “the bumpiness of the ride.” It effectively captures the ups and
downs of investment returns in a single statistical measure and incorporates total
risk (both systematic and unsystematic risk). Most investment and statistics
textbooks provide a lengthy discussion of how standard deviation is calculated.
For our purposes, however, only a working definition of this important concept is
relevant:

Standard deviation is the variability of an investment’s returns around its


average, or mean, return.

In the case of QRS and TUV stocks, above, the lower variability of annual returns
of QRS would result in a lower standard deviation of returns than that of TUV. In
other words, QRS has lower risk than TUV. This can be thought of in simple,
common sense terms. If, over the past 10 years, investment A had returns between
3.0% and 5.0% and investment B had returns that ranged from -20% to +25%, it
would be much easier to reasonably predict the return of investment A than of
investment B. Saying this a different way, there is less uncertainty in the returns of
investment A than of B. And the uncertainty of returns is one definition of risk.

Knowing the standard deviation calculations is not enough, however. You also
need to know how to interpret standard deviation. Statisticians have found that in
a “normal distribution” (where 50% of returns fall above the mean and 50% fall
below the mean return,) 68% of returns will fall within one standard deviation on
either side of the mean. Likewise, 95% of returns will fall within two standard
deviations, and 99% within three standard deviations. With this knowledge, the
probability of expected returns can be assessed. Figure 3 shows how this can be
accomplished. The value of one standard deviation is added to, and subtracted
from, the mean to determine the interval within which the returns can be

22  Investment Risk, Return, and Performance


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
expected to fall 68% of the time. The 95% confidence interval is then plus and
minus two times the standard deviation value from the mean. The 99%
confidence interval is plus and minus three times the standard deviation value
from the mean.

To illustrate this, assume the following investment of stock S that has a mean
return of 7% and a standard deviation of 6.42%.

Figure 3: Standard Deviations of Stock S

68%

95%

99%

3σ 2σ 1σ X 1σ 2σ 3σ
Stock: -12.26 -5.84 0.58 7.00 13.42 19.84 26.26

According to this data, the following can be said about the stock (S):

 +0.58% to +13.42% would be 1 standard deviation (68% of the returns)

 –5.84% to +19.84% would be 2 standard deviations (95% of the returns)

 –12.26% to +26.26% would be 3 standard deviations (99% of the returns)

In the investment world, investments with higher standard deviations have higher
variability (risk). As we will see in the next module, the standard deviation of
returns for various asset classes has been calculated, providing us with a sense of
how variable the returns of these assets have been over time. For example, the
compound annual growth rate of large company stocks was about 10.1% between
1926 and 2013. That figure tells us how much an investment in common stocks
would have grown on a compounded basis over that long period. It fails, however,
to tell us anything about the ups and downs of stock investing during those years.
For that, we need to consider the standard deviation, which was 20.2% for the same
period of time. By comparison, the standard deviation of long-term U.S.
government bonds was only about 9.8%—less than half as variable.

Chapter 2: The Risk/Return Relationship  23


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Note: While standard deviation is a useful measure of risk, it assumes that
returns are bunched together in a normal bell curve. Recent research by
Morningstar and Ibbotson Associates has shed new light on this. In reality, stock
returns have “fat tails,” meaning there are more extreme highs and lows than
would be associated with a normal bell curve. Under the traditional view of stock
variability, there is about a 1% chance of the S&P 500 index having a five-year
loss of 40% or more. Morningstar Inc. estimates these odds at 3% to 6%. While
still small odds, if accurate, this suggests an investor should factor in this
possibility in their investment strategy by taking less risk, which would be
especially important for people near or in retirement.

Beta coefficient. Another valuable measure of risk is the beta coefficient or


“beta.” This is a measure of a stock’s systematic risk. It is also a measure of
volatility, relative to an appropriate benchmark.

It has long been observed that some stocks outpace the general stock market
during bull markets, and that these same stocks fall further than the general stock
market during bear markets. Other stocks lag behind market upswings but do not
lose value as rapidly as most stocks when the market declines. Thus, individual
stocks, over time, have demonstrated a price movement relationship to the overall
stock market.

Statistical analysis can be applied to the past price movements of an individual


stock and the market as a whole to derive a single number—the beta
coefficient—that describes the volatility of that stock relative to the overall
market based on those past movements. It can be used to indicate the expected
movement of a stock or portfolio relative to the market.

The computation of beta requires calculating the standard deviations of both the
individual security and the market (appropriate benchmark). It also requires
calculating the correlation coefficient between the security and the
market/benchmark. The formula is as follows:

σi
β= × Rim
σm

24  Investment Risk, Return, and Performance


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
In the formula, σi is the standard deviation of the individual asset, σm is the
standard deviation of the market, and Rim is the correlation coefficient between
the individual asset and the market.

Example. Assume that the standard deviation of a stock is 22, the standard
deviation of the market index is 16, and that the correlation coefficient between
the stock and the market is .66. What is the beta of the stock?
σi
β= × Rim
σm

22
β= × .66 = .91
16
Betas for many individual issues are readily available from a variety of
investment research sources. The stock market as a whole has a beta of 1.0, and
individual issues have betas either equal to, or higher or lower than, that figure. If
a stock has a beta of 1.0, it is expected to move in the same proportion as the
market; that is, if the market drops 10%, that stock should drop 10%. If a stock
has a beta of 1.2, and the market rises 10%, the stock should rise 12% (10% ×
1.2) and can be viewed as being 20% more volatile than the market. A stock with
a beta less than 1.0, say 0.9, would be expected to rise only 9% if the overall
market rose by 10% (10% × 0.9).

Table 2: Standard Deviation vs. Beta

Standard Deviation Beta


Measures: Total risk Systematic risk
Absolute risk Relative risk
Variability Volatility

Determining the Weighted-Average Beta of a Portfolio


We all know how to find the average (the “mean”) of a group of numbers. If the
group contains four different numbers, for instance, we add all the numbers
together and divide by four.

Chapter 2: The Risk/Return Relationship  25


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Example. Amy Marble’s new portfolio contains four stocks whose individual
betas are 1.1, 1.15, 1.25, and 1.3. The average beta of these four stocks is 1.1 +
1.15 + 1.25 + 1.3 = 4.80 ÷ 4 = 1.20. If she had the same amount invested in each
of these four stocks, this arithmetic average would accurately describe her
portfolio’s beta. However, some of the four stocks represent a larger portion of
the portfolio than do others, and the betas of those stocks have a greater impact
on the beta of the entire portfolio. As a result, we need to compute a weighted-
average beta, one that recognizes the different proportions of the four stocks.

In this case, the portfolio is weighted as follows:

% of Portfolio Value Beta Weighted Beta

Stock A 20% 1.1 0.22


Stock B 20% 1.15 0.23
Stock C 40% 1.25 0.50
Stock D 20% 1.3 0.26

Portfolio Beta 1.21

The weighted-average beta, or portfolio beta, is here calculated by multiplying


each stock’s beta by the percentage that the stock represents in the dollar value of
the portfolio. This indicates the proportionate contribution of each stock to the
overall portfolio beta. By summing these contributions (the rightmost column),
we obtain the portfolio beta of 1.21.

