Risk, uncertainty and behavioral pitfalls

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Risk, uncertainty and behavioral pitfalls

Post by gbs » Sat Feb 24, 2007 3:28 pm

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Risk post

Post by gbs » Mon Feb 26, 2007 3:32 pm

It�s not what we don�t know that hurts us; it�s what we know for sure that just ain�t so. Mark Twain


Mike Tyson was preparing to defend his heavyweight title against Michael Spinks. A reporter, at the press conference before the fight, told Tyson: "You know, Spinks has plan for how to fight you." Tyson replied: "They all have a plan - until they get hit!"



Risk: What Exactly Is It?
by: Larry Swedroe
date: 08/08/2003
Since none of us can clearly see into the future, achieving an accurate assessment of risk and its related expected returns is a cornerstone of prudent investing. (...) Risk takes on many guises and can be different things to different people.



What Risk Matters?
by: Robert D. Arnott
date: 06/2003
Academics tell us that the most important risk in an investment portfolio is some variation of standard deviation. Practitioners �know� that the greatest peril is the risk of being wrong and alone.



For Long-Term Investors, the Focus Should Be on Risk
by: Zvi Bodie and Paula H. Hogan
date: 06/2005
It makes more sense to think first about what risk you are able and willing to bear, and then to think about what potential investment returns you might be able to capture.



The Psychology of Successful Investing
by: Paul Merriman
date: 02/10/2005
Because your emotions will never be a reliable guide, your best bet is to put it all on automatic. That means automatic savings, automatic investing, automatic asset allocation, automatic rebalancing, and automatic distributions in retirement.



Rubble Logic: What Did We Learn from the Great Stock Market Bubble?
by: Clifford S. Asness
date: 2005
Despite all the criticism I have leveled at our collective understanding, we basically know how to invest. A good analogy is to dieting and diet books. We all know how to lose weight and get in better shape: Eat less and exercise more. But as Warren Buffett would say, that is simple�but not easy. Investing is no different.



The Stockholm Syndrome and the Market
by: Todd Hickman
date: 07/22/2003
Are you hurrying to rush to the defense of your broker? Perhaps it was just all a bad dream? Perhaps if you study enough you might find a way to distract yourself from the main issue?

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Post by simba » Mon Feb 26, 2007 4:04 pm

Risk and Risk Control in an Era of Confidence (or is it Greed?)
By John Bogle
Date: 04/06/2000
In these extraordinary and volatile markets we are facing today, it�s difficult for me to imagine more appropriate subjects than �Risk� and �Risk Control� to sound the keynote for an �Agenda for the Future��the perennial theme, as I understand it, for this conference. It has been "Reward,� of course, that has been the keynote of the past 18 years, and most particularly for the past six years, during which the longest and strongest bull market in the history of the world has taken a new lease on life. Even as �it is always darkest before the dawn,� however, it may well always be brightest just before evening begins to fall. When reward is at its pinnacle, risk is near at hand.

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Post by gbs » Fri Mar 02, 2007 2:01 am

Bubble Logic: Or, How to Learn to Stop Worrying and Love the Bull
by: Clifford S. Asness
date: 08/2000
A bull market, and the incentives of those who make their living from bull markets, can create its own form of logic.

contributed by: Barry Barnitz

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Downside Risk: Finding the Best Allocation

Post by Barry Barnitz » Mon Mar 05, 2007 11:18 am

What allocations minimize the downside risk of an investment portfolio? The following papers suggest a maximum allocation to equity of 25%.

Definitions of Statistical Terms


Papers

1. The Uncertain Science of Asset Allocation by Cotton, Benjamin L, (1999)
Descriptive statistics for asset class return distributions are compared to inferential statistics produced by Monte Carlo simulations to illustrate that the assumption of normality and constant correlation can understate the risk associated with a given portfolio. Results are presented in a form accessible to students, investors, and practitioners alike.

The table also illustrates that a 75% allocation to fixed income would be required to bring the portfolio�s worst case within the expectations set by the simulation. Even a 50/50 allocation between fixed income and equities underestimates our actual worst case by over 80% relatively. This is quite disturbing when you consider that most advisors consider a 60/40 allocation between equities and fixed income to be conservative.


