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Black-Litterman Approach
Time diversification
Half or half
Ramana Sonti
BITS Pilani, Hyderabad Campus
Term II, 2014-15
1/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Agenda
Example
2 Using the CAPM
4
5
2/48
Factor models
Single index model
Estimating CAPM parameters
Application: Markowitz optimization
Market risk premium
Empirical evidence
The equity premium puzzle
Black-Litterman Approach
Time diversification
True or false?
Resolution
Optimal investment mix and age
Half or half
The puzzle
Evaluation
Lecture 6: Practical Matters - Asset allocation, the CAPM and investing
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Example
Canada
Germany
Hong Kong
India
Japan
Singapore
United Kingdom
United States
3/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Example
India
12 months
60 months
0.451
0.494
-2.12
-0.99
0.028
0.016
USA
12 months
60 months
0.283
-0.946
-2.27
-2.42
0.008
0.023
4/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Example
0 and VC matrix
Use these inputs to calculate 25 portfolios on the efficient frontier
Minimum exp. return portfolio: global minimum variance portfolio
Maximum exp. return portfolio: maximum expected return asset
23 intermediate portfolios
5/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Example
Mean return
0.040
0.045
0.050
0.055
Standard deviation
6/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Example
0
the original optimization inputs:
0 and
Step 5: Repeat Steps 2 through 4 for say, 500 trials
optimal allocations
7/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Example
0.020
Resampling: Results
0.010
0.005
0.000
Mean return
0.015
0.005
0.04
0.05
0.06
0.07
0.08
0.09
Standard deviation
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Example
0.005
0.000
0.005
Mean return
0.010
0.015
0.040
0.045
0.050
0.055
0.060
0.065
Standard deviation
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Factor models
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Factor models
Multi-factor models
Multi-factor models posit more than one factor, and are written as
there is one more macro factor, inflation, INF affecting all stocks
11/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Factor models
(factor betas)
For instance, the most general asset pricing model called the
12/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
the factor is. Following from the CAPM logic, one might choose the
return on a market index as the only macro factor
A related model which is very popularly used is the single index
model ri rf = i + i (rm rf ) + i , where E (i ) = 0
Here, rm represents the return on an index, such as the BSE Sensex
Why is the single index model a valid single factor model?
Taking expectations on both sides, we have
E (ri ) rf = i + i [E (rm ) rf ]
Subtracting the second equation from the first, we have
ri E (ri ) = i [rm E (rm )] + i , which is a clearly a single factor
model
William Sharpe (of CAPM fame), and is also called the diagonal
model
13/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
unpredictable
Cov (i , rm ) = 0: the idiosyncratic part of the security return is
j?
Cov (ri , rj ) = Cov (i + i (rm rf ) + i , j + j (rm rf ) + j )
2
which reduces to Cov (ri , rj ) = i j m
after using the last two
assumptions above
14/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
0.3
0.2
0.1
0.0
-0.30
-0.25
-0.20
-0.15
-0.10
-0.05
0.00
-0.1
0.05
0.10
0.15
0.20
-0.2
-0.3
-0.4
Index excess returns
How do we read
i , i and i,t from this graph?
16/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
index as the U.S. market index proxy, and runs the regression:
ri,t = ai + bi rm,t + ei,t
Their estimate
of alpha is related to our alpha estimate as:
ai =
i + 1 i rf , where rf is the average risk-free rate over the
sample period
The beta estimates of both regressions are the same
Adjusted beta: Merrill obtains adjusted betas as
18/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Fundamental betas
Can betas estimated from historical data be used as predictors of future beta?
Note that historical beta is an unbiased estimator of the true historical beta
averaged over past periods. Whether this is a good predictor of the future
depends on whether the change in the true beta from past average to the future
value is zero or not
A firms beta tends to drift about an industry norm. A good predictor of future beta
will have to incorporate a weighted average of the historical beta, and the industry
norm
Events to which a firm might have heavy exposure are expected to become more
important for the market portfolio in the future, although the firms exposure to such
events is not expected to change
K
X
k=1
19/48
ck firmchark +
J
X
dj inddumj + e
j=1
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
performance
20/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Using historical average returns results in a portfolio with large positions (long
and short)
21/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Portfolios formed on the basis of the CAPM and the single index
22/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Empirical evidence
Country
U.S.A.