You can also use your financial calculator to arrive at the answer. Here are the
keystrokes for the HP10bII+:

1.10, INPUT
20, ∑+
1.15, INPUT
20, ∑+
1.25, INPUT

26  Investment Risk, Return, and Performance


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
40, ∑+
1.30, INPUT
20, ∑+
SHIFT, 6, = 1.21

Amy’s aggressive stance is reflected in the high volatility of her portfolio


relative to the market. This volatility will, of course, work against her if the
market heads in the opposite direction. Had she been content to just “match the
market” instead of outpacing its performance, she could have constructed her
portfolio of issues with a weighted average of 1.0. The simple way to do this,
of course, is to buy an “indexed fund”—a mutual fund that mirrors the market
(which, by definition, has a beta of 1.0).

Caveat on the use of betas. Betas are determined by a statistical process called
simple linear regression. This process looks at price movements of a stock and
the market for a number of periods in the past. Thus, the use of betas is a
projection of past price behaviors into the present and future—a practice that
contains certain perils. Scholars have made two important observations about the
behavior of betas over time:

1. Betas for individual stocks change over time, but betas for portfolios are
fairly stable and the larger the number of stocks in the portfolio, the more
stable the beta will be.

2. As time passes, portfolio betas tend to “regress to the mean”—that is, betas
tend to approach the market beta of 1.0 over time (Reilly and Brown 2006).

Thus, while the services that compute and publish stock betas keep them up to
date, the investment professional should be cautious with the tactical use of betas
when applied to single stocks and to portfolios of just a few issues. You also
should know that the same stock might have different betas, depending upon who
is measuring it and over what period of time. This difference results from the
various measurement methodologies employed by the data services. The
differences, however, tend to be minor.

Chapter 2: The Risk/Return Relationship  27


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
One additional caveat is that one should not automatically assume that a low beta
means low volatility. A low beta indicates low volatility relative to the market if
the stock is highly correlated to that market (review the formula presented
above). If this high correlation does not exist, then the beta can be very
misleading. For example, gold stocks are highly volatile but have low betas when
compared to a large-cap U.S. stock index, like the S&P 500, because gold is not
highly correlated with the stock market. Therefore, care is needed when using
betas, and this is where the coefficient of determination becomes very important.

Few investors have heard of the term coefficient of determination; many,


however, have heard of the term “R-squared (R2).” They both refer to the same
thing. R2 is the square of the correlation coefficient. (R-squared is the
terminology used by Morningstar.) R-squared indicates the percentage of one
asset’s movement that can be explained by the movement of a second asset.
Generally, the second asset is a market index or benchmark, such as the S&P 500
index, and the first asset is an individual stock or a mutual fund.

We are not taking a deep dive into the coefficient of determination (r-squared) in
this course. However, it is still important to point out that for beta to be
considered reliable in either a Jensen’s alpha or a Treynor calculation that we
will cover later, the r-squared should be .70 or higher.

Risk-Adjusted Returns
Reading the following material should enable you to:

2–3 Calculate the return of a stock or portfolio using the capital asset
pricing model.

Nowhere is the relationship between risk and return more clearly seen than in the
investment world, where the returns on risky assets, such as common stocks,
provide higher total returns over time than do low-risk assets like T-bills and
commercial paper. Modern financial markets are fairly efficient in adjusting rates
of return in response to risk.

28  Investment Risk, Return, and Performance


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
The capital market line. Investment scholars describe the relationship between
risk and return with the capital market line (CML), shown in Figure 4. As the
chart makes clear, there is a risk-free rate (Rf) where the line intersects the rate of
return axis. The current rate on T-bills can be used as a proxy for this risk-free
rate. Risk in the CML framework is total risk and is measured by standard
deviation. Only efficient portfolios will fall on the CML. Since the CML is
upward sloping to the right, all investments along the line beyond Rf become
progressively riskier but also have higher potential returns.

Figure 4: Capital Market Line

Rate of
Return %

Rf=3%

0
Risk (Standard Deviation)

Moving up this sloped line of increasingly risky but potentially higher return
assets, we might progressively encounter the various assets shown in Figure 5.

Chapter 2: The Risk/Return Relationship  29


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Figure 5: Capital Market Line Illustrated

Return %
20 International Small
Large Stocks Stocks
Stocks
15 Intermediate-term
Bonds
Gold

10

Long-Term
Bonds
5 Short-term Bonds
Treasury Bills

0
0 5 10 15 20 25
Risk (Standard Deviation)

The capital asset pricing model (CAPM). The logic of the capital market line
can be applied to an individual stock or to a portfolio. This application is known
as the security market line (SML) and incorporates beta, rather than standard
deviation, as the measure of risk. Since unsystematic risk can be diversified
away, what is left is systematic risk, which is measured by beta. The formula
used to plot the expected return for various levels of risk (beta) along the SML is
known as the capital asset pricing model (CAPM), which calculates the required
return for an individual stock or portfolio. Symbolically, the CAPM is

Rs = Rf + (Rm – Rf) βs
where
Rs = the required return of the individual stock
Rf = the risk-free rate, generally the current T-bill rate
βs = the stock’s beta
Rm = the stock market return
(Rm – Rf) = the “market risk premium”—the extra rate of return that
stock market investors obtain over investors in T-bills

30  Investment Risk, Return, and Performance


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Thus, if we are considering a stock with a beta of 1.10 when the current risk-free
rate is 1%, and there is a stock market return of 8%, we could restate the equation
as follows:

Rs = .01 + (.08 – .01)


1.10
= .01 + .077
= .087 or 8.7%

Notice in this calculation first we subtract .01 from .08 to get .07. This amount in
the parentheses is known as the “market risk premium” and represents the
amount above the risk-free rate that the market rewards those willing to risk their
capital in the market. Then we multiply .07 (market risk premium) by 1.10 (beta
of the individual security) to get .077. Finally we add .077 to .01 (the risk-free
rate) to get .087 or 8.7%, the return an investor should require if they are to
invest in this security.

Here, we have demonstrated the application of the CAPM to estimating the risk-
adjusted return of a single stock. The model can be extended, with little extra
work, to estimating the return of an entire portfolio (Rp). The only element that
changes is the beta. Instead of using the beta of a single stock, as in the example
just given, we use the weighted-average beta, or portfolio beta (Bp), whose
calculation was described earlier. The equation would then be as follows:

Rp = Rf + (Rm – Rf) βp

The concept of risk-adjusted returns will be covered in greater detail later when
measuring investment performance.

The investment pyramid. “Okay,” you say, “we’ve got our betas covered;
figuring the weighted-average beta of a portfolio is straightforward. But most of
my clients would start looking at their smartphones if I started explaining this to
them. And that business about Rs = Rf + (Rm – Rf) βs just would lose them
altogether.”

Chapter 2: The Risk/Return Relationship  31


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
You are right. As a financial professional, you can benefit from these concepts in
managing your clients’ money, but if clients are to participate in investment
decisions, they probably need to approach the issue of risk and return in a
different way. One way is through the use of the investment pyramid, as shown
in Figure 6. This pyramid has been around in many forms for a number of years.
The base of the pyramid is the “foundation” assets of insured savings accounts,
bank CDs, Treasury securities (which, if held to maturity, will pay back all
principal invested), and other investments that are conservative and liquid; those
at the top are considered to be riskier and possibly illiquid.

The arrow rising up the left side of the pyramid indicates that there is an
increasing risk of loss of principal as one moves up from the conservative base
toward the top; but there is an increasing potential for capital appreciation as
well. Conversely, the arrow pointing downward along the right side of the
pyramid indicates increasing safety of principal, but with an increasing risk of
purchasing power loss.

