Risk Adjusted Rate of Return for a portfolio – Part 1

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.

Good example of a risk managed asset portfolio – why invent your own when you can mimic the pros ?

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

3 Step process for Identifying weakness in internal control design for Financial Reporting

STEP 1 – Preparation

1. Review relevant control information
2. Review Systems and Material Account Balance for the controls
3. Review Financial Reporting and Disclosure Risks

STEP 2 – Assessment

1. Assess Control Environment
2. Entity level controls
3. Process controls

STEP 3 – Conclusion and Disclosure

1. Assess findings and make appropriate disclosures

It is very important to clearly distinguish the following when you do an assessment (step2).

• The overall control environment including the ‘tone from the big guys’ and the extent and nature of involvement of the audit committee and board of directors. Remember that the ‘tone’ gives the direction on how internal controls are setup.
• Controls over the preparation of financial statements, including controls regarding accounting estimates, closing adjustments and the application of accounting principles in the preparation of financial statements and the information disclosed in the notes to the financial statements.
• Controls in the various accounting systems that capture, summarize and record the routine accounting transactions (e.g., recording of revenue, expenses, etc.) on which the financial statements are based. These are referred to as process controls.

Inherent vs Residual Risks

Risks which exists ‘already’ before you address it is called Inherent Risk ; i.e., the risk to your company in the absence of any actions you might take to alter either the likelihood or impact. Every company in every
industry faces inherent risk; of course, not every company manages it
effectively or efficiently. Some examples for this are

• lack of management competence. Management competence refers to the competence of directors and other senior management personnel. It includes matters such as their:
  • industry experience,
  • knowledge of the entity’s business,
  • commercial skills,
  • common sense,
  • knowledge of good corporate governance, and
  • communication and judgement ability.

Auditors can assess management competence by speaking to directors individually as well as considering such factors as the number of years experience of each director in the industry, the number of years experience with the entity, and the extent of changes to management during the past several years.

• another example is the extent of significant and prolonged under staffing of the accounting department. Such understaffing could be indicative of management’s lack of interest in quality reporting, or even a positive interest in poor quality reporting.

Residual risk is also known as your “vulnerability” or “exposure”; .e., the risk that remains after you have attempted to mitigate the
inherent risk. Companies can only understand residual risk if they ave first addressed inherent risk. An example for this which could be unique to a company are strikes, the outcome of unfavorable litigation, or a natural catastrophe that can be eliminated through diversification.

Assets – what it means here

An asset is something which within your context has some value which is important to preserve.

• Business
  • Project
• Deliverables
• Life
• Health
• Savings
• Legacy
• Digital Assets
• Property
  • Cars
• Reputation

and many more…

Risk Identification

This is a process of determining which risks might affect the project (an example of an asset) and documenting their characteristics.

Risk Identification is an iterative process, involving the project team, management team, stakeholders and subject matter experts (if required).

Risk Identification process is a part of “Project Planning Phase”.

Risk Management Components

The major components for risk management would be the following :

1. Asset (Includes anything you deem important and could include current assets and projected assets)
2. Risk (anything which can reduce the value of your asset)
   1. Risk Event / Instance (the actual event)
3. Probability of the Risk happening
4. Impact (Quantifiable change in your asset value)