U.K.
Japan
Germany
France
Sweden
India
India
23/48
Period
1926-2004
1947-1999
1970-1999
1978-1997
1973-1998
1919-2003
1981-1991
1991-2005
Equities (%)
8.0
5.7
4.7
9.8
9.0
11.1
23.23
22.96
Risk-free (%)
0.7
1.1
1.4
3.2
2.7
5.6
12.02
9.51
Premium (%)
7.2
4.6
3.3
6.6
6.3
5.5
11.21
13.45
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Big question
The US equity premium is between 7-8 %. Is this justified?
Did people know in say, 1925 or 1947 that stocks would earn 7%
more than bonds on average; and were somehow rationally unwilling
to hold more stocks?
Mehra and Prescott (1985): The 7% difference between stocks and
T-bills is too large to be explained by standard economic models:
This is the equity premium puzzle
Essentially, says that people are much more risk averse according to
economic models, compared to what they actually seem to be...
24/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
25/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Consensus surveys
A recent survey (2007) of finance professors says the most common
2005:
26/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Conclusion
27/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
P(GoodSAPMgrade | HighFOFAgrade) =
P(HighFOFAgrade|Goodstudent)P(Goodstudent)
P(HighFOFAgrade)
28/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Market weights
Equilibrium/implied
expected returns
w portfolio managers to
e confidence in their subjective
expected return
Subjective views on
expected returns
Degree of confidence
in subjective views
erman (1992)
Ramana Sonti
Half or half
7 countries
asset allocation
Global
3 asset
classes per country: Stocks, Bonds and Currencies
7 countries
Exhibit
20 risky assets: 7x3=21; USD
cash3is an idle asset
Searching for an efficient portfolio with 10.7% volatility (Global CAPM equilibrium portfolio)
Results
using
meansasasexpected
expected
returns
usinghistorical
historical means
returns
Results
Unconstrained
Germany
Currency exposure
Bonds
Equities
78.7
30.4
4.4
France
Japan
U.K.
U.S.
15.5
40.4
15.5
28.6
1.4
13.3
54.5
44.0
Japan
U.K.
U.S.
18.0
88.8
0.0
23.7
0.0
0.0
0.0
0.0
46.5
40.7
4.4
Canada Australia
65.0
95.7
44.2
5.2
52.5
9.0
160.0
7.6
0.0
France
115.2
0.0
0.0
Canada Australia
77.8
0.0
0.0
13.8
0.0
0.0
is the
asset
allocation?
Where
Where
is the
asset
allocation?
30/488
14 Sonti
Ramana
Fixed
IncomeMarket risk premium
Research
Black-Litterman Approach
Time diversification
Half or half
Exhibit
Exhibit 66
Black and
LittermanEquilibrium
example
2 Premiums
Risk
The BL example
...nnucontinued
Fixed
((ppeerrce
aali
cenntt aannu
lizzeedd exce
excess
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Income
Research
Equilibrium
expected
excess
returns
(using
Blacks
global CAPM)
expected
excess
(using
Blacks
global
Equilibrium
expected
excess returns
returns
(using
Blacks
global CAPM)
CAPM)
Equilibrium
Germany
Germany
Currencies
Currencies
Bonds
Bonds
Equities
Equities
France
France
Japan
Japan
U.K.
Exhibit
Exhibit 77U.K.
U.S.
U.S.
