Riskd – Risk Management Blog

Recently, one of our staff bought a cologne (Chemistry from clinique) for her husband for father’s day from an online shop (not mentioning the name because she is still sorting out the issue). The perfume, cheaper compared to other online merchants, turned out to be a  ’fake’ .  Anyways, to keep things short, the reason this person bought this was because of the reviews she read on their testimonials page.  Obviously, even though the reviews sounded authentic, turned out to be made up. She found that out by googling one of the names of the companies listed there. 

The risk of buying a bad product / service online reduces greatly when you have other people giving a positive review or a testimonial. But what if these are not original reviews and were made up by the seller of the service to increase his conversion rate.  Conversion rate increases dramatically when you have positive reviews and online marketeers know that and use that to their advantage.

Validating these online reviews or testimonials is a challenge for the end consumer and hence trusting the seller or the service provider becomes a challenge. Buyers should look for verified testimonials. A video testimonial with the name of the person and his job, his company would be ideal.  But that is hard for small companies to produce and maintain and even that might not be authentic. So what do consumers do ? Look for independent 3rd party verified reviews and testimonials.

A startup company is getting launched solving this very problem. The company (http://www.ReviewScale.com) helps in improving online reputation and builds tools to manage testimonials, reviews and rating and also has a process to independently verify them. I guess a service offering like that might help consumers from getting ripped by the online sharks.

Trader’s should know this – The 2% risk management rule. The two percent risk management rule states that you must limit your risk on any single trade to a maximum of two percent of your trading capital. For amateur traders, the two percent rule gives leeway for mistakes and gives the amateur trader time in the market to learn and survive for the longer term. For professional traders, the two percent risk management is their margin of error.

Read more about this here

As time progressed, three major composite measures of risks for a Portfolio were adopted by the risk professionals.

1. Treynor Index
2. Sharpe Performance Index
3. Jensen Performance Index
   

Treynor Index :

In order to use the Treynor Index, you must know three things; the portfolio return, the risk-free rate of return, and the beta of the portfolio. For the risk-free rate of return, you may use the average return (over the period of time) of some government bond or note. The beta of the portfolio is a measure of the systematic risk of the portfolio. Using the beta, rather than the standard deveiation, you are assuming that the portfolio is a well diversified portfolio. If you are looking at the return of a mutual fund, this figure is typically available from the fund company itself.

For those of you who want to know the formula for the index;

Treynor = (Portfolio Return – Risk-Free Return) / Beta

Let’s use the same example information. A portfolio manager achieved a return of 15.0%, his portfolio had beta measurement of 1.1 and the market achieved a return of 14.6% vs. a risk free rate of return of 7%. To calculate the Jensen Index:

index = (.15 – .07) / 1.1 = 0.0727

To compare, another portfolio manager achieved a return of 13.5% with a beta of .81. The Treynor index for this porfolio manager is:

index = (.135 – .07) / 0.81 = 0.0802

This means that the 2nd portfolio manager out performed the first portfolio manager on a risk-adjusted basis.

Sharpe Performance Index :
In order to use the Sharpe Index, you must know three things; the portfolio return, the risk-free rate of return, and the Standard Deviation of the portfolio. For the risk-free rate of return, you may use the average return (over the period of time) of some government bond or note. The Standard Deviation of the portfolio is a measure of the systematic risk of the portfolio. Using the Standard Deviation, rather than the beta (as in the Treynor Index), you are assuming that the portfolio is NOT a deversified portfolio.

Because the numerator is the Portfolio’s Risk Premium, the Sharpe Index measures the Risk Premium earned per unit of total risk.

Si = Ri – RFR / oi

Ri = Average Rate of Return for Portfolio
RFR = Average Rate of Return for Risk-Free Assets
oi = Standard Deviation of Rate of Portfolio’s Return

Jensen Peformance Measure:

Superior portfolio managers who accurately predict market turns or who identify undervalued investments earn higher have consistently positive random error terms

rjt = rfrt + bj[rmt - rfrt ] + ujt

this version of capm suggests that return is a function of risk-free rate, plus risk premium that depends on systematic risk, plus, random error term with an intercept to measure the positive or negative difference,

the equation becomes rjt – rfrt = alpha + bj[rmt - rfrt ] + ujt

rearranged —– alpha = (rjt – rfrt) – bj (rmt – rfrt)

where alpha measures how much of the rate of return on the portfolio is attributable to the manager’s ability to derive above-average returns adjusted for risk

Years ago, investors evaluated Portfolio Performance almost entirely on the basis of the Rate of Return. Investors were aware of the concept of Risk, But were uncertain how to quantify or measure it. Developments in Modern Portfolio Theory in the 1960s showed investors how to quantify and measure risk in terms of the variability of returns.

At first, Risk and Return had to be measured independently; Analysts grouped portfolios into similar risk classes then compared the Rates of Return within these classes.

Subsequently, major composite measures of Portfolio Performance were developed that combine Risk and Return.

Rest in the next post – Part 2.

We as individual investors are regularly taught that asset allocation is about finding the right risk/return balance by picking from asset classes like domestic equity, foreign equity, fixed income and cash, but those working at Harvard and Yale are maintaining a portfolio that is radically different. How can you mimic a portfolio like that ? especially when they have thought through how to reduce long term risk in a managed portfolio.

The FACTS are Harvard’s endowment earned 15% per annum in the last 10 years, and Yale’s boasted an annualized return of 17.2% during the same timeframe

Note that the asset allocation shown here is with ETFs and other mutual funds based in the U.S