The investment pyramid can be used to good effect with clients in explaining
many issues of risk and return treated earlier in this module. Keep in mind that
the pyramid reflects generalizations, so there may be exceptions to these
rankings when considering specific securities. Many misinterpret this diagram to
clients, however, suggesting that the larger “base” indicates that a larger
proportion of the client’s funds should be invested in the lower-tier financial
instruments, and that other investment instruments should be funded in
increasingly smaller proportions. While this may be ideal for some clients, one
size does not fit all. The choice of investment assets and their proportion in a
client’s portfolio should instead depend on suitability and the client’s stated
objectives, circumstances, and preferences. (Note: New HH bonds are no longer
being issued after August 2004, and many HH bonds still outstanding have stopped
earning interest.)

32  Investment Risk, Return, and Performance


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Figure 6: The Investment Pyramid

Futures
contracts

Speculative Gold
common &
stocks & bonds collectibles

Limited Real estate Puts


partner- investment &
ships properties calls

High-grade Variable Growth


common annuities mutual
stock funds

Balanced High-grade High-grade


mutual preferred convertible
funds stock securities

High-grade Fixed- High-grade Money


municipal income corporate market
bonds annuities bonds accounts

U.S.-insured Treasury Life EE, HH, & I U.S.-insured


checking & securities insurance bonds certificates
savings accounts cash values of deposit

Chapter 2: The Risk/Return Relationship  33


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Chapter 2 Review
1. Assume a stock has a mean return of 8% and a standard deviation of 8%.
What would be the range of returns to be expected for the following?
a. 68% of the returns

Go to answer.

b. 95% of the returns

Go to answer.

c. 99% of the returns

Go to answer.

2. Bill Harrington has a portfolio of stocks with an average weighted beta of


0.9. What is the approximate decrease in this portfolio relative to a market
decrease of 20%?
Go to answer.

3. What is the capital market line?


Go to answer.
4. What is the formula for the capital asset pricing model (CAPM)?
Go to answer.

5. The risk-free rate is 1.25%, the market rate of return is 9%, and the beta of
ABC stock is .80. Given this information, and using the capital asset pricing
model, what is the expected return of ABC stock?
Go to answer.

34  Investment Risk, Return, and Performance


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Chapter 3: Managing Risk in
Portfolios

N
ow that we understand the important concepts of risk and required
returns, we can proceed to the active business of managing risk in client
portfolios, perhaps the greatest value-added service the investment
professional can render.

Risk Reduction Through Diversification


After reading this chapter, you should be able to:

2–4 Explain how to achieve risk reduction through diversification.

From time to time, diversification seems like an old fashioned concept, especially
during strong bull markets. If stocks provide much higher returns, for example,
why invest in bonds or other asset classes at all? Certainly this reasoning existed
at the beginning of the year 2000. At that time, a suggestion to cut back on stocks
and reinvest elsewhere would have seemed like a foolish idea. However, three
years later, the logic of a diversified portfolio became apparent as stocks fell
significantly and high quality bonds increased in price. In other words, in the
short run diversification can seem like a way to lower a portfolio’s return, but
long-term, it provides a smoother path toward investment goals.

This can be further illustrated by looking at the performance of bonds and stocks
over the 10-year period ending in 2010. This period is an important example
because it includes a strong bull stock market and two strong bear stock markets.
Using the Barclays Capital Aggregate Bond index as a proxy for bonds and the
S&P 500 stock index for stocks, we can see the following returns through
December 31, 2010:

Chapter 3: Managing Risk in Portfolios  35


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Table 3: Returns through December 31, 2010

1 Year 3 Years 5 Years 10 Years


Bonds 6.54% 5.90% 5.80% 5.84%

Stocks 15.06% –2.86% 2.29% 1.41%

These returns illustrate that strong bear markets can have a significant negative
impact on returns as the 10-year returns incorporate the bear markets of 2000–
2002 and 2007–2009. Although not shown, the returns for stocks through 2007
were 5.49% (1 year), 8.62% (3 years), 12.83% (5 years), and 5.91% (10 years).
These returns, compared to the returns through 2010, show the devastating
effects of a major bear market.

As seen here, there are periods when bonds can significantly outperform stocks.
The recent 10-year period shown above was one of the worst in history for
stocks; it was unusual, yet it did happen. As mentioned, bonds, and in particular
high-quality bonds, can smooth out a portfolio’s returns, which means at certain
times they can hold back a portfolio’s performance (as in 1999 when the
Barclays Aggregate index was down 0.82% while the S&P 500 was up 21.04%)
and at other times enhance it (as in 2008 when the Barclays Aggregate index was
up 5.24% while the S&P 500 index was down 37.00%). When reviewing these
returns, keep in mind that high-yield bonds often act more like stocks than bonds
because their risk of default increases during weak economic periods.
Diversification and asset allocation, then, are critically important in constructing
a portfolio in line with a client’s investment objectives.

Note: Should you or your clients ever need a reminder of the importance of asset
allocation, you can refer to The Callan Periodic Table of Investment Returns
(https://www.callan.com/research/periodic/) for the 20-year rolling asset class
returns. Alternatively, J.P. Morgan Asset Management provides a similar
analysis in the Asset Class Returns segment of their Guide to the Markets
publication, which can be found at https://am.jpmorgan.com/us/en/asset-
management/gim/adv/insights/guide-to-the-markets.

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Earlier discussion categorized the risk inherent in stock ownership as being
twofold: systematic risk, or the risk of the market, and unsystematic risk, or the
risks that are unique to a single company. Together, these represent “total risk” to
the investor. We know that there is no way to eliminate systematic risk. Stock
investors are stuck with systematic risk. Unsystematic risk, however, can be
reduced through diversification, or the addition of different stock issues and/or
different types of investments to the portfolio.

Consider Figure 7, which displays total risk on the vertical axis and (referring
specifically to large company stocks) the number of stocks in the portfolio or the
degree of diversification along the horizontal axis. As more stocks are added to
the portfolio, the total risk decreases marginally, so as the number of stocks
approaches 10 to 15 different issues (and in different industries), eventually
almost all unsystematic risk can be eliminated, and only systematic risk remains.

Figure 7: The Effects of Diversification on Total Risk

Standard
Deviation
(σ)
Total
Risk

Unsystematic
Risk
σm
Systematic
Risk

Number of Securities (N)

The number of stocks needed to achieve diversification of the unsystematic risk


is something that is continually studied. Evans and Archer were the first to put
the number at “10 or so securities.” More recent studies have pegged the number
at anywhere from 50 stocks to more than 100 stocks.

Chapter 3: Managing Risk in Portfolios  37


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
The concept of “different issues” more precisely involves investments whose
returns vary from each other. This concept is called correlation coefficient, or
simply correlation. A correlation coefficient—ranging from –1.0 to +1.0—
measures the degree to which an investment’s return varies from (or moves in
concert with) another investment’s return. Two stocks (or other investments) are
said to be perfectly positively correlated (+1.0) when their returns always move
up and down at the same time, in the same direction, and in the same proportion.
Two stocks are perfectly negatively correlated (‒1.0) when their returns move in
exactly the opposite direction to each other, at the same time, and in the same
proportion (as shown in Figure 8).

The reduction in unsystematic risk occurs only if the stocks being added to the
portfolio are less than perfectly positively correlated. As illustrated in Figure 8
below, the further the correlation is from +1.0, the more diversification is
provided.

Figure 8: Correlation Coefficient

The further away from +1, the more diversification

-1 0 +1

That is, a stock with a correlation of .90 adds a small amount of diversification,
but a stock with a correlation of .20 adds much more diversification. Likewise,
additional diversification occurs if the correlation is ‒.20; and even more if the
correlation is ‒.80 (in practice, assets with large negative correlations are very
rare).

