CFA LEVEL I

2024 EXAM

PORTFOLIO MANAGEMENT
By: Mr. Pham Anh Tuan, CFA
 CONTENT

LEARNING MODULE 1 LEARNING MODULE 4

Portfolio Management: An Overview Basics of Portfolio Planning and Construction

LEARNING MODULE 2 LEARNING MODULE 5

Portfolio Risk & Return – Part 1 The Behavioral Biases of Individuals

PORTFOLIO
MANAGEMENT

LEARNING MODULE 3 LEARNING MODULE 6

Portfolio Risk & Return – Part 2 Introduction to Risk Management

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LEARNING MODULE 1
PORTFOLIO MANAGEMENT:
AN OVERVIEW

4
LM 1: Portfolio Management: An Overview
Portfolio approach: Evaluating individual securities in relation to their contribution
to the investment characteristics of the whole portfolio.

Avoid disastrous investment outcomes

Offer equivalent E(R) with lower risk

(overall volatility of return) Diversified
Portfolio
Compositions of individual securities
affect the risk-return trade off (which
securities, their weight)

Lower ratio
Not necessarily provide downside indicates better
protection diversification

𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑓𝑜𝑟 𝑒𝑞𝑢𝑎𝑙𝑙𝑦 𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑜𝑓 𝑛 𝑠𝑡𝑜𝑐𝑘𝑠

𝐷𝑖𝑣𝑒𝑟𝑠𝑖𝑓𝑖𝑐𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑖𝑜 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑛 𝑠𝑡𝑜𝑐𝑘𝑠

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LM 1: Portfolio Management: An Overview
Portfolio Management Process

Execution
• Asset allocation
• Security analysis
Planning Feedback
• Portfolio construction
• Understanding the • Portfolio monitoring
client’s needs and rebalancing
• Preparation of an • Performance
investment policy measurement and
statement (IPS) reporting

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LM 1: Portfolio Management: An Overview

1 2 3
Planning Execution
Execution Feedback
▪ Understanding the client’s needs ▪ Asset Allocation: ▪ Portfolio Monitoring and
▪ Preparation of an investment ✓ Form economic and capital market Rebalancing:
policy statement (IPS): expectations; ✓ Asset class allocations and
✓ IPS is a written planning ✓ Determine suitable allocations to securities holdings in
document that describes the various asset classes response to market
client’s investment objectives ▪ Security Analysis: performance
and constraints; ✓ Top-down (Macro – Industry – ▪ Performance Evaluation and
✓ IPS should be reviewed and Company) Reporting:
updated regularly ✓ Bottom up (Company specific) ✓ Evaluate the portfolio’s
performance;
▪ Portfolio Construction:
✓ Combine individual securities to ✓ Assess if the client’s
achieve diversification by: objectives have been met
o Asset class weighting
o Sector weighting
o Individual security selection and
weighting
✓ In line with objectives and
constraints (IPS)

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 LM 1: Portfolio Management: An Overview
Type of Investors
Fund that provide ongoing
financial support for a
Save and invest for a variety specific purpose (i.e.
of reasons (Short-term goals, Individual Endowments university endowment)
Long-term goals) 01 Investors & Foundations 08 Receiving funding
through donation

Professional managers
manage pooled funds of Invest premiums for
Investment Insurance
many investors (often 02 Companies Companies 07 funding customer claims
when they occur)
individuals)

Earn a return on its loans that

is greater than the interest Sovereign Pools of assets owned by a
that it pays to depositors 03 Banks Wealth Funds 06 government

Employers contribute fixed Employers to provide

amount Defined Defined Benefit certain annual benefits to
▪ Employees makes 04 Contribution Pension Plans 05 retirees
investment decision and Plans ▪ Employers contribute
takes investment risk funds to DB plan
▪ No guarantees of ▪ Plan manager invests
specific future value of to match the
plan assets or future payments to retirees
pension payments ▪ Employers takes
investment risk

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LM 1: Portfolio Management: An Overview
Type of Investors

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LM 1: Portfolio Management: An Overview
Asset Management Industry
Buy-side firms Sell-side firms
▪ Asset managers/ Portfolio managers that use Brokers/ Dealers/ Investment banks that sell
(buys) the services of sell-side firms securities and provides independent investment
research and recommendations to their clients

Full-service asset managers Specialist asset managers Multi-boutique asset managers

▪ Offer a variety of investment ▪ Focus on a particular ▪ A holding company includes a

styles and asset classes investment style or a particular number of different specialist
asset class asset managers
Active management Passive management
▪ Use fundamental research, quantitative ▪ Replicate the performance of a chosen benchmark
research, or a combination of both, to index
outperform a chosen benchmark ▪ Include traditional broad market index tracking
or a smart beta approach
Traditional managers Alternative asset managers
▪ Focus on long-only equity and fixed-income ▪ Focus on hedge fund, private equity, venture
securities capital strategies, real estate, or commodities

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LM 1: Portfolio Management: An Overview
Asset Management Industry Trends

01 02 03
Growth of Use of “Big Robo-Advisers
Passive Data” in the
Investing Investment
Process

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 LM 1: Portfolio Management: An Overview

MUTUAL FUNDS

Open-end Fund Close-end Fund

▪ Accept new investment

money → issue additional
shares ▪ Do NOT take new investments
▪ Investors buy and redeem ▪ New investors invest by
shares at net assets value Each investor owns a portion buying existing shares &
(NAV) of overall portfolio liquidate by selling their shares
▪ Charge on-going management to other investors
fee 𝐍𝐞𝐭 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐚𝐬𝐬𝐞𝐭𝐬 → Shares can trade at premium or
▪ No load funds: no up-front 𝐍𝐀𝐕 = discount to NAV
𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐬𝐡𝐚𝐫𝐞𝐬
fees or redemption fees ▪ Charge on-going management
▪ Load funds: charge either up- fee
front fees, redemption fees, or
both

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LM 1: Portfolio Management: An Overview

