Risk premia

Our last post discussed using the discounted cash flow model (DCF) as a method to set return expectations that one would ultimately employ in building a satisfactory portfolio. We noted that if one were able to have a reasonably good estimate of the cash flow growth rate of an asset, then it would be relatively straightforward to calculate the required return. The problem, of course, is figuring out what the cash flow growth rate should be.

SKEWed perceptions

The CBOE’s SKEW index has attracted some headlines among the press and blogosphere, as readings approach levels not see in the last year. If the index continues to draw attention, doomsayers will likely say this predicts the next correction or bear market. Perma-bulls will catalogue all the reasons not to worry. Our job will be to look at the data and to see what, if anything, the SKEW divines. If you don’t know what the SKEW is, we’ll offer a condensed definition.

A weighty matter

When we were testing random correlations and weighthings in our last post on diversification, we discovered that randomizing correlations often increased portfolio risk. Then, when we randomized stock weightings on top of our random correlations, we began to see more cases in which one would have better off not being diversified. In other words, the percentage of portfolios whose risk exceeded the least risky stock began to rise. By chance, the least risky stock (in terms of the lowest volatility), also happened to enjoy the highest risk-adjusted return, so our random selection of stock returns might be a bit anomalous.

Back to diversification

In our last post, we took a detour into the wilds of correlation and returned with the following takeaways: Adding assets that are not perfectly positively correlated to an existing portfolio tends to lower overall risk in many cases. The decline in risk depends a lot on how correlated the stocks are in the existing portfolio as well as how the additional stocks correlate with all the existing assets.

Detour: correlation

In our last post, we asked the simple question of whether an investor is better off being diversified if he or she doesn’t know in advance how a stock is likely to perform. We showed some graphs that suggested diversification lowered risk (or, more precisely, volatility), but this came at the expense of accepting less than maximal returns. We then showed that a diversified portfolio was able to produce better risk-adjusted returns on 8 out of 10 of the stocks we had randomly generated.