Stocks within a specific industry tend to have high correlations so if, for
example, you start with the stock of a semiconductor manufacturer and add the
stock of two more semiconductor manufacturers, the diversification effect is
likely to be very minimal. For purposes of discussion here, you will diversify
away unsystematic risk as you add stocks having low correlations from different
industries to the portfolio.

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When constructing an investment portfolio using mutual funds, one should not
purchase a fund with a +.88 correlation coefficient with the S&P 500 and another
with a +.93 correlation coefficient with the S&P 500. These two funds are far too
related. The investor may as well invest all of his or her money in one of the two
funds. The names, management companies, portfolio managers, and even
companies in which the two funds invest may be different, but both funds move
in the same direction, and in about the same proportion, as the market. A better
combination of funds would be one with a correlation coefficient of +.88 with the
S&P 500 and a second with a correlation coefficient of +.35 with the S&P 500.
When constructing portfolios, it is not necessary (and it is virtually impossible) to
have negative correlation coefficients among all assets and the market. Assets
with low positive correlation coefficients diversify a portfolio quite well.

Figure 9 demonstrates how two “perfectly negatively correlated” stocks held in a


portfolio effectively reduce all the unsystematic risk, taking all of the volatility of
returns associated with unsystematic risk out of the portfolio. The two stocks
here are perfectly negatively correlated in the sense that, as one stock moves up,
the other moves down.

Figure 9: Portfolio of Two Perfectly Negatively Correlated Stocks

Return

Stock B

Stock A

Time

Chapter 3: Managing Risk in Portfolios  39


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Normally, a reduction in risk goes hand in hand with a reduction in return. We
observed this on the capital market line. The great benefit of portfolio
diversification stems from reducing risk that might reduce the portfolio’s return.
However, the reduction of unsystematic risk does not necessarily reduce return.
By helping the client to diversify his or her portfolio, it is possible to maintain
the expected return, but at a lower risk level, depending on the asset mix. This is
known as the “diversification effect.” For example, as seen in Table 4, adding
foreign securities (represented by the EAFE index) to a portfolio containing
nothing but U.S. large-cap stocks generally reduces risk and can maintain or even
increase return over the long term.

Table 4: Correlation of Returns Among Select Asset Classes (2007–2016)

Corp.
U.S High
Large Yield Muni Comm-
Cap EAFE EME Bonds Bonds Bonds REITs odities
U.S. Large 1.00
Cap
EAFE 0.89 1.00
EME 0.79 0.90 1.00
Bonds -0.29 -0.14 -0.04 1.00
Corp High 0.75 0.79 .86 -0.05 1.00
Yield Bonds
Muni Bonds -0.12 0.00 0.08 0.81 0.12 1.00
REITs 0.77 0.67 0.55 0.02 0.67 0.09 1.00
Commodities 0.53 0.61 0.68 –0.10 0.66 –0.09 0.40 1.00
Source: J.P. Morgan Asset Management Guide to the Markets, Q1 2017.

Looked at another way, if you do not diversify, you are taking additional risk
without additional return.

Diversification within asset classes. The effects of this method have already
been explained. But assuming that the stocks added to a portfolio are not in the
same industry or subject to the same business forces, how many stocks are
needed to eliminate most of the unsystematic risk? For this course, the general
rule of thumb is that 10 to 15 large company U.S. stocks (in different industries)

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are sufficient to eliminate most unsystematic risk, while small-cap stock
portfolios require 20 to 30 different issues to achieve the same level of
diversification.

Fixed-income investors can diversify within the asset class by combining


securities that are of different types (corporate, government, foreign) and by
combining securities that have different maturities, different issuers, and different
credit ratings.

Real estate investors can diversify by combining assets representing different


types (office buildings, residential structures, shopping malls, raw land) and/or
different geographic locations.

Diversification across asset classes. The precondition for the diversification


effect is that assets within a portfolio have returns that are “independent” of each
other to some degree. Figure 9 demonstrated the effect of this independence with
two stocks whose returns were perfectly negatively correlated. While it is
practically impossible to find perfectly negatively correlated investments, the
investment professional can choose stocks, bonds, real estate, precious metals,
and other asset classes that have some degree of negative correlation. As
mentioned, any correlation among assets (or individual securities) that is less
than 1.00 will provide some diversification, and the farther from 1.00, the more
the diversification effect. For example, if the correlation of small-cap stocks is
.72 with large-cap stocks and the correlation of corporate bonds with large-cap
stocks is .31, clearly corporate bonds provide more diversification to large-cap
stocks than do small-cap stocks.

Chapter 3: Managing Risk in Portfolios  41


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Client Time Horizons and Portfolio Risk
Reading the upcoming information will help you to:

2–5 Explain the importance of client time horizons to portfolio risk.

Perhaps the most important part of the client assessment that precedes any
investment action is determining the client’s time horizon. Is the client investing
to accumulate college funds needed 15 years from today? Are the funds
represented by the account needed in three years to repay a loan? Are the client’s
funds needed in six months to purchase a house?

The following examples illustrate the notion of time horizons.

 Harvard University has an endowment of about $38 billion. It has its own
asset management department to invest this sum in real assets, stocks, bonds,
and alternative investments such as hedge funds, venture capital situations,
private equity, commodities, and LBO funds. Although it draws millions of
dollars each year from the earnings of its endowment to support operations,
financial aid, and facilities expansion, Harvard is a long-term investor. Its
endowment is viewed as a “permanent fund” and is invested, for the most
part, with more concern for high, long-term returns than for short-term
fluctuations in asset values. The investment managers at Harvard know that
in general the risk of investing in volatile assets like stocks decreases as
one’s time horizon increases. This is the common definition of time
diversification. (Of course, this assumes high-quality investments are purchased;
owning financially weak, highly speculative securities can lead to large losses
over time as demonstrated by the savings and loan debacle of the mid-’80s.)

 Bill Walters has accumulated $50,000 for the education of his two children,
the first of whom will begin college in just one year. His concern is for the
value of his portfolio at those moments when he must withdraw funds for
scheduled tuition payments.

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Harvard University and Bill Walters represent the two poles of investor time
horizons, and most investment professionals have clients who mirror their
concerns. Their usual alternatives are to invest in assets that have high returns
and high volatility (as measured by standard deviation) or to invest in assets that
have lower returns and low volatility. Typically, this translates into the choice
between stocks and short-term bonds, CDs, money market funds, or some similar
very low risk investment. Figure 10 illustrates these two choices. The short-term
investor cannot usually bear the risk (volatility) of needing the funds during one
of the occasional downturns in the stock market.

Figure 10: High Return/High Volatility vs. Lower Return/Low Volatility

Return

Stocks

Bonds

Time

Stocks grow to materially greater values over time in this illustration (as they have
done historically), but with much greater volatility. Obviously, a client such as
Harvard, which views its funds as “permanent,” can live through the ups and downs
of stock fluctuations; Bill Walters, however, cannot risk the possibility that the
stock market will be in a slump one year from now. CDs or one-year notes may be
the better approach for him.

Chapter 3: Managing Risk in Portfolios  43


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Example. A church endowment of $1 million is invested as follows:

 40% in T-bills

 50% in two- to five-year bonds

 10% in blue-chip stocks

The church withdraws a small amount of its funds each year to meet current
obligations, but members of its investment committee view the endowment as
permanent funds. When asked by their investment adviser if they would consider
shifting the portfolio to contain 50% to 70% stocks, they reply: “Oh, no. That
would be too risky. We cannot afford to lose this money.” Of course, the real
risks are (1) risk of paper losses if they shift more into stocks, and (2) purchasing
power risk if they pursue their current investment policy. In other words, there is the
risk of having to sell stocks at a loss and the risk of being too conservative and not
being in investments that can earn a return above the inflation rate over time.