TYPE OF MUTUAL FUNDS

Money Market Bond Mutual Hybrid/Balanced

Stock Mutual Funds
Funds Funds Funds

▪ Invest in short- ▪ Invest in FI Actively

term debt securities Index funds
managed funds
securities with ▪ Examples ▪ Invest in both
low risk of include ▪ Select ▪ Passive bonds and
value change government securities investment to stocks
▪ Aim to provide bond funds, with object to match the
security of tax-exempt beat performance
principal, high bond funds, benchmark of a particular
levels of high-yield ▪ Higher index
liquidity, and (lower rated turnover,
returns in line corporate) higher
with money bond funds, management
market rates and global fees, higher
bond funds tax liabilities

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LM 1: Portfolio Management: An Overview

OTHER FORMS OF POOLED INVESTMENTS

Exchange-trade funds (ETFs) Separately managed accounts Hedge funds

Portfolio that is owned by a ▪ Typically use leverage,

▪ Purchase and sale of single investor and managed derivatives, and long & short
investments between investors according to that investor’s investment strategies;
(similar to closed end funds) needs and preferences ▪ Qualified investors (normally
▪ Are often index funds rich individuals)
▪ Special redemption provisions
for ETFs → keep market prices Private equity funds
Venture capital funds
very close to NAVs
▪ Can be shorted or margined,
traded at intraday prices ▪ Seek to buy, optimize, and
ultimately sell private ▪ Invest in companies in start-
▪ Less capital gain tax liability up phase with intension to sell
than open end funds portfolio companies to
generate profits in IPO or to an established
▪ Dividends on ETFs are paid out firm after growing the
to the shareholders whereas ▪ Managers of funds may take
active roles in managing the company
mutual funds usually reinvest ▪ Expertise in industries in
the dividends companies in which they
invest which they focus

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LM 1: Portfolio Management: An Overview
Example 1:

1. Which of the following is the best reason for an investor to be concerned with the composition of a portfolio?
A. Risk reduction.
B. Downside risk protection.
C. Avoidance of investment disasters.
2. The planning step of the portfolio management process is least likely to include an assessment of the client’s
A. securities.
B. constraints.
C. risk tolerance.
3. Which of the following institutions will on average have the greatest need for liquidity?
A. Banks.
B. Investment companies.
C. Non-life insurance companies.
4. Which of the following pooled investments is most likely characterized by a few large investments?
A. Hedge funds.
B. Buyout funds.
C. Venture capital funds.

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LEARNING MODULE 2
PORTFOLIO RISK AND RETURN:
PART I

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LM 2: Portfolio Risk and Return: Part I
Risk and Return of Major Asset Classes

Risk and Return of Major Asset Classes in the United States (1926–2017):

➢ Asset classes with the greatest average returns also have the highest standard
deviations of returns.
➢ When choosing investments, beside expected returns and variance of returns, we
should also consider the return distribution, skewness, kurtosis and liquidity.

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LM 2: Portfolio Risk and Return: Part I
Covariance & Correlation

CALCULATION

Variance
▪ Measure variability of return Covariance Correlation
around the mean The extent to which 2 variables Relation between
▪ Higher variance => Less move together 2 returns
predictable return

𝐶𝑜𝑣1,2
Sample variance σ𝑛𝑡=1{ 𝑅𝑡,1 − 𝑅1 [𝑅𝑡,2 − 𝑅2 ]}
=
Variance 𝑛−1 Cov1,2
S2 R t,1 R t,2 = return on asset 1&2 in P1,2 =
= σ2 ഥ)2 σ1 σ2
σTt=1(R T − R period t
=
T−1 R1 R 2 = mean return on asset 1,2
n = number of period

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LM 2: Portfolio Risk and Return: Part I
Covariance & Correlation

Covariance Correlation

Negative Zero Positive -1 0 1

Variables No linear Variables Linear No linear Linear
move relationship move relationship, relationship relationship,
opposite between together opposite between two same
variables direction stock’s direction
return

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LM 2: Portfolio Risk and Return: Part I
Portfolio of 2 Risky Assets

Portfolio return Portfolio risk

σportfolio = Varportfolio

Where:
❑ W1 = Weight of asset 1
❑ W2 = 1 - W1 = Weight of asset 2
𝐶𝑜𝑣1,2
❑ 𝜌1,2 = 𝑎𝑛𝑑 𝐶𝑜𝑣1,2 = 𝜌1,2 𝜎1 𝜎2
𝜎1 𝜎2

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LM 2: Portfolio Risk and Return: Part I
Example 2:

An investor is considering investing in a small-cap stock fund and a general bond fund. Their
returns and standard deviations are given below and the correlation between the two fund
returns is 0.10.

1. If the investor requires a portfolio return of 12%, what should the proportions in each fund
be?
2. What is the standard deviation of the portfolio constructed in Part 1?

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LM 2: Portfolio Risk and Return: Part I
Example 3:

Consider two risky assets that have returns variances of 0.0625 and 0.0324, respectively. The
assets’ standard deviations of returns are then 25% and 18%, respectively. Calculate the variances
and standard deviations of portfolio returns for an equal-weighted portfolio of the two assets
when their correlation of returns is 1, 0.5, 0, and –0.5.