1.01
1.10
1.40
0.91
1.01
1.10
1.40
0.91
Equilibrium
Optimal
Portfolio
2.29
2.23
2.88
3.28
1.87
2.29
2.23
2.88
3.28
1.87
6.27
8.48
8.72
6.27
8.48
8.72
7.32
((ppeerrce
ppoorrttfo
vvaalluue)
cenntt of
of
foli
lio10.27
o10.27
e) 7.32
Canada
Canada
0.60
0.60
2.54
2.54
7.28
7.28
Australia
Australia
0.63
0.63
1.74
1.74
6.45
6.45
Results
using
equilibrium
expected
returns
using
equilibrium
returns
Results
using
equilibrium expected
expected
returns
Results
Germany
Germany
Currency
Currency exposure
exposure
Bonds
Bonds
Equities
Equities
France
France Japan
Japan
1.1
1.1
2.9
2.9
Exhibit
Exhibit
2.6
2.6
0.9
0.9
1.9
1.9
shows
shows
2.4
2.4
U.K.
U.K.
5.9
2.0
5.9
2.0
1.8
6.0
1.8
the
equilibrium
the6.0
equilibrium
23.7
8.3
23.7
8.3
U.S.
U.S.
Canada
Canada Australia
Australia
0.6
0.6
0.3
0.3
16.3
1.4
0.3
16.3
1.4 for
0.3as66
risk
premiums
risk
premiums
for all
all
as29.7
1.6
1.1
29.7
1.6
1.1
sets,
sets, given
given this
this value
value of
of the
the universal
universal hedging
hedging constant.
constant.88
This
is
neutral
benchmark
This
is the
the
neutral
benchmark
is the
neutral
benchmark.
How
is one
toweincorporate
This
Let
adopt
Let us
us consider
consider what
what happens
happens when
when we
adopt these
these equilibequilibrium
risk
premiums
as
our
neutral
means
when
we
have
subjective
views
of
the
portfolio
manager?
rium
risk
premiums
as
our
neutral
means
when
we
have no
no
one
views
of
portfolio
manager?
How is
isViews
one to
to incorporate
incorporate
subjective
views
of the
the
portfolio
manager?
How
he
basic
that
confronts
investors
trying
to
hesubjective
basic problem
problem
that
confronts
investors
trying
to
III.
III. Expressing
Expressing
Views
views.
77 shows
optimal
portfolio.
It
the
views. Exhibit
Exhibit
shows the
the
optimal
portfolio.
It is
is simply
simply
the
use
quantitative
asset
allocation
models
is
how
to
use
quantitative
asset
allocation
models
is
how
to
Mid-1991
was
a
time
of
recession:
(not-so-confident)
views
are
that...
Mid-1991
a time
of recession:
(not-so-confident)
are
that...
Mid-1991
waswas
a time
of
recession:
(not-so-confident)
views
are
market
capitalization
portfolio
80%
currency
risk
market
capitalization
portfolio with
withviews
80% of
of the
the
currency
risk
that...
31/48
translate
translate their
their views
views into
into aa complete
complete set
set of
of expected
expected
hedged.
Other
portfolios
on
the
frontier
with
different
levels
hedged.returns
Other
portfolios
onthat
the can
frontier
with
different
levels
...stocks
equilibrium
expected
returns
2.5%
...stocks will
will underperform
underperform
equilibrium
expected
returns
by
2.5%
excess
on
be
used
as
for
excess
returns
on assets
assets
that
can
be by
used
as aa basis
basis
for
of
correspond
combinations
of
borrowof risk
risk would
would
correspond
towe
combinations
of risk-free
risk-free
borrowportfolio
optimization.
As
will
show
the
is
portfolio
optimization.
