Risk Analysis and Technical Analysis Tanveer Singh Chandok (Director of Mentorship)

Risk Analysis and Technical Analysis

Tanveer Singh Chandok (Director of Mentorship)

GTSF Investments Committee2

What we have done so far Efficient Market Hypothesis Investing Styles (IC) Time Value of Money Financial Statement Analysis Valuation and important terms Important Ratios Fundamental Analysis (Macro/Micro) Intro to Fixed Income


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 – “average” Median - “middle number” Mode – “occurs most often”

0, 0, 2, 4, 6, 8, 10 Standard Deviations Normal Distributions


What is “Risk”? Uncertainty Risk What are we uncertain about? Generally:

The more uncertain the cashflows of a particular investment are the higher the risk

The higher the risk, the higher the required interest rate

Thus: Higher Risk = Higher Rate of Return Risk – return trade-off


Terms “Rate of Return” “Sample” = our dataset Sample mean returns

Sample variance of returns


More terms Sample covariance

Standard Deviation Square root of variance = σ

Sample correlation


Correlation Patterns


Correlation Patterns


Normal or “Gaussian” Distributions


Compare to uniform distribution


Characteristics of Probability Distributions Mean

Most likely value – “Expected value” Variance or Standard Deviation

Volatility – “Degree of deviation from the mean value”

Skewness Degree of asymmetry in distribution

Kurtosis Degree of fatness in tail area


Standard Deviation Defined by the following equation:

Step 1: Find the mean of the dataset Step 2: Subtract the mean from each value Step 3: Square the values from Step 2 Step 4: Add up all the values from Step 3 Step 5: Divide the value from Step 4 by (n-1) Step 6: Take the square root of the value from

Step 5


Standard Deviation as a measure of risk Std. Dev. tells us what the normal distribution

probability function looks like Pros

Easy to calculate and implement If return distribution is symmetric, the upside risk

is the same as downside risk, and therefore standard deviation is a good measure of downside risk

If returns are normally distributed, standard deviation would be adequate in characterizing the risk

Upside risk vs. Downside risk


Standard Deviation as a measure of risk Cons

Investors are concerned about downside risk Standard deviation includes both the above-average

returns (upside risk) and the below-average returns (downside risk)

If returns are skewed, standard deviation is not the only relevant measure of risk

Holding expected return and standard deviation constant, investor would prefer positive skewed distribution


Risk Practice Problems You are thinking about investing in 2

companies. One of them (let’s call it ABC) has the 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?


More Risk! 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


Beta The most common way to see how a stock

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

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. 1.0e. .35f. 1.9

Which stock will move the most in relation to the market? Which one will move the least?


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

“The abnormal rate of return on a security or portfolio in excess of what would be predicted by an equilibrium model like the capital asset pricing model (CAPM)”

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 in

terms of excess return● 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 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


Technical Analysis Live demo

Quiz Time!

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

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!

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

Quiz Time!

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

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Risk Analysis and Technical Analysis Tanveer Singh Chandok (Director of Mentorship)