2. Asset Allocation in a Value-at-Risk Framework by Huisman, Ronald, Koedijk, Kees C.G. and Campbell, Rachel A.J. (April 27, 1999)
In this paper we develop an asset allocation model which allocates assets by maximising expected return subject to the constraint that the expected maximum loss should meet the Value-at-Risk limits set by the risk manager. Similar to the mean-variance approach a performance index like the Sharpe index is constructed. Furthermore it is shown that the model nests the mean-variance approach in case of normally distributed expected returns. We provide an empirical analysis using two assets: US stocks and bonds. The results highlight the influence of non-normal characteristics of the expected return distribution on the optimal asset allocation.

At the 99% confidence level mandated by Basel for commercial bank value-at-risk use, the optimal portfolio under realistic non-normal distributions consists of 23.93% stock; 35.59% bonds; and 40.68% cash.
Last edited by Barry Barnitz on Wed Jul 11, 2007 12:21 pm, edited 5 times in total.
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Post by gbs » Tue Mar 06, 2007 7:17 pm

The Courage of Misguided Convictions
by: Brad M. Barber and Terrance Odean
date: 12/1999
link: here
We highlight two common mistakes investors make: excessive trading and the tendency to disproportionately hold on to losing investments while selling winners. We argue that these systematic biases have their origins in human psychology. The tendency for human beings to be overconfident causes the first bias in investors, and the human desire to avoid regret prompts the second.


A survey of behavioral finance
by: Nicholas Barberis and Richard Thaler
date: 2003
link: here
Behavioral finance argues that some financial phenomena can plausibly be understood using models in which some agents are not fully rational.


Seven Sins of Fund Management
by: James Montier
date:11/18/2005
link: here
How can behavioral finance inform the investment process? We have taken a hypothetical 'typical' large fund management house and analyzed their process. This collection of notes tries to explore some of the areas in which understanding psychology could radically alter the way they structure their businesses. The results may challenge some of your most deeply held beliefs.


Psychological biases of investors
by: H. Kent Baker and John R. Nofsinger
date:04/15/2002
link: here
We review the field of behavioral finance as it relates to investors. Specifically, we examine common investment mistakes caused by an investor's cognitive and emotional weaknesses and group this mistakes into two categories: how investors think and how investors feel. (...) We suggest five steps that investors can take to overcome common investor mistakes

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Solutions & Alternatives for Addressing Concentrated Equ

Post by Barry Barnitz » Wed Apr 18, 2007 10:01 am

Investment Solutions and Alternatives for Addressing Concentrated Equity by Vanguard Investment Counseling & Research, Donald G. Bennyhoff, CFA

Executive summary
Concentrated equity holdings in a client’s portfolio raise substantial concerns about idiosyncratic risk and portfolio diversification; the larger the portion of the portfolio invested in one stock, the greater the risk that the portfolio will fall short of its required returns. Because investors have vastly different reasons for holding individual stocks, concentrated equity holdings must be handled on a client-by-client basis and are difficult to incorporate into the wealth-management process. With that in mind, when the primary goal is to maximize risk-adjusted returns, our research suggests that immediate liquidation is the best solution for the vast majority of investors. This is not to suggest that immediate liquidation should be the initial and only choice considered. Such a choice is not always preferred or even possible. For example, immediate liquidation may not be the ideal course for investors who have enough other wealth to weather substantially poor performance by the concentrated stock, or for investors who are absolutely convinced that the concentrated holding will significantly outperform the overall market (overconfidence is a common behavioral bias). Furthermore, if an investor anticipates his or her own death in the near future (and thus, a step-up in the portfolio’s cost basis) or has charitable intentions, alternative strategies may be more beneficial. Finally, some investors may not be able to immediately liquidate their concentrated holdings because of legal or other restrictions.

This paper not only addresses why concentrated positions should be liquidated but, for those investors who are unwilling to or are prohibited from selling their shares, also explores ways to manage concentrated stock holdings and the associated risks.


Reference Papers

1.The Enviable Dilemma: Hold, Sell, or Hedge Highly Concentrated Stock? by Boyle, Patrick S., Daniel J. Loewy, Jonathan A. Reiss, and Robert A. Weiss. 2004.

2. Full Report: The Enviable Dilemma: Hold, Sell, or Hedge Highly Concentrated Stock? by Alliance Bernstein

3. Exchange Funds: A Solution to Concentrated Wealth by 2000 Bailard, Biehl & Kaiser, Inc.

4. Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk by John Y. Campbell & Martin Lettau & Burton G. Malkiel & Yexiao Xu. 2000

5. The Role of Company Stock in Defined Contribution Plans by Mitchell, Olivia S. and Utkus, Stephen P. (October 2002)

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