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LM 2: Portfolio Risk and Return: Part I
Example 3:

Solution:
σportfolio = Varportfolio

σportfolio = w1 2 σ1 2 + w2 2 σ2 2 + 2w1 w2 ρ1,2 σ1 σ2

▪ ρ = +1:
σ = portfolio standard deviation = 0.5 × 0.25 + 0.5 × 0.18 = 21.5%

▪ ρ = 0.5:
𝜎 2 = 0.52 × 0.0625 + 0.52 × 0.0324 + 2 × 0.5 × 0.5 × 0.5 × 0.25 × 0.18 = 0.034975 => σ = 18.70%

▪ ρ = 0:
𝜎 2 = 0.52 × 0.0625 + 0.52 × 0.0324 = 0.023725 => σ = 15.40%

▪ ρ = –0.5:
𝜎 2 = 0.52 × 0.0625 + 0.52 × 0.0324 + 2 × 0.5 × 0.5 × (–0.5) × 0.25 × 0.18 = 0.012475 => σ = 11.17%

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LM 2: Portfolio Risk and Return: Part I
Portfolio Risk & Return Relationship

𝐸(𝑅𝑝 )
100% Asset B
▪ If 2 risky asset returns are perfectly
positive correlated => greatest
portfolio risk
▪ The lower correlation of asset
returns, the greater the risk 𝜌 = +0.5
reduction (diversification) benefit
𝜌 = −0.5
of combining assets in a portfolio
𝜌=0 𝜌 = +1
▪ If 2 risky asset returns are perfectly 𝜌 = −1
negatively correlated => portfolio
risk could be eliminated altogether
(specific set of asset weights) 100% Asset A

𝜎𝑝

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LM 2: Portfolio Risk and Return: Part I
Portfolio of many Risky Assets

Portfolio return Portfolio risk

Where:
❑ N = Number of risky assets
❑ Assume portfolio has equal weights (1/N) for all N assets
❑ = Average Variance of N assets
❑ = Average Covariance of N assets

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 LM 2: Portfolio Risk and Return: Part I
Diversification Approaches

Diversify with asset Diversify by not

classes owning your
employer’s stock

Diversify with index Buy insurance for

funds risky portfolios

Evaluate each asset

Diversification among before adding to a
countries portfolio
LM 2: Portfolio Risk and Return: Part I
Risk Aversion Concept

Risk Seeking Risk Neutral Risk Adverse

Choose riskier investment Has no preference regarding Choose guaranteed outcome,
given equal expected risk and would be indifferent prefer the investment with
returns between two such investments less risk

Example:
A coin will be flipped; if it comes up heads, you receive $100; if it comes up tails, you receive
nothing.
Solution:
Expected return = 0.5 × $100 + 0.5 × $0 = $50.
➢ A risk-averse investor would choose a payment of $50 (a certain outcome) over the gamble.
➢ A risk-seeking investor would prefer the gamble to a certain payment of $50.
➢ A risk-neutral investor would be indifferent between the gamble and a certain payment of $50.

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LM 2: Portfolio Risk and Return: Part I
Utility Theory

Utility is a measure of relative satisfaction that an investor derives from a portfolio.

▪ U = Utility of an investment
▪ E(r) = Expected return
▪ σ2 = Variance of the investment.
▪ A = Risk aversion coefficient
➢ Risk seeker: A < 0
➢ Risk neutral: A = 0
➢ Risk-averse investor: A > 0

• Higher E(r) → Higher U

• Higher σ2 → Lower U
• U can be useful only in ranking various investments

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LM 2: Portfolio Risk and Return: Part I
Example 4:

Assume that you are given an investment with an expected return of 10% and a risk (standard
deviation) of 20%, and your risk aversion coefficient is 3.

1. What is your utility of this investment?

2. What must be the minimum risk-free return you should earn to get the same utility?

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LM 2: Portfolio Risk and Return: Part I
Example 5:

Based on investment information given below and the utility formula, answer the following
questions:

1. Which investment will a risk-averse investor with a risk aversion coefficient of 4 choose?
2. Which investment will a risk-neutral investor choose?
3. Which investment will a risk-loving investor choose?

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LM 2: Portfolio Risk and Return: Part I
Utility Theory & Indifference Curves

Indifference curve (IC) plots the combinations of risk–return pairs that an investor would accept
to maintain a given level of utility.

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LM 2: Portfolio Risk and Return: Part I
Utility Theory & Indifference Curves
▪ Curves upward for risk-averse investors and downward for risk-seeker
▪ Steeper IC → More risk-averse

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LM 2: Portfolio Risk and Return: Part I
Capital Allocation Line (CAL) & Portfolio Selection
▪ CAL plots the set of feasible portfolios in a market with 2 assets (risky and risk-free).
▪ The plot of the CAL is a straight line. The line begins with the risk-free asset as the leftmost
point with zero risk and a risk-free return, Rf.
▪ Move further along the line in pursuit of higher returns by borrowing at the risk-free rate and
investing the borrowed money in the portfolio of all risky assets.

100% invested at risky

asset
E ( Ri ) − R f
E ( RP ) = R f + ( ) P
i Borrow at risk-free
rate to invest in
risky assets
E ( RP ) = w1 R f + (1 − w1 ) E ( Ri )

 P = (1 − w1 ) i
100% invested at
risk-free asset

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LM 2: Portfolio Risk and Return: Part I
Capital Allocation Line (CAL) & Portfolio Selection

▪ The optimal portfolio is the point of tangency between the CAL and the IC for that investor
→ the optimal portfolio maximizes the return per unit of risk (as it is on the CAL), and it
simultaneously supplies the investor with the most satisfaction (as it is on the IC).

(above the CAL)

desirable but not Less risk
achievable with adverse
available assets

More risk
adverse
Optimal Portfolio

(below the CAL)

attainable but are not
preferred

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LM 2: Portfolio Risk and Return: Part I
Efficient Frontier

▪ Minimum-variance
portfolio: For a given level of
E(R), portfolios with lowest 𝜎
▪ Minimum-variance frontier:
Graph connecting minimum –
variance portfolios
▪ Efficient frontier: Top
portion of minimum –
variance frontier
 All portfolios on EF provide
highest level of E(R) for a
given level of risk
▪ Global minimum-variance
portfolio: Portfolio on the
efficient frontier that has the
least risk (Portfolio Z)

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LM 2: Portfolio Risk and Return: Part I
Two-fund Separation Theorem

• The two-fund Risk-free asset and

Optimal Portfolio
Optimal Risky Portfolio
separation theorem (Two-fund separation
(combining
states that all investors indifference curve)
theorem)
regardless of taste,
risk preferences, and
initial wealth will hold
a combination of 2
portfolios or funds: A
risk-free asset and an
optimal portfolio of
risky assets.
• All portfolios on the
efficient frontier are
candidates for being
combined with the
risk-free asset.