Asto
we
will
show
here,
the problem
problem
is
outperform
equilibrium
expected
returns
by
0.8%
...bonds
will
outperform
equilibrium
expected
returns
by here,
0.8%
...bonds
...stocks
willwill
underperform
equilibrium
expected
returns
by model
2.5%
ing
lending
plus
or
of
portfolio.
ing or
or
lending
plus more
more
or less
less
of this
this
portfolio.
that
optimal
portfolio
weights
from
aa mean-variance
that
optimal
portfolio
weights
from
mean-variance
model
Simply
the
expected
return
vector
to
reflect
this
Simply adjust
adjust
the
expected
return
vector
to
reflect
this
...bonds
will outperform
equilibrium
returns
by 0.8%
are
sensitive
minor
in
excess
are incredibly
incredibly
sensitive to
toexpected
minor changes
changes
in expected
expected
excess
By
the
equilibrium
is
but
particularly
By itself,
itself,The
theadvantage
equilibrium
is interesting
interesting aa
but
not equilibrium
particularly
of
global
returns.
The
advantage
of incorporating
incorporating
global
equilibrium
Why not simplyreturns.
adjust
the
expected
return
vector
tonot
reflect
this?
useful.
The
real
value
of
the
equilibrium
is
to
provide
aa
useful.
The
real
value
of
the
equilibrium
is
to
provide
will
become
apparent
will
become
apparent when
when we
we show
show how
how to
to combine
combine it
it with
with
INVA
School
of
15
INVA -- Term
Term 44 -- 2007
2007 -- Indian
Indian
School
of Business
Business
neutral
framework
to
which
the
investor
can
add
his
own
neutral
framework
to
which
the
investor
can
add
his
own 15
an
an investors
investors views
views to
to generate
generate well-behaved
well-behaved portfolios,
portfolios, withwithperspective
in
terms
of
views,
optimization
objectives,
and
perspective
in
terms
of
views,
optimization
objectives,
and
out
out requiring
requiring the
the investor
investor to
to express
express aa complete
complete set
set of
of exexLecture 6: Practical
Matters - Asset
allocation,
CAPM
and investing
Ramana Sonti
constraints.
These
are
the
issues
to
constraints.
These
arethe
the
issues
to which
which we
we now
now turn.
turn.
Income
Market risk premium
Research
Black-Litterman Approach
Time diversification
Half or half
Exhibit 8
Portfolios
Based on a Moderate View
InvestorInvestor
views:Optimal
Naive
adjustment
views:
(perNaive
cent of portfoliadjustment
o value)
Results
usingusing
adjusted
expected
returns
adjusted
expected
returns
Results
Unconstrained
Currency exposure
Bonds
Equities
Germany
France
1.3
13.6
3.7
8.3
6.4
6.3
Japan
U.K.
U.S.
3.3
15.0
27.2
6.4
3.3
14.5
112.9
30.6
Japan
U.K.
U.S.
5.0
0.0
28.3
3.0
0.0
13.6
35.7
0.0
Canada Australia
8.5
42.4
24.8
1.9
0.7
6.0
2.3
0.0
2.6
France
4.3
0.0
5.3
Canada Australia
9.2
0.0
13.1
0.6
0.0
1.5
We see that:
that:
bonds. This lack of apparent connection between the views
Allocation
decreases
and
US
(expected)
AllocationtotoUS
USstocks
stocks
decreases
andthat
that
USbonds
bonds
increases
(expected)
the investor
attempts
tototo
express
andincreases
the optimal
portfolio
Allocation to German
Canadian
bonds
sharply
(unforeseen)
theand
model
generates
is decreases
a pervasive
problem
with standard
mean-variance
arises because,
as we returns
saw in
Problem: Optimal allocation
a highlyoptimization.
non-linear It
function
of expected
trying
to generate
a portfolio
representing
no views,
in the
Optimal
allocation
a highly
non-linear
function
of expected
returns
Big problem:
(involving
variances
and correlations
optimization
there is a complex interaction between expected
(involving variances
and correlations
32/48
Black-Litterman Approach
Time diversification
Half or half
assets
e.g., the expected return on stocks will be 2% more than that on
bonds in the next quarter, and I believe in this view with 90%
confidence
Mathematically all the investors views are written as
0
P E (r ) = Q + ; N (0, )
33/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Example of views
Imagine 3 views:
IBM will have an expected return of 1% next month (65%
confidence)
GE will outperform GM by 0.4% next month (75% confidence)
MSFT return will be 0.2% more than that of IBM next month (90%
confidence)
These views can be succinctly written as:
0
P E (r ) = Q + ; N (0, ), where:
1
P = 0
1
E (r ) =
0
1
0
E (rIBM )
0
0
1
E (rGM ) E (rGE )
1%)
Q = 0.4%
0.2%
34/48
0
1
0
1/0.65
0
0
0
1/0.75
0
E (rMSFT )
0
1/0.90
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
35/48
Ramana Sonti
directly.
directly.