Sometimes the opposite situation can occur when a strong bull market over a
period of time makes it seem that investing in stocks is low in risk. For example,
during 1998 and 1999, when the S&P 500 and NASDAQ composite stock
indexes reached record levels, day trading became popular. Making money by
trading stocks based on very short time frames, sometimes just hours or even
minutes, seemed so easy that many people became involved in day trading. Not
everyone was successful, as certain tragic stories reported in the news
demonstrated. For some of these people expecting to become wealthy in a short
period of time, the risk of investing in stocks to achieve their short-term goal
became all too clear in very short order as they watched investment portfolios
plummet.

The time horizon for a goal, then, has a direct bearing on what investments are
appropriate for achieving that goal. In general, if the time horizon is more than
five years, common stocks are appropriate since there should be sufficient time to
make up for any down markets during that period. After the “credit crisis” of
2008–2009 and current economic and market conditions, some planners have

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even begun extending the time horizon to 10 years. If the time horizon is one to
five years, investments should be in lower-risk investments like high-quality
intermediate- and short-term bonds. For a time horizon of less than one year,
money market instruments and money market funds make the most sense. The
priority should be achieving the goal within that time horizon, not seeing how
much more beyond the amount needed for the goal can be possibly accumulated.

Educating clients to understand the relationship between risk and return, and the
part played by their own investment time horizons, is extremely important.

Practical Approaches to Creating Client


Portfolios
Given what we have learned so far about risk and return, how do we go about
creating portfolios for our clients?

Client assessment. Any actions taken on behalf of the client must always be
preceded by a “client assessment.” The manner of making this assessment was
discussed in Module 1 under the subjects of data gathering, information
analysis, building a relationship, and helping the client to establish specific
and reasonable goals. The object of client assessment is to determine the
following:

1. What are the client’s current financial resources—income, savings,


investments, and retirement plans?

2. What are the client’s financial goals?

3. How long or short is the client’s time horizon for each goal?

4. Does the client have investment income or liquidity needs (for emergencies,
college funding, and so forth) that should be considered?

5. What is the client’s risk tolerance? Does this risk tolerance match up with the
client’s expectations of investment returns?

Chapter 3: Managing Risk in Portfolios  45


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
6. What experience, aptitude, or knowledge will the client bring to the
investment decision-making process?

7. Are there special tax considerations?

8. What retirement planning measures has the client undertaken?

Answers to these questions will determine the parameters within which risk-
adjusted portfolios can be developed. The client assessment process also assures
that we are meeting the “know your customer” requirement of professional
practice.

Chapter 3 Review
1. How does correlation relate to risk reduction?
Return to question.

2. What is the importance of negative or positive but low correlation of assets in


terms of diversifying a portfolio?
Go to answer.

3. Assume the following correlations between long-term U.S. Treasury bonds


and the given asset classes:
Large-cap stocks: .35
Gold: .12
Treasury bills: -.05
Corporate bonds: .89
In what order do these asset classes provide diversification to long-term U.S.
Treasury bonds?
Go to answer.

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© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Chapter 4: Measuring Investment
Performance

W
hether we are training for a marathon race, developing new on-the-
job skills, or managing investments, we need some measurement
device to know how well we are doing or progressing toward our
goal. For investment professionals, investment performance is
receiving more attention as investors become more sophisticated. This chapter
includes a number of practical performance measures.

How are we doing? How have we done? Why did we get the performance we
did? Was the investment manager lucky or skillful? As you will see at the end of
the chapter, there are performance measurements that the client will favor and
performance measurements that the investment manager will prefer. Therefore,
these questions are important as you monitor the performance of client accounts
and as you discuss results with your clients. Some investment institutions are
officially obliged to calculate their performance on a regular basis. Mutual fund
and pension fund managers must make this calculation for shareholders and
pension sponsors, respectively. For managers dealing with listed securities, these
calculations are straightforward, as beginning and ending values and the total of
distributions are easily obtainable. For the investment professional, it becomes
more difficult when clients hold securities whose market value is not listed.

The following sections will enable you to:

2–6 Compare portfolio performance using various performance


measurement tools.

Excess Return
One common measure of portfolio performance is “excess return.” This figure is
defined and calculated as follows:

Excess return = Total portfolio return – Risk-free rate

Chapter 4: Measuring Investment Performance  47


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Excess return is a measure of the portfolio’s return over and above what the
client could have earned had he or she simply invested in “risk-free assets,”
generally considered to be Treasury bills. Thus, if the total portfolio return for the
year is 8% and the T-bill rate for this period has been 1%, the excess return is
7%. Notice, however, that excess return does not consider the amount of risk it
may have taken to earn that 7%.

Risk-Adjusted Measures of Return


Earlier, the capital asset pricing model provided us with the formula for
calculating the required return of a portfolio relative to its risk (the weighted beta
of the portfolio) as follows:

Rp = R f + ( Rm − R f ) βp

Here, if we assembled a portfolio whose beta was slightly larger than that of the
overall market, say 1.10, at a time when the risk-free rate was 1% and the actual
market return was 7%, that portfolio’s required rate of return could be calculated
as shown below:

Rp = .01 + (.07 − .01) 1.10 = .076 or 7.6%

If our client’s portfolio returned less than 7.6%, then somehow we would not
have achieved the required returns, given the level of risk that we took. Perhaps
our selection of securities was faulty; perhaps the current betas of our stocks
were different than their published betas. On the other hand, if the client’s return
is greater than 7.6%, we have returned more than what was required for the level
of risk taken. To illustrate the possibilities of either underperforming (point B,
which is below the security market line) or outperforming (point A) the required
rate of return, based on the risk taken as measured by beta, we need to return to
the security market line (Figure 11).

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Figure 11: Outperforming and Underperforming the Market

Expected
Return %

Security
Market
Line

Portfolio A Portfolio B

Risk (Portfolio Beta)

Earlier in this module, we saw the risk and return relationship of the assets
classes as demonstrated by the Capital Market Line (CML). The CML graphed
the risk premium as we moved from the risk-free asset through the riskiest of
asset classes, using standard deviation as the risk measurement. The Security
Market Line (SML) is a similar-looking risk-return graph that focuses on the
systematic risk using beta. The SML can be used for both efficient portfolios (as
per Figure 11) or for individual assets. In Figure 11, the point where the Security
Market Line intercepts the “Required Return %” axis is the risk-free rate (Rf).
The condition described as alpha is the difference between the return that was
realized and the required rate of return, given the level of risk that was taken. The
goal is to have a positive alpha, such as reflected by Portfolio A. The alpha for
the security market line is zero in that it always delivers exactly what is expected.

The Jensen Performance Index (alpha)


Any point along the security market line represents the return we would expect for
that particular level of risk (as measured by beta), both of which increase as we
move out toward the right. Naturally, if a portfolio were able to increase the level of
return for the same level of risk, as has Portfolio A, we would have to say that the
manager has delivered superior performance on a risk-adjusted basis.

Chapter 4: Measuring Investment Performance  49


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Jensen’s measure is an absolute measure of risk, meaning it can be used as a
stand-alone measure, as opposed to a relative measure, that compares the risk of
something to an appropriate benchmark. In looking at the formula, you can see
that we are simply taking the return that was realized and subtracting the required
return (CAPM).

