More About the Markets Abhijan Khosla (Director of Mentorship)

More About the Markets

Abhijan Khosla (Director of Mentorship)

GTSF Investments Committee2

Who Am I?


NO MENTORSHIP THURSDAY

TEST IS TEUSDAY OCTOBER 1st!


A quick review● There are two kinds of markets

○ Primary ○ Secondary

● Securities can be listed in two ways ○ Listed ○ OTC

● The Efficient Market Hypothesis has 3 “levels”○ Strong ○ Semi-strong ○ Weak


A quick review● The 3 main styles of investing

○ Value○ Growth ○ Momentum

● What is the difference between going long and short? How do we “short” a stock?

● Different levels of market cap○ Large○ Mid ○ Small

● What does “liquidity” mean and why is it so important?


What we’re doing today● We use statistics to measure risk ● Some basic concepts ● Properties of data sets

○ Mean○ Median - “middle number”○ Mode - occurs most often

● Normal Distributions● Standard Deviations


Normal or “Gaussian” Distributions


Measuring Risk in Markets● Name some major risks people lending

money may face● How do we measure the risk of a stock?● We use the Standard Deviation of returns to

compare similarly performing companies ● Standard Deviation formula


Risk Practice Problems● You are thinking about investing in 2

companies. One of them (let’s call it ABC) following monthly returns○ 4%○ 2%○ 3%○ 1%○ -8%

● What is this stocks average return and standard deviation?


Risk Practice Problems● The next company (DEF) has the following

returns;○ 1%○ 2%○ 1%○ 3%○ 2%

● What is this stocks average return and standard deviation?

● Which stock would you most likely invest in?● What other factors should influence your

decision?


Risk and Return● The basic assumption about financial

markets is that greater risk is met with greater return

● If you invest in a risky security you expect to be compensated with a greater return

● The risk/return relationship is central to determining if securities are mispriced in the market


More Risk!● Standard deviation is a good measure of risk

for an individual securities ● What about a stock’s sensitivity to the

market?● When the broader market is down individual

company stocks are often down, why is that?● Traders use stocks as a way to express their

views on the market, often movements in stocks are not due to company news but market news


More Risk!● The most common way to see how a stock

moves in relation to the broader market (represented by the S&P 500) is Beta

● Beta (or market risk) is a measure of a securities relative volatility as compared to the broader market

● Beta > 1 means the stock is more volatile than the market

● Beta < 1 means the stock is less volatile than the market


Beta


Beta Practice● Consider the following security beta’s;

a. 1.3b. 1.4c. .6d. .4e. .35f. 1.9

● If the market rose 10% by how much would you expect each of the securities to rise?


Using Beta to determine return● We previously calculated expected return by

taking the average of past returns ● With Beta we know how a security compares

to the market return● Using this information we can calculate the

E(r) of a security without knowing its previous returns

● E(r) = Risk Free Rate + Beta (Market Risk Premium) ○ Market risk premium = market return - risk

free rate


CAPM● The use of Beta, Market Return and the Risk

Free Rate to determine expected return is called the Capital Asset Pricing Model or CAPM

● What do you think we use for the risk free rate?

● If a stock’s beta is 1.2 and the market has returned 10% on average while the risk free is 2% what is the stock’s expected return?


Alpha● If everything perfectly followed CAPM then

we would be able to very accurately predict what a given stock would return

● If this was true then we would not need actively managed funds to gain outsized returns

● Alpha is the portion of returns associated with a given security or set of securities

● Alpha represents a greater return for lower risk


Risk/Return Payoff● Which portfolio manager did a better job last

year and why?

Bill - 25% return Carl - 20% return

● What does the information above NOT tell us about the returns of the portfolios in question?


The Risk Return Payoff● RISK! ● We haven’t accounted for the risk each

manager took so we don’t know if they got those returns by picking smart investments or simply taking a lot of risk


Risk Adjusted Returns

● Let’s take another look at those returns

Bill – (25% return, stdev of 20%) Carl – (20% return, stdev of 25%)


What does the Sharpe Ratio Tell Us?● A sharpe ratio tells us how much return the

portfolio gets for every “unit” of risk it takes ● A sharpe ratio of > 1 means for every unit of

risk we get more than 1 unit of return ● A sharpe ratio of > 2 means that we are

getting double the return for every unit of risk we take


Where does “risk” come from?● Beta measures risk compared to markets● Alpha measures risk of individual assets ● If we hold multiple securities at the same

time can we increase/decrease our risk?● Correlation - the degree to which two things

move together ● If we have a portfolio of highly correlated

stocks then our entire portfolio will rise and fall at the same time


Correlation Correlation - a measure of how closely two

things move together


Why We Care About Correlation


Diversification● We can increase our portfolio’s risk/return

relationship by diversifying● If we hold non-correlated assets then they

will move separately eliminating moves cause by correlations

● Say you have a portfolio of only Tech stocks (GOOG, APPL, MSFT) how would you diversify your holdings so a drop in the tech sector wouldn’t bankrupt you?


Diversification

Quiz Time!

What is Beta?1. Security Risk2. Market Risk3. Treasury Risk4. Interest Rate Risk

Quiz Time!

How many low correlation stocks do we need to achieve the diversification benefit

1. 52. 203. 304. 33

Quiz Time!

What is NOT a component of CAPM1. Market Risk2. Risk Free Rate3. Beta4. Market Return

More About the Markets Abhijan Khosla (Director of Mentorship)

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