Market risk premium
Black-Litterman Approach
Time diversification
Half or half
In
InExhibit
Exhibit99we
weshow
showthe
thecomplete
completeset
setofofexpected
expectedexcess
excess
returns
returns when
whenwe
weput
put100%
100%confidence
confidenceininaaview
viewthat
thatthe
the
differential
of
expected
excess
returns
of
U.S.
equities
Fixed
differential
of expected excess returns of U.S. equitiesover
over
Fixed
bonds
is
2.0
percentage
points,
below
the
equilibrium
differIncome
bonds
is 2.0 percentage points, below the equilibrium differIncome
ential
ofof5.5
Research
ential
5.5percentage
percentagepoints.
points.Exhibit
Exhibit10
10shows
showsthe
theoptimal
optimal
Research
portfolio
portfolioassociated
associatedwith
withthis
thisview.
view.
Back
Back to
to the
the BL
BL example
example
Exhibit
9views
Using their formula, BL
can incorporate
Exhibitinexplicable
9
This
Thisisisinincontrast
contrasttotothe
the inexplicableresults
resultswe
wesaw
sawearlier.
earlier.
We
see
here
a
balanced
portfolio
ininwhich
the
Expected
Excess
Returns
They
try
a
simple
view
that
says
US
stocks
will
outperform
UShave
BL
can
views
WeExpected
see
hereincorporate
a balanced
portfolio
which
theweights
weights
have
Using
Excess
Returns
Usingtheir
theirformula,
formula,
BL
can
incorporate
views
tilted
away
from
market
capitalizations
toward
U.S.
bonds
Combining
Investor
With
Equilibrium
tilted
away
from Views
market
capitalizations
toward
U.S.
bonds
bonds
(with
100%
confidence).
Note
that
this
isweless
than
the
Investor
Views
With
Equilibrium
They by
try Combining
a2%
simple
view
that
says
US
stocks
will
outperform
US
bonds
by
2%
(100%
away
from
U.S.
equities.
Given
our
view,
now
obtain
They try a simple and
view
that says
US
outperform
US bonds
by 2%
(100%
and away
U.S.
our view,
we now
obtain
(from
a(annu
aalistocks
zzeeequities.
ddppewill
rece
nn
tGiven
)t)
nnu
liconsider
rce
confidence
view).
Note
that
this
is
less
than
the
equilibrium
difference
of
5.5%
equilibrium
difference
of
5.5%
a
portfolio
that
we
reasonable.
confidence view). Note
that this
lessconsider
than the
equilibrium difference of 5.5%
a portfolio
thatiswe
reasonable.
Revised
expected
returns
Revisedset
set of expected
returns
Revised set of expected returns Exhibit 10
Exhibit 10
Germany
France
Japan
U.K.
U.S.
Canada Australia
Germany
France
Japan
U.K.
U.S.
Canada Australia
Optimal
Portfolio
Optimal
Currencies
1.32
1.28
1.73 Portfolio
1.22
0.44
0.47
Currencies
1.32
1.28
1.73
1.22
0.44
0.47
Investor
Views
Equilibrium
Bonds Combining
2.69
2.39
3.29
3.40
2.39
2.70
1.35
Investor
ViewsWith
With
Equilibrium
Bonds Combining
2.69
2.39
3.29
3.40
2.39
2.70
1.35
Equities
5.28
6.42
7.71
7.83
4.39
4.58
3.86
(6.42
p(peerrcecennt tofof7.71
ppoortrfo
Equities
5.28
4.58
3.86
tfolilioov7.83
vaalulue)e) 4.39
Revised portolio
allocation
weights
Revised
Revised
portolio
allocation
weights
set
of portfolio
allocations
Currency exposure
Currency exposure
Bonds
Bonds
Equities
Equities
22
22
Germany
France
JapanAboveU.K.