Portfolio A has generated returns above the SML by the amount alpha (α); thus,
the alpha for this portfolio is positive. Portfolio B, on the other hand, has a
negative alpha. A negative alpha does not necessarily mean the portfolio had a
negative return but instead indicates that the portfolio achieved a lower return
than we would expect/require for the risk taken (as measured by CAPM using
beta). Alpha is a stand-alone performance measurement tool, meaning it can be
used by itself as an indication of a portfolio manager’s performance. That is, a
positive alpha indicates the manager performed better than expected given the
risk he or she took, while a negative alpha indicates that the manager performed
worse than expected given the risk he or she took. The greater the positive
(negative) alpha, the better (worse) the portfolio manager performed on a risk-
adjusted basis. The Jensen model uses this formula:

αp = Rp − Rf + (Rm − Rf ) βp 

where
Rp = the portfolio’s actual return
Rf = the risk-free rate
βp = the portfolio’s beta
Rm = the stock market’s return

For example, assume a mutual fund, with a beta of 1.1, had a return of 14%, the
stock market returned 10% in that same period, and the risk-free return was 4%.
Using the above formula, we would get:

αp = .14 – [.04 + (.10 − .04)1.1]

αp = .14 − [.04 + .066] = .034 or 3.4%

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This fund has a positive alpha of 3.4% meaning its return exceeded its required
return by 3.4% (this number is often stated as simply 3.4), given the risk taken
(as measured by beta).

The Treynor and Sharpe Indexes


Like the Jensen model, both the Treynor and Sharpe indexes (also known as
Treynor and Sharpe ratios) establish measures of portfolio performance for a
given time period that are adjusted by the amount of risk. However, unlike
Jensen’s model, both Treynor and Sharpe’s models are relative measures of risk.
This means that we calculate the Treynor or Sharpe in order to compare the risk-
adjusted returns of two different funds with one another.

Both Treynor and Sharpe achieve their measures of portfolio performance by


dividing the excess return—the return that is above the risk-free return—by the
amount of risk being taken, with Treynor using beta and Sharpe using standard
deviation to measure risk. The availability of this data, and in particular for the
Sharpe indexes, makes these performance indexes very practical ways for the
investment professional to measure risk-adjusted performance. In this way return
per unit of risk can be compared between one investment and another. The
Treynor model uses the following formula:

Excess return
Ti =
Portfolio beta
Another way of putting it would be:

Total portfolio return − Risk-free rate


Ti =
Portfolio beta

Thus, if the manager of Portfolio A achieved a total return of 12.5% at a time


when the risk-free rate was 3% and the beta of the portfolio was 0.81, the
manager’s Treynor index would be:

.125 − .03
TA = = 0.117
0.81

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© 1996, 2002–2018, College for Financial Planning, all rights reserved.
The manager of Portfolio B, on the other hand, achieved a greater total return,
15%, during this same period, but his portfolio beta was higher at 1.1. This
manager’s Treynor index would be:
.15 − .03
TB = = 0.109
1.1
The calculation shows how much return each fund generated per one unit of risk
(as measured by beta in the case of Treynor and standard deviation in the case of
Sharpe). Thus, even though the manager of Portfolio B turned in a higher total
return, we could say that, on a risk-adjusted basis, he underperformed the
manager of Portfolio A based on the Treynor index. Because the Treynor index
uses beta as its measure of risk, and beta is a measure of systematic risk only,
Treynor is only appropriate and useful for fully diversified portfolios.

The Sharpe performance index is similar to the Treynor index but uses the
portfolio standard deviation instead of the portfolio beta. Therefore, using the
Sharpe index is appropriate whenever you have a portfolio that is not fully
diversified (as standard deviation is a measure of total risk). The Sharpe index
formula is as follows:
Total portfolio return − Risk-free rate
Si =
Portfolio standard deviation
Thus, if the manager of Portfolio A earned a total return of 12% when the risk-
free return was 3% and the standard deviation of the portfolio was .25, the
manager’s Sharpe index would be:
.12 − .03
SA = = .36
.25
If the manager of Portfolio B earned a total return of 10% during the same
period, but his portfolio standard deviation was .15, his Sharpe index would be as
follows:
.10 − .03
SB = = .47
.15
Therefore, although the manager of Portfolio A earned a higher return, the
manager of Portfolio B had a better risk-adjusted return based on the Sharpe
performance index.

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Since the Sharpe index can be used with either diversified or nondiversified
portfolios, it is used more often that the Treynor index. Thus, a nondiversified
portfolio, such as a sector fund, requires the use of Sharpe’s model measuring
total risk.

Performance Benchmarks
Table 5 identifies some of the more popular stock and bond benchmarks used by
investment professionals.

Table 5: Asset Class Benchmarks

Asset Class Benchmarks


U.S. large-cap stocks S&P 500
U.S. mid-cap stocks S&P Mid-Cap 400
U.S. small-cap stocks S&P Small-Cap 600
Russell 2000
International developed markets MSCI EAFE
International emerging markets MSCI Emerging Markets
S&P/IFCI
U.S. intermediate-term or long-term bonds Barclays Aggregate Bond
U.S. high-yield bonds CS First Boston High Yield
Municipal bonds Barclays Municipal Bond
Equity REITs Wilshire US Real Estate Securities

A synopsis of these indices is shown in Table 6.


Table 6: Descriptions of Popular Benchmarks

Benchmark Synopsis
S&P 500 Tracks performances of 500 of the largest companies listed on
the NYSE, the AMEX, and the NASDAQ system, accounting for
approximately 64% of the market value of stocks listed on the
exchanges
S&P Mid-Cap 400 Tracks performances of stocks listed on the NYSE that have a
market capitalization between $1.4 billion and $5.9 billion
Russell 2000 Tracks performances of the smallest 2,000 stocks in the Russell
3000 index and includes a market capitalization up to $6 billion

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© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Benchmark Synopsis
S&P Small-Cap 600 Tracks performances of 600 companies that have an average
market value range of $400 million to $1.8 billion and are in
market sectors representative of the sectors typical in the small
company universe
MSCI EAFE Tracks performances of more than 960 companies representing
85% of the market capitalization in 21 developed countries in
Europe, Australia, and the Far East
S&P/IFCI Tracks performances of approximately 2,400 stocks in 23
developing countries in Europe, the Middle East, Africa, Asia,
and Latin America that are available for purchase by foreign
institutional investors
MSCI Emerging Tracks performances of almost 900 stocks in 23 developing
Markets countries that are open to foreign investment
Barclays Aggregate Tracks performances of more than 5,000 U.S. government,
Bond corporate, mortgage-backed, and asset-backed bonds
CS First Boston High Tracks performances of publicly traded bonds rated BBB or
Yield lower
Barclays Municipal Tracks performances of more than 25,000 investment-grade,
Bond tax-exempt bonds
Wilshire US Real Tracks performances of more than 110 publicly traded equity
Estate Securities REITs, real estate operating companies, and master limited
partnerships

In evaluating client portfolio performance, care must be taken to

1. use the most appropriate (and representative) index as a benchmark, and

2. be sure to add back all dividends or other distributions taken. The indexes all
assume that dividends and distributions are reinvested.

Mutual Fund Benchmarks


Benchmarks to use in comparing and analyzing various mutual funds can be
found in information services, such as Morningstar and Lipper, or in financial
publications like Barron’s, the Wall Street Journal, and Forbes, which often use
data from Morningstar or Lipper. Classifications for equity funds are generally
broken down by capitalization size (large, mid, and small) and investment style
(value, blend, and growth). Classifications for bond funds are generally broken

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down by duration (short, intermediate, or long), quality (high, medium, or low), and
type (U.S. government, corporate, municipal, or international). Some publications
even list the betas of these funds.