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 LM 2: Portfolio Risk and Return: Part I
Investor’s Optimal Portfolio
The Optimal Investor Portfolio lies on the investor’s CAL and tangent to the investor’s IC.

The location of an optimal investor

Investment
portfolio depends on the investor’s risk
Opportunity Set
preferences.
• A highly risk-averse investor may
invest a large proportion, even
100%, of his/her assets in the risk-
free asset → The optimal portfolio
will be located close to the y-axis.
• A less risk-averse investor may
invest a large portion of his/her
wealth in the optimal risky asset →
The optimal portfolio will lie closer
to Point P.
• Some less risk-averse investors (i.e.,
with a high risk tolerance) may
borrow money to invest more in the
risky portfolio → The optimal
investor portfolio will lie to the right
of Point P on the CAL.

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LEARNING MODULE 3
PORTFOLIO RISK AND RETURN:
PART II

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LM 3: Portfolio Risk and Return: Part II
Capital Market Line (CML)

▪ Each investor might have a

different IC & a different CAL →
Different optimal risky asset
portfolio
▪ Modern portfolio theory: simply
assumes that investors have
homogeneous expectation →
same efficient frontier of risky
portfolios and same optimal
risky portfolio (the only one
exists) and CAL
▪ Capital market line (CML):
Optimal CAL for all investors,
where the optimal risky portfolio
is the market portfolio

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LM 3: Portfolio Risk and Return: Part II
Capital Market Line (CML)

All investors have homogeneous

expectation

To allocate market portfolio and

risk free asset

Market portfolio is the point at

which the CML is tangent to the
efficient frontier

E ( Rm ) − R f
E ( RP ) = R f + ( ) P
m

E ( RP ) = w1 R f + (1 − w1 ) E ( Rm )

 P = (1 − w1 ) m

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LM 3: Portfolio Risk and Return: Part II
Capital Market Line (CML)

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 LM 3: Portfolio Risk and Return: Part II
Leveraged Portfolios with Different Lending and Borrowing Rates

E(R P ) = w1 R b + (1 − w1 )E(R m )

▪ Rb is the borrowing rate

▪ Rf is the lending rate (risk-
free rate)

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LM 3: Portfolio Risk and Return: Part II
Example 6:

Mr. Bean borrow money from his broker against securities held in his portfolio. Broker’s
lending rate is 7%. Risk-free rate is 5%, market return is 15% with standard deviation of 20%.
Calculate expected return & standard deviation if Mr. Bean:
1. Invests 75% of his money in the market
2. Borrows 25% of his of his initial money and invest all in the market
3. Borrows 75% of his of his initial money and invest all in the market

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LM 3: Portfolio Risk and Return: Part II
Investment Strategy

ACTIVE
▪ Market are not
informationally PASSIVE
efficient
▪ When investors
▪ Overweight the
believe market is
undervalued &
efficient
underweight the
overvalued securities ▪ Index investment
to generate active
return

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LM 3: Portfolio Risk and Return: Part II
Systematic Risk & Nonsystematic Risk

Systematic risk (non diversifiable,

market risk)
𝜎
Risk that can not be eliminated Total risk = Systematic risk +
through diversification (e.g. interest Unsystematic risk
rates, inflation, economic cycles,
TYPES OF RISK

political uncertainty, etc.)

Firms highly correlated with market
increase systematic risks Unsystematic
 mkt risk

Nonsystematic Risk (unique,

diversifiable, firm specific risk) Systematic
risk
Risk that is local or limited to a
particular asset or industry that need
not affect assets outside of that asset Number of securities in portfolio ~30
class (e.g. airline crush, etc.)
Eliminated through diversification

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 LM 3: Portfolio Risk and Return: Part II
Return-Generating Model
Equation
Macroeconomic factor models
(e.g., economic growth rates,
interest rates, and inflation rates)

𝐸(𝑅𝑖 ) − 𝑅𝑓
Fundamental factor models
Return-generating model

Multifactor = 𝛽𝑖1 × 𝐸 𝐹𝑎𝑐𝑡𝑜𝑟 1 + 𝛽𝑖2

(e.g., earnings, earnings growth, and
model cash flow growth) × 𝐸 𝐹𝑎𝑐𝑡𝑜𝑟 2 + ⋯ + 𝛽𝑖𝑘
× 𝐸 𝐹𝑎𝑐𝑡𝑜𝑟 𝑘
Statistical factor models
(use historical and cross-sectional
returns data)

Single-index model
Single-factor
model
Market model

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LM 3: Portfolio Risk and Return: Part II
Multifactor Model

Fama & French 3-factor model

Carhart 4-factor model

47
LM 3: Portfolio Risk and Return: Part II
Example 7:

A regression of ABC Stock’s historical monthly returns against the return on the S&P 500
gives an 𝛼𝑖 of 0.002 and a 𝛽𝑖 of 1.05. Given that ABC Stock rises by 3% during a month in
which the market rose 1.25%, calculate the abnormal return on ABC Stock.

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LM 3: Portfolio Risk and Return: Part II
Calculation & Interpretation of Beta

Definition Formula

Beta (𝜷): sensitive of an asset’s return to the

return on the market index

𝜷 captures an asset’s systematic or nondiversifiable risk

𝜷 > 0: asset’s return follows the market

Key points 𝜷 < 0: asset’s return opposites the market

𝜷 = 0: asset’s return is uncorrelated with the market

Market 𝜷 = 1

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LM 3: Portfolio Risk and Return: Part II
Example 8:

Given the standard deviation of the returns on the market is 18%, calculate beta for the
following assets:
1. Asset A, which has a standard deviation twice that of the market and zero correlation with
the market.
2. Asset B, which has a standard deviation of 24% and its correlation of returns with the
market equals -0.2.
3. Asset C, which has a standard deviation of 20% and its covariance of returns with the
market is 0.035.