U.S. only
Canada
Australiato
totoadjust
accordingly.
we
the
Germany
JapanAboveU.K.
U.S. only
Canada
Australiato
adjustFrance
accordingly.
weadjusted
adjusted
thereturns
returns
U.S.
and
U.S.
other
1.4 bonds1.1
7.4equities,
2.5holding fixed all0.8
0.3
U.S.
and U.S.7.4equities,2.5holding fixed all0.8
otherexpectexpect1.4 bonds1.1
0.3
3.6
2.4
7.5
2.3
67.0
1.7
0.3
ed
excess
Another
difference
isisthat
3.6
2.4
7.5
2.3
67.0
1.7 we
0.3
ed
excessreturns.
returns.
Another
difference
thathere
here
wespecify
specify
3.3
2.9
29.5
10.3
3.3
2.0
1.4
aa differential
letting
3.3
2.9 ofofmeans,
29.5
10.3 the
3.3
2.0 determine
1.4
differential
means,
letting
theequilibrium
equilibrium
determine
the
theactual
actuallevels
levelsofofmeans;
means;above
abovewe
wehad
hadtotospecify
specifythe
thelevels
levels
Well-behaved portfolio;
changes are in line with views, with no strange sidedirectly.
Well-behaved portfolio;
changes are in line with views, with no strange sideWell-behaved
portfolio;directly.
changes
are in line with views, with no
effects
effects
9 we show the complete set of expected excess
strange side effects InInExhibit
Exhibit 9 we show the complete set of expected excess
differential
of expected excess returns of U.S. equities over
INVA - Term 4 - 2007 - Indian School
of
20
is Business
2.0 percentage points, below the equilibrium differINVA - Term 4 - 2007 - Indianbonds
School
20
bonds of
is Business
2.0 percentage points, below the equilibrium differ36/48
ential -of
5.5allocation,
percentage
points.
Exhibit 10 shows the optimal
Lecture 6: Practical Matters
the CAPM
and investing
Ramana Sonti
ential Asset
of 5.5
percentage
points.
Exhibit 10 shows the optimal
Black-Litterman Approach
Time diversification
Half or half
True or false?
Time diversification
fallacy
37/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
True or false?
Defining returns
Suppose the prices of a risky asset are P0 and P1 on consecutive
days. Then we can define the following returns over one period
P1
The gross return is (1 + R1 ) = P
0
The continuously compounded return is
P2
P0
= (1 + R1 )(1 + R2 )
1
38/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
True or false?
[ + + + ] =
2
Var [log(1 + r0,T )] = T12 2 + 2 + + 2 = T
Standard deviation of annualized return =
T
Expected return stays constant with horizon, while risk (standard
deviation) decreases with time. This is why there is so much popular
advice saying stocks are less risky in the long run
E [log(1 + r0,T )] =
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
True or false?
Horizon (years)
1
5
10
20
Sdev(total)(%)
15.00
33.54
47.43
67.08
Sdev(annualized)(%)
15.00
6.71
4.74
3.35
40/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Resolution
Bonds ($)
1030.45
1161.83
1349.86
1822.12
horizon
41/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Resolution
However...
Consider the expected value of terminal wealth with investment in
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
The puzzle
Half stocks all the time or all stocks half the time?
Which alternative is better?