Care should be taken to compare performance against the correct category of


funds. For example, the performance of a large-cap fund should not be compared
against small-cap funds nor should large-cap growth funds be compared to large-
cap value funds. Market cycles are such that sometimes funds concentrating in
large stocks outperform small stocks (and vice versa) and growth stocks
outperform value stocks (and vice versa). In other words, when comparing funds
and benchmarks, be sure you are making an “apples to apples” comparison.
Morningstar, Lipper, and other sources provide averages in various categories of
mutual fund performance.

The Importance of Time Periods


Selecting a time period in which performance is optimum can make an
investment professional look great, but is misleading and clearly unethical. First,
special care must be taken in comparing your client’s portfolio performance
against any one of the benchmarks cited here that is the closest match to his or
her portfolio. Then the time periods must be (1) matched correctly—that is,
performance measures of your client’s portfolio and those of the public
benchmark must be made over identical time periods and (2) chosen on some
objective basis, and not simply on a basis that will make the investment adviser
look good. For example, investment professional Smith’s stock recommendations
from January through June of this year performed poorly, but they did well for
the rest of the year, increasing in value by 12% between July and December. To
ignore the first six months’ performance and say that his “annualized
performance was 24%” would be misleading and unethical.

Time-Weighted Returns
Time-weighted returns are most applicable when determining the performance of
an investment manager. For a fund manager, the benefit of time-weighted returns is
that they negate the effects of contributions and withdrawals made by investors

Chapter 4: Measuring Investment Performance  55


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
(which are beyond the manager’s control and which can affect the reported
performance of the fund). Performance measurements should ultimately attempt to
quantify the value added by the investment decisions being made by the portfolio
manager, and the CFA Institute requires the use of time-weighted returns within the
Institute’s Global Investment Performance Standards. While time-weighted returns
are the best measure of the manager’s performance, they are not the best way to
measure client performance (i.e., behavior).

Dollar-Weighted Returns
We have established that time-weighted returns are the preferred method to
compare the performances of two different portfolio managers or funds, but a
method is still needed to determine the rate of return actually received by the
client on the total funds he or she has invested. The answer to that problem is
found by calculating the compound returns of all funds in the portfolio for the
period of investment. The time-weighted method does not recognize the impact
of cash flows and, therefore, is not an accurate representation of how the client
fared. For this reason, a client’s investment performance in, say, XYZ Fund will
very rarely be the same as XYZ Fund’s performance.

For example, assume Fund A had the following annual returns for the past five
years: 10%, 12%, –8%, 15%, and 9%. If a client invested $1,000 in Fund A five
years ago and still held the investment today, the client would have earned a
compound annual return of 7.3% (this is the time-weighted return). If the client
makes an additional investment of $500 at the end of the second year, the
portfolio return would change dramatically. This new $500 investment would
have missed out on the good returns of years one and two and then would have
been exposed to the poor return in year three. The overall effect would be a
reduction in the rate of return to about 6.8% (this is the dollar-weighted return).

Dollar-weighted returns do take into account the effect of adding or subtracting


investment dollars to or from the portfolio. It is also called the internal rate of return
(IRR). (The mathematics used to solve internal rate of return is beyond the scope of
this course; however, many financial calculators can easily compute an IRR.)

56  Investment Risk, Return, and Performance


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Advisers can use the dollar-weighted return to express what the client actually
experiences in terms of performance (that is, what the client actually sees in his or
her account in dollars). For this reason, a dollar-weighted return is a better measure
of performance for a client than a time-weighted return. This also explains why
investors in mutual funds almost always earn a return different from the return
earned by the fund. Often the investor’s return is lower because the investor
“chases performance” and therefore often makes his or her investment after the
fund has already had high performance.

Chapter 4 Review
1. Describe how the Jensen performance index can be used.
Go to answer.

2. What is the difference between the Treynor and Sharpe indexes?


Go to answer.

3. How are the Treynor and Sharpe indexes best used?


Go to answer.

Chapter 4: Measuring Investment Performance  57


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Summary

T
his module has examined in detail one of the most important sets of
concepts in the investment business—risk, returns, and managing risk
through diversified and risk-adjusted portfolios.

The module ended with a discussion of investment performance and presented a


number of practical methods you can use to measure portfolio performance on a
risk-adjusted basis.

Having read the material in this module, you should be able to:

2–1 Explain “risk” in terms of investing.

2–2 Calculate the relative risk of stocks or portfolios using betas.

2–3 Calculate the return of a stock or portfolio using the capital asset
pricing model.

2–4 Explain how to achieve risk reduction through diversification.

2–5 Explain the importance of client time horizons to portfolio risk.

2–6 Compare portfolio performance using various performance


measurement tools.

58  Investment Risk, Return, and Performance


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Chapter Review Answers
Chapter 1
2–1 Explain “risk” in terms of investing.

1. Define risk in terms of investing.


The degree of uncertainty associated with the return of an asset; risk
can also be thought of in terms of price volatility or the possibility of
loss.
Return to question.

2. Define the following types of systematic risk.

a. market risk
Stems from factors that are independent of any particular security;
factors include political events, broad economic and social
changes, and the mood of the investing public.
Return to question.

b. interest rate risk


The risk that the price of a security will fall as a result of rising
interest rates (generally associated with fixed-income securities).
Return to question.

c. reinvestment risk
The risk that an investor will be reinvesting his or her payment
amount from a fixed income instrument at a time when rates are
lower than they had been previously. This risk is sometimes called
reinvestment rate risk.
Return to question.

Chapter Review Answers  59


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
d. purchasing power risk
The effect of inflation on an investor’s principal and return,
reducing the purchasing power of both.
Return to question.

e. exchange rate risk


Principal and return can be diminished by changes in the relative
values of U.S. and foreign currencies.
Return to question.

3. Define the following types of unsystematic risk.


a. business risk
Relates to the nature of a given company’s operations,
management, and its position in its industry
Return to question.

b. financial risk
This is the degree to which a company utilizes debt to finance
operations. Leverage can increase return on equity (ROE) but it
can also magnify losses.
Return to question.

c. default risk
The risk that an entity cannot make good on its obligations (such
as bonds paying their required payments of interest and principal
when due)
Return to question.

d. credit risk
The risk that bond’s credit rating will be lowered, causing the
bond’s price to fall
Return to question.

60  Investment Risk, Return, and Performance


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
e. liquidity risk
The uncertainty of transforming the investment into cash in a short
period of time with little or no change in price
Return to question.

f. event risk
The risk that a bond or stock holder will be negatively affected by
an unanticipated and damaging event
Return to question.

g. call risk
The risk that a bond will be called by the issuer prior to maturity
Return to question.

h. political risk
This type of risk is the uncertainty caused by the possibility of
adverse political events occurring in another country
Return to question.

Chapter 2
2–2 Calculate the relative risk of stocks or portfolios using betas.

1. Assume a stock has a mean return of 8% and a standard deviation of 8%.


What would be the range of returns to be expected for the following?

a. 68% of the returns


For 68% of the returns, we would expect the range to be one
standard deviation on either side of the mean. Therefore, the
range would be (8% – 8%) and (8% + 8%), or 0% to 16%.
Return to question.