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 LM 3: Portfolio Risk and Return: Part II
Capital Asset Pricing Model (CAPM) and the Security Market Line (SML)

▪ CAPM provides a linear expected return–beta relationship that precisely determines the
expected return given the beta of an asset.
▪ The Security Market Line (SML) is a graphical representation of the CAPM with beta,
reflecting systematic risk, on the x-axis and expected return on the y-axis.

CAPM assumptions
(1) Investors are risk-averse, utility-maximizing,
rational individuals.
(2) Markets are frictionless, including no
transaction costs and no taxes.
(3) Investors plan for the same single holding period.
(4) Investors have homogeneous expectations or
beliefs.
(5) All investments are infinitely divisible.
(6) Investors are price takers.

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LM 3: Portfolio Risk and Return: Part II
Compare the CML and the SML

▪ CML uses total risk (σp) on the x-axis while SML uses systematic risk (beta) on the x-axis.
▪ While CML applies only to portfolios on the efficient frontier, the SML applies to any
security, efficient or not.

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LM 3: Portfolio Risk and Return: Part II
Example 9:

Suppose the risk-free rate is 3%, the expected return on the market portfolio is 13%, and its
standard deviation is 23%. An Indian company, Bajaj Auto, has a standard deviation of 50%
but is uncorrelated with the market. Calculate Bajaj Auto’s beta and expected return.

53
LM 3: Portfolio Risk and Return: Part II
Portfolio Return and Beta

54
LM 3: Portfolio Risk and Return: Part II
Example 10:

You invest 20% of your money in the risk-free asset, 30% in the market portfolio, and 50% in
RedHat, a US stock that has a beta of 2.0. Given that the risk-free rate is 4% and the market
return is 16%, what are the portfolio’s beta and expected return?

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LM 3: Portfolio Risk and Return: Part II
Compare Forecast return [E(R)] vs Required Return (RR)

E(R) SML
E(R) > RR => Security is B Above the SML
Undervalued C
undervalued (plot above the On the SML
Fairly valued
SML) (Asset B)

E(R) < RR => Security is

overvalued (plot below the A
SML) (Asset A)
Below the SML
Overvalued

E(R) = RR => Security is

fairly valued (plot on the
SML) (Asset C) Rf

βRISK

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LM 3: Portfolio Risk and Return: Part II
Example 11:

The following figure contains information based on analyst’s forecasts for three stocks. Assume a
risk-free rate of 7% and a market return of 15%. Compute the expected and required return on each
stock, determine whether each stock is undervalued, overvalued, or properly valued, and outline an
appropriate trading strategy.

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LM 3: Portfolio Risk and Return: Part II
Example 11:

Solution:

▪ Stock A is overvalued. It is expected to earn 12%, but based on its systematic risk, it should earn
15%. It plots below SML => Short sell Stock A
▪ Stock B is undervalued. It is expected to earn 17.5%, but based on its systematic risk, it should
earn 13.4%. It plots above the SML => Buy Stock B
▪ Stock C is properly valued. It is expected to earn 16.6%, and based on its systematic risk, it
should earn 16.6%. It plots on the SML => Buy, sell, or ignore Stock C

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LM 3: Portfolio Risk and Return: Part II
Portfolio Performance

Sharpe ratio (SR)

▪ SR: Excess return per unit of

total portfolio risk

▪ Can be applied on both ex

ante (before the fact) basis and
ex post (after the fact) basis
▪ A relative measure & slope of
CML & CAL

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 LM 3: Portfolio Risk and Return: Part II
Portfolio Performance

M-squared (M2)

▪ M2: Return on a leveraged or de-

leveraged portfolio which has the same
risk as the market portfolio

▪ M2 alpha: Difference between the risk-

adjusted performance of the portfolio
and the performance of the market

M2 alpha =

▪ Produces the same portfolio rankings as

SR but measured in percentage terms

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LM 3: Portfolio Risk and Return: Part II
Portfolio Performance

Treynor ratio (TR)

▪ TR: Excess returns per

unit of systematic risk

▪ Does not work for

negative-beta assets

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LM 3: Portfolio Risk and Return: Part II
Portfolio Performance

Jensen’s alpha (𝜶)

▪ 𝜶: % return in excess of those

from a portfolio with the same
β but lies on SML

▪ Market 𝜶 = 0
▪ 𝜶 > 0: Outperform the market
▪ 𝜶 <0: Underperform the
market

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LM 3: Portfolio Risk and Return: Part II
Security Characteristic Line

We estimate asset 𝜷 by
regressing returns on the
asset (Ri) on those of the
market index (RM)

The Security SCL

Characteristic Line (SCL)
• SCL for a security is a
plot of the excess
return of the security
on the excess return of
the market
▪ The intercept is
Jensen’s alpha (∝)
▪ The slope of this line
is our estimate of Beta
(𝜷)

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LM 3: Portfolio Risk and Return: Part II
Example 12:
The following table provides information about the portfolio performance of an investment
manager:
Manager Average Return 𝝈 𝜷
X 10% 20% 1.1
Market (M) 9% 19%
Risk-free rate (Rf) 3%

Calculate the following ratio for investment manager X:

a. Expected return based on the CAPM
b. Sharpe ratio
c. Trey nor ratio
d. M2 alpha
e. Jensen’s alpha

64
LEARNING MODULE 4
BASICS OF PORTFOLIO
PLANNING & CONSTRUCTION

65
LM 4: Basics of Portfolio Planning & Construction
The Investment Policy Statement

Written document Understanding of

governing the process client’s needs,
of portfolio circumstances &
construction constraints

IPS

IPS includes investor’s To be reviewed

risk tolerance, return regularly to stay
requirements & consistent with client’s
constraints condition

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LM 4: Basics of Portfolio Planning & Construction
Major Components of An IPS

Statement of Procedures to Investment Appendices

purpose of IPS IPS update Guidelines

01 02 03 04 05 06 07 08

Description of Statement of Investment Evaluation of

Client Duties & Objectives & Performance
Responsibilities of Constraints
investment
manager,
custodian & client

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LM 4: Basics of Portfolio Planning & Construction
Risk Objectives

Risk Objectives Risk Tolerance

▪ Risk objectives are specifications for portfolio Risk Tolerance = Ability to bear risk + Willingness
risk that reflect the risk tolerance of the client to take risk
▪ Can be absolute or relative, or combination of ▪ The ability to bear risk is measured mainly in
both terms of objective factors, such as time horizon,
✓ Absolute: e.g. no loss of capital of 10% in expected income, and the level of wealth relative
any year to liabilities.
➔ Measures include the variance or standard ▪ The willingness to take risk, or risk attitude, is a
deviation of returns and value at risk more subjective factor based on the client’s
✓ Relative: relative to benchmark, e.g. S&P 500 psychology and also his or her current
circumstances.
➔ Measures include tracking risk & tracking error

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LM 4: Basics of Portfolio Planning & Construction
Risk Tolerance Questionnaire

69
LM 4: Basics of Portfolio Planning & Construction
Example 13:

The Case of Henri Gascon: Risk Tolerance

Henri Gascon is an energy trader who works for a major French oil company based in Paris. He is
30 years old and married with one son, aged 5. Gascon has decided that it is time to review his
financial situation and consults a financial adviser, who notes the following aspects of Gascon’s
situation:
▪ Gascon’s annual salary of €250,000 is more than sufficient to cover the family’s outgoings.
▪ Gascon owns his apartment outright and has €1,000,000 of savings.
▪ Gascon perceives that his job is reasonably secure.
▪ Gascon has a good knowledge of financial matters and is confident that equity markets will
deliver positive returns over the long term.
▪ In the risk tolerance questionnaire, Gascon strongly disagrees with the statements that “making
money in stocks and bonds is based on luck” and “in terms of investing, safety is more
important than returns.”
▪ Gascon expects that most of his savings will be used to fund his retirement, which he hopes to
start at age 50.
Based only on the information given, which of the following statements is most accurate?
A. Gascon has a low ability to take risk but a high willingness to take risk.
B. Gascon has a high ability to take risk but a low willingness to take risk.
C. Gascon has a high ability to take risk and a high willingness to take risk.
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LM 4: Basics of Portfolio Planning & Construction
Return Objectives

▪ Return objectives may be stated on an absolute or a relative basis:

✓ Absolute: e.g. annual return of 10% (can be in nominal term, real term, or
inflation-adjusted)

✓ Relative: relative to benchmark or peer group, or universe of managers, e.g.

annual return within 5% of S&P 500 return

▪ Can be stated before or after fees, pre- or post-tax basis

▪ Can be a required return—that is, the amount the investor needs to earn to meet a
particular future goal, such as a certain level of retirement income

➔ To make sure that this return objectives are realistic

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LM 4: Basics of Portfolio Planning & Construction
Example 14:
The Case of Marie Gascon: Return Objectives
Having assessed her risk tolerance, Marie Gascon now begins to discuss her retirement income needs with
the financial adviser. She wishes to retire at age 50, which is 20 years from now. Her salary meets current
and expected future expenditure requirements, but she does not expect to be able to make any additional
pension contributions to her fund. Gascon sets aside €100,000 of her savings as an emergency fund to be
held in cash. The remaining €900,000 is invested for her retirement.
Gascon estimates that a before-tax amount of €2,000,000 in today’s money will be sufficient to fund her
retirement income needs. The financial adviser expects inflation to average 2% per year over the next 20
years. Pension fund contributions and pension fund returns in France are exempt from tax, but pension
fund distributions are taxable upon retirement.
1. Which of the following is closest to the amount of money Gascon will have to accumulate in
nominal terms by her retirement date to meet her retirement income objective (i.e., expressed in
money of the day in 20 years)?
A. €900,000
B. €2,000,000
C. €3,000,000
2. Which of the following is closest to the annual rate of return that Gascon must earn on her
pension portfolio to meet her retirement income objective?
A. 2.0%
B. 6.2%
C. 8.1%
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 LM 4: Basics of Portfolio Planning & Construction
Constraints
Liquidity
The ability to turn investment assets
into cash in a short period of time

Time horizon Legal and regulatory

The longer an investor’s time Trust, corporate, and qualified
horizon, the more risk and less investment accounts may all be
liquidity the investor can accept restricted by law from investing
in the portfolio in particular types of securities
and assets

Tax concerns Unique circumstance

Some investors are tax-exempt. Restrictions due to investor
Income & capital gains may be preferences (i.e., ethical,
taxed differently → must religious and diversification
consider optimal types of assets needs) or other factors not ready
to invest considered

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LM 4: Basics of Portfolio Planning & Construction
Example 15:

1. Frank Johnson is investing for retirement and has a 20-year horizon. He has an average
risk tolerance. Which investment is likely to be the least suitable for a major allocation in
Johnson’s portfolio?
A. Listed equities
B. Private equity
C. US Treasury bills
2. Al Smith has to pay a large tax bill in six months and wants to invest the money in the
meantime. Which investment is likely to be the least suitable for a major allocation in
Smith’s portfolio?
A. Listed equities
B. Private equity
C. US Treasury bills
LM 4: Basics of Portfolio Planning & Construction
Example 16:
LM 4: Basics of Portfolio Planning & Construction
Portfolio Construction and Asset Allocation

▪ Strategic asset allocation: Specifies the percentage allocations to the included

STRATEGIC asset classes to achieve client’s objectives given client’s constraints
ASSET ▪ Asset class: a category of assets that have similar characteristics, attributes & risk-
ALLOCATION return relationships
(SAA) ▪ Correlation of return within asset class should be high & between asset classes
should be low

TACTICAL ASSET
Variation from strategic asset allocation weights to take advantage of short term
ALLOCATION
opportunities
(TAA)

SECURITY
Deviation from index weights on individual securities within an asset class
SELECTION

Decide on amount of risk to assume in a portfolio (the overall risk budget), and
RISK BUDGETING subdividing that risk over the sources of investment return (e.g., SAA, TAA and
security selection)