1 Invest half your wealth in stocks and half in risk-free bonds all the
time
2 Invest all your wealth in stocks half the time and risk-free bonds for
the other half
To analyze this, lets make the following assumptions:
We expect stocks to have a higher average return than risk-free
bonds
Stock returns are random; hence we cannot anticipate whether
44/48
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
The puzzle
45/48
Stock
20%
-5%
20%
-5%
20%
-5%
20%
-5%
20%
-5%
20%
-5%
20%
-5%
20%
-5%
20%
-5%
20%
-5%
Results:
Bond
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
Returns
Balanced
Switching
12.5%
20.0%
0.0%
-5.0%
12.5%
20.0%
0.0%
-5.0%
12.5%
20.0%
0.0%
-5.0%
12.5%
20.0%
0.0%
-5.0%
12.5%
20.0%
0.0%
-5.0%
12.5%
5.0%
0.0%
5.0%
12.5%
5.0%
0.0%
5.0%
12.5%
5.0%
0.0%
5.0%
12.5%
5.0%
0.0%
5.0%
12.5%
5.0%
0.0%
5.0%
6.25%
6.25%
Wealth
Balanced
Switching
1.125
1.200
1.125
1.140
1.266
1.368
1.266
1.300
1.424
1.560
1.424
1.482
1.602
1.778
1.602
1.689
1.802
2.027
1.802
1.925
2.027
2.022
2.027
2.123
2.281
2.229
2.281
2.340
2.566
2.457
2.566
2.580
2.887
2.709
2.887
2.845
3.247
2.987
3.247
3.136
3.247
3.136
Exposure
Balanced
Switching
0.500
1.000
0.563
1.200
0.563
1.140
0.633
1.368
0.633
1.300
0.712
1.560
0.712
1.482
0.801
1.778
0.801
1.689
0.901
2.027
0.901
1.925
1.014
0.000
1.014
0.000
1.140
0.000
1.140
0.000
1.283
0.000
1.283
0.000
1.443
0.000
1.443
0.000
1.624
0.000
0.9551
0.8234
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
The puzzle
Stock
17.6%
28.4%
-6.1%
33.6%
9.1%
11.6%
-0.8%
35.7%
21.2%
30.3%
22.3%
25.3%
-11.0%
-11.3%
-20.8%
33.1%
13.0%
7.3%
16.2%
7.3%
Bond
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
Balanced
11.3%
16.7%
-0.5%
19.3%
7.0%
8.3%
2.1%
20.3%
13.1%
17.7%
13.6%
15.1%
-3.0%
-3.1%
-7.9%
19.1%
9.0%
6.2%
10.6%
6.1%
Returns
Switch 1
17.6%
28.4%
-6.1%
33.6%
9.1%
11.6%
-0.8%
35.7%
21.2%
30.3%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
Switch 2
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
22.3%
25.3%
-11.0%
-11.3%
-20.8%
33.1%
13.0%
7.3%
16.2%
7.3%
Balanced
1.113
1.299
1.292
1.541
1.650
1.787
1.824
2.195
2.483
2.921
3.320
3.822
3.706
3.590
3.306
3.936
4.291
4.555
5.039
5.348
Wealth
Switch 1
1.176
1.510
1.418
1.895
2.067
2.306
2.289
3.105
3.762
4.903
5.149
5.406
5.676
5.960
6.258
6.571
6.900
7.244
7.607
7.987
Switch 2
1.050
1.103
1.158
1.216
1.276
1.340
1.407
1.477
1.551
1.629
1.992
2.495
2.219
1.969
1.559
2.076
2.345
2.517
2.926
3.139
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Evaluation
47/48
Balanced
5.66
9.06
7.97
Switch 1
5.58
9.05
11.97
Switch 2
5.58
9.06
11.97
Ramana Sonti
Black-Litterman Approach
Time diversification
Half or half
Evaluation
you can time the market to generate an expected return more than
the balanced strategy. How much more?
The Sharpe ratio is a good way to compare the balanced and
switching strategies, since it represents a reward-to-risk ratio
Sharpe ratio =
E (r )rf
Question: If you believe you are a market timer, what extra return
0.09060.05+
?
0.1197
This means your timing skill will have to result in a 2% extra annual
48/48
Ramana Sonti