Chapter Review Answers  61


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
b. 95% of the returns
For 95% of the returns, we would expect the range to be two
standard deviations on either side of the mean. Therefore, the
range would be (8% – 16%) and (8% + 16%), or –8% to 24%.
Return to question.

c. 99% of the returns


For 99% of the returns, we would expect the range to be three
standard deviations on either side of the mean. Therefore, the
range would be (8% – 24%) and (8% + 24%), or –16% to 32%.
Return to question.

2. Bill Harrington has a portfolio of stocks with an average weighted beta of


0.9. What is the approximate decrease in this portfolio relative to a market
decrease of 20%?
.20 × .09 = .18, or an expected decrease of 18%.
Return to question.

2–3 Calculate the return of a stock or portfolio using the capital asset
pricing model.

3. What is the capital market line?


A graphical representation of the relationship between risk and return,
where risk is measured by standard deviation; the CML includes the
concept of a risk-free rate of return
Return to question.

62  Investment Risk, Return, and Performance


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
4. What is the formula for the capital asset pricing model (CAPM)?

Rs = Rf + (Rm – Rf) Bs

where
Rs = the required return of the individual stock
Rf = the risk-free rate
Bs = the stock’s beta
Rm = the stock market’s return
(Rm – Rf) = the “market premium”—the extra rate of return that
stock market investors obtain over investors in T-bills
Return to question.
5. The risk-free rate is 1.25%, the market rate of return is 9%, and the beta of
ABC stock is .80. Given this information, and using the capital asset pricing
model, what is the required return of ABC stock?
.0125 + [(.09 – .0125) .80] = .0745 or 7.45%
Return to question.

Chapter 3
2–4 Explain how to achieve risk reduction through diversification.

1. How does correlation relate to risk reduction?


In general, the less two assets are correlated the more risk is
reduced. Assets that are negatively correlated provide the most risk
reduction.
Return to question.

Chapter Review Answers  63


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
2. What is the importance of negative or positive but low correlation of assets in
terms of diversifying a portfolio?
Negatively correlated assets add diversification to a portfolio, but
positive correlations of less than 1.00 also add some diversification
(with assets having lower positive correlation numbers adding more
diversification than those with high numbers).
Return to question.
3. Assume the following correlations between long-term U.S. Treasury bonds
and the given asset classes:
Large-cap stocks: .35
Gold: .12
Treasury bills: -.05
Corporate bonds: .89
In what order do these asset classes provide diversification to long-term U.S.
Treasury bonds?
The assets that have the lowest correlations provide the most
diversification. Correlations range from +1.0 to -1.0 so assets with
correlations that are the farthest from +1.0 offer the most
diversification. Therefore, the most diversification in this scenario is
provided by Treasury bills at -.05, then gold, then large-cap stocks,
and the least diversification is from corporate bonds.
Return to question.

Chapter 4
2–5 Explain the importance of client time horizons to portfolio risk.

2–6 Compare portfolio performance using various performance


measurement tools.

1. Describe how the Jensen performance index can be used.


This model is useful in comparing performance money managers on a
risk-adjusted basis and can be used by itself. A number above 0.00

64  Investment Risk, Return, and Performance


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
indicates the manager had better performance than would be
expected given the risk he or she took, while a number below 0.00
indicates the manager had worse performance than would be
expected given the risk he or she took.
Return to question.

2. What is the difference between the Treynor and Sharpe indexes?


While the numerator of both indexes is excess return, the
denominator (risk measure) is beta for Treynor and standard deviation
for Sharpe.
Return to question.

3. How are the Treynor and Sharpe indexes best used?


Both are used to compare the risk-adjusted returns of different funds.
The higher the risk-adjusted return, the better. The key difference is
that Treynor uses beta as its measure of risk, so Treynor can only be
used with fully diversified portfolios. Sharpe, on the other hand, uses
standard deviation (total risk) as its measure of risk and therefore can
be used with either fully diversified or nondiversified portfolios.
Return to question.

Chapter Review Answers  65


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
References
Alexeev, Vitali and Tapon, Francis. “Equity Portfolio Diversification: How
Many Stocks are Engough? Evidence from Five Developed Markets,” 2012.
Barnewall, Marilyn MacGruder. “Psychological Characteristics of the Individual
Investor.” Asset Allocation for the Individual Investor, William Droms, ed.
Charlottesville, VA: Association for Investment Management and Research,
1987.

Campbell, Lettau, Malkiel and Xu. “Have Individual Stocks Become More
Volatile? An Empirical Exploration of Idiosyncratic Risk,” 2000.

College for Financial Planning. CFP Certification Professional Education


Program: Investment Planning. Denver: College for Financial Planning, 2017.

Jensen, Michael L. “The Performance of Mutual Funds in the Period 1945–


1964.” Journal of Finance, May 1968.

Perritt, Gerald W. Small Stocks, Big Profits. Homewood, IL: Dow Jones-Irwin,
1994.

Quattlebaum, Owen M. “Loss Aversion: The Key to Determining Individual


Risk.” Journal of Financial Planning, vol. 1, no. 2, October 1988.

Reilly, Frank K. and Keith C. Brown. Investment Analysis and Portfolio


Management, 8th ed. Fort Worth, TX: The Dryden Press, 2006.

Sharpe, William F. “Mutual Fund Performance.” Journal of Finance, January


1966.

Smith, Randall. “Zero-Coupon Bond’s Price Swings Jolt Investors Looking for
Security.” The Wall Street Journal, p. C1. June 6, 1984.

Treynor, Jack L. “How to Rate Management of Investment Funds.” Harvard


Business Review, January/February 1965.

66  Investment Risk, Return, and Performance


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
About the Author
Craig Kinnunen, MS, CFP® is an associate professor at the
College for Financial Planning. Prior to joining the
College, Craig enjoyed a long and successful career in
personal financial planning and wealth management.
Craig’s enthusiasm for financial planning extends beyond
the classroom, as he also spends time providing pro bono
financial education and individual financial counseling to
members of the Colorado National Guard. Craig earned a
bachelor of science degree in accounting from Northern
Michigan University and followed that up with a master of science degree in
finance from the University of Colorado in Denver. You can contact Craig at
craig.kinnunen@cffp.edu.

About the Author  67


© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Index
A master index covering all modules of this course can be found on eCampus.

Beta coefficient, 24 systematic (nondiversifiable) risk, 6


Business risk, 10 unsystematic (diversifiable) risk, 9
Call risk, 12 Risk-adjusted returns, 29
Capital asset pricing model (CAPM), 30 measures of, 48
Capital market line, 29 Sharpe index, 51, 52, 53
Client assessment, 45 Standard deviation, 22
Correlation coefficient, 38 Systematic risk, 6
Credit risk, 11 exchange rate (currency) risk, 8
Default risk, 10 interest rate risk, 7
Diversification, 35, 40 market risk, 7
Dollar-weighted returns, 56 purchasing power (inflation) risk, 6
Event risk, 11 reinvestment risk, 7
Exchange rate risk, 8 Time horizons, 42
Financial risk, 10 Treynor index, 51
Interest rate risk, 7 Unsystematic risk, 9
Investment pyramid, 34 business risk, 10
Jensen Performance Index, 50 call risk, 12
Liquidity risk, 11 credit risk, 11
Market risk, 7 default risk, 10
Performance benchmarks, 53 event risk, 11
Political risk, 13 financial risk, 10
Purchasing power (inflation) risk, 6 liquidity risk, 11
Reinvestment risk, 7 political risk, 13
Risk, 3 Weighted-average beta, 26

68  Investment Risk, Return, and Performance


© 1996, 2002–2018, College for Financial Planning, all rights reserved.

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