▪ Keep monitor results of strategic asset allocation

MONITORING
▪ Rebalance weights of asset classes back to the portfolio weight when they change

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LM 4: Basics of Portfolio Planning & Construction
Portfolio Construction and Asset Allocation

ACTIVE PORTFOLIO
MANAGEMENT CORE-SATELLINE APPROACH
Has 2 drawbacks

Investor may have Major portfolio

multiple (core) invested Minor portfolios
managers, one on a passive or (satellites)
Managers may
may overweight low active risk invested to earn
trade too
stock X while basis high active return
frequently
other may without regard to
=> Higher taxes
underweight X Often includes benchmark
=> No net active only stocks and exposure
management risk bonds

77
LM 4: Basics of Portfolio Planning & Construction
ESG Considerations in Portfolio Planning and Construction

78
LM 4: Basics of Portfolio Planning & Construction
ESG Considerations in Portfolio Planning and Construction

Negative screening Excluding specific companies or industries based on ESG factors

Positive screening Investing in companies that have positive ESG practices

Thematic investing Selecting sectors or companies to promote specific ESG-related goals

Selecting investments both to provide a return and to promote positive

Impact investing
ESG practices

Using share ownership as a platform to promote improved ESG

Engagement/active
practices at a company, using share voting rights and by influencing
ownership
management or board members

Considering ESG factors throughout the asset allocation and security

ESG integration
selection process

79
LEARNING MODULE 5
THE BEHAVIORAL BIASES OF
INDIVIDUALS

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LM 5: The Behavioral Biases of Individuals

Cognitive Errors Emotional Biases

▪ Arise from faulty reasoning or irrationality ▪ Stem from feelings, impulses,

→ not understanding statistical analysis, or intuition
information processing errors, illogical
reasoning, or memory errors

▪ Can be reduced by increased awareness, ▪ Difficult to overcome and may

better training, or more information have to be accommodated

➢ A bias may have elements of both cognition and emotion.

➢ When trying to overcome or mitigate biases that are both emotional and
cognitive, success is more likely by focusing on the cognitive issues.

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 LM 5: The Behavioral Biases of Individuals

Cognitive Errors

Belief Perseverance Processing Errors

▪ Cognitive dissonance: A situation when • Information is being processed and used
new information conflicts with previously illogically or irrationally.
held beliefs or cognitions. • Relate more closely to flaws in how
▪ Resolution: Ignore or modify conflicting information itself is processed.
information and consider only information
that confirms their existing beliefs or
thoughts.

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LM 5: The Behavioral Biases of Individuals

03
02 04
01 Representativeness 05
Confirmation Hindsight

Conservatism Illusion of control

Belief
Perseverance

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LM 5: The Behavioral Biases of Individuals
1. Conservatism bias

Occur when ▪ People maintain their prior views or forecasts by inadequately

incorporating new, conflicting information.
▪ Overweight their prior probabilities and do not adjust them
appropriately as new information becomes available.

Consequences ▪ Individuals may react slowly to new data or ignore information that
is complex to process.
▪ Holding investments too long because they are unwilling or slow to
update a view or forecast.

Solutions ▪ Properly analyzing and weighting new information.

▪ If information is difficult to interpret or understand → Should seek
guidance from someone who can either explain how to interpret the
information or can explain its implications.

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LM 5: The Behavioral Biases of Individuals
1. Conservatism bias

Example:
John Molinari allocates assets based on his observation that over the last 80 years, recessions
occurred in 20% of those years. When a coworker informs Molinari that the country’s central
bank has announced a policy change to a tightening of monetary conditions, Molinari does not
adjust his recommended asset allocations. Does this reflect conservatism bias?

Answer:
Molinari should consider that the conditional probability of a recession, given that the central
bank is tightening, may differ from the unconditional probability of a recession that he
previously estimated. He is showing conservatism bias by not considering the impact of this
new information.

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LM 5: The Behavioral Biases of Individuals
2. Confirmation bias

Occur when ▪ Market participants focus on or seek information that supports prior
beliefs, while avoiding or diminishing the importance of conflicting
information or viewpoints.
▪ Distort new information in a way that remains consistent with their
prior beliefs.
Consequences ▪ Consider positive information but ignore negative information.
▪ Set up a decision process or data screen incorrectly to support a
preferred belief.
▪ Become overconfident about the correctness of a presently held
belief.
Solutions ▪ Seeking out information that challenges existing beliefs.

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LM 5: The Behavioral Biases of Individuals
2. Confirmation bias

Example:
A private wealth adviser have dealt with a client who conducts some research and insists on
adding a particular investment to the portfolio. The client may insist on continuing to hold the
investment, even when the adviser recommends otherwise, because the client’s follow-up
research seeks only information that confirms his belief that the investment is still a good
value.

Answer:
The client is subject to confirmation bias because he seeks only information that supports his
prior beliefs, while not considering other information or viewpoints from the portfolio
manager.

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LM 5: The Behavioral Biases of Individuals
3. Representativeness bias

Occur when People classify new information based on past experiences and
classifications. New information may resemble or seem representative
of familiar elements already classified, but in reality, it can be very
different.
▪ Base-rate neglect: Analyzing an individual member of a
population without adequately considering the probability of a
characteristic in that population (the base rate).
▪ Sample-size neglect: Making a classification based on a small and
potentially unrealistic data sample.
Consequences ▪ Attach too much importance to a few characteristics based on a
small sample size.
▪ Make decisions based on simple rules and classifications rather
than conducting a more-thorough and complex analysis.

Solutions ▪ Do more research to obtain base-rate information and/or widen the

sample size of observations.

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LM 5: The Behavioral Biases of Individuals
3. Representativeness bias

Example:
XYZ company has long been recognized as a growth stock, delivering superior earnings
growth and stock price appreciation. While earnings have continued to grow, last year’s
revenue has not, and neither has the stock price. Under the following two conditions, would an
analyst be more likely to buy or sell the stock?
1. The analyst suffers from base-rate and sample-size neglect.
2. The analyst treats the growth classification as representative.

Answer:
1. If the analyst exhibits sample-size neglect and base-rate neglect biases, the analyst will
ignore XYZ’s long record as a growth stock, focus on the short-term disappointing results,
and may recommend selling the stock without considering the long-term possibility it will
revert to growth behavior.
2. However, if the analyst over-relies on the initial growth classification, the analyst may
assume that the stock will return to growth and recommend buying it, without properly
considering the reasons for its recent results or their longer-term implications.

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LM 5: The Behavioral Biases of Individuals
4. Illusion of control bias

Occur when ▪ People tend to believe that they can control or influence outcomes
when, in fact, they cannot.
Consequences ▪ Inadequately diversify portfolios → Some investors prefer to invest
in companies they feel they have control over, such as the
companies they work for, leading them to hold concentrated
positions.
▪ Trade more than is prudent.
▪ Construct financial models and forecasts that are overly detailed,
believing that forecasts from these models can control uncertainty.
Solutions ▪ Investors need to recognize is that investing is a probabilistic
activity.
▪ Seek contrary viewpoints.

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LM 5: The Behavioral Biases of Individuals
4. Illusion of control bias

Example:
Adelia Scott is a wealth adviser for high-net-worth individuals. Scott meets with a client who has
30% of his account in shares of his employer’s stock. The client is not subject to any employee
holding requirement.
Prior meeting notes indicate that the client initially agreed to diversify the concentrated position
over a five-year period. Scott recommends a faster schedule, however, based on recent research
indicating that the company’s future growth prospects have considerably worsened as a result of
industry trends and macroeconomic conditions.
When presented with this information, the client is reluctant to change his diversification plan,
citing the company’s history of double-digit growth and his belief that this rate of growth will
continue for the foreseeable future. The client remarks, “Trust me, my team and I are not going to
let those forecasts you’re citing come true.”

Answer:
The client is subject to illusion of control bias. He is unwilling to believe Scott’s opinion because
he believes that he and his team can control the company’s performance and stock price.

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LM 5: The Behavioral Biases of Individuals
5. Hindsight bias

Occur when ▪ Individual’s tendency to see things as more predictable than they
really are.
▪ After an event, people often believe that they knew the outcome of
the event before it actually happened → I-knew-it-all-along
phenomenon
Consequences ▪ Overconfidence in ability to predict outcomes.
▪ Unfairly assess money manager or security performance.
Solutions ▪ Carefully record their investment decisions and key reasons for
making those decisions in writing at or around the time the decision
is made.

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LM 5: The Behavioral Biases of Individuals
5. Hindsight bias

Example:
Beverly Bolo, an analyst at an investment advisory firm, is giving a presentation to clients that,
among other topics, explains the firm’s investment results during past macroeconomic
downturns. In the presentation, Bolo points out that the “occurrence of the last recession was
obvious upon inspection of the yield curve and other leading indicators eight months before the
downturn started.”

Answer:
Bolo’s comment exhibits hindsight bias. Recessions, like any other event, appear obvious in
hindsight but are hardly ever accurately predicted. Bolo could augment her remarks by
exploring how often these leading indicators suggested that a recession is imminent against
how often a recession subsequently occurred.

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LM 5: The Behavioral Biases of Individuals

Framing Availability

Processing Errors

Anchoring & Mental accounting

Adjustment

94
LM 5: The Behavioral Biases of Individuals
1. Anchoring and Adjustment bias

Occur when ▪ Basing expectations on a prior number (an “anchor”) and

overweighting its importance, making adjustments in relation to
that number as new information arrives.
→ Closely related to conservatism bias
Consequences ▪ Stick too closely to their original estimates when learning new
information
→ Underestimating the implications of new information
Solutions ▪ New data should be considered objectively without regard to any
initial anchor point.

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LM 5: The Behavioral Biases of Individuals
1. Anchoring and Adjustment bias

Example:
Aiden Smythe is an equity research analyst at a brokerage firm. Smythe covers Industrial Lift
Plc, a company that manufactures construction machinery. The company’s business is sensitive
to macroeconomic conditions, particularly non-residential construction activity. Last year,
Industrial Lift reported £1.00 in EPS amid mostly strong non-residential construction activity
levels. Smythe is updating his EPS estimate for this year. Non-residential construction activity
has severely declined in the last two months, and some economists fear that a recession is
likely. As a result, Smythe forecasts that EPS will fall 10% from the prior-year level,
publishing a £0.90 estimate for the year.”

Answer:
Smythe’s estimate exhibits anchoring and adjustment. Smythe’s anchor is the prior year’s EPS
of £1.00, despite the possibility of a material change in underlying conditions.

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LM 5: The Behavioral Biases of Individuals
2. Mental Accounting Bias

Occur when ▪ Viewing money in different accounts or from different sources

when making investment decisions.
▪ Conflicts with the idea that security decisions should be made in the
context of the investor’s overall portfolio of assets based on their
financial goals and risk tolerance.
Consequences ▪ Not consider correlations between investments, leading to
unintentional risk taking.
▪ Irrationally distinguish between returns derived from income and
those derived from capital appreciation.
Solutions ▪ Create a portfolio strategy taking all assets into consideration.

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LM 5: The Behavioral Biases of Individuals
2. Mental Accounting Bias

Example:
An investor who receives an unexpected bonus at work and chooses to invest it in a very risky
biotechnology stock, reasoning that the bonus is “found money” that can acceptably be risked
on speculation.

Answer:
The investor exhibits mental accounting bias. In fact, while such a stock may have a place in
the investor’s portfolio, decisions about whether and how much of it to include should be
based on a total portfolio approach.

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LM 5: The Behavioral Biases of Individuals
3. Framing Bias

Occur when ▪ A person answers a question differently based on the way in which
it is asked or framed.
▪ Narrow framing occurs when people evaluate information based
on a narrow frame of reference → losing sight of the big picture in
favor of one or two specific points.
Consequences ▪ Becoming more risk-averse when presented with a gain frame of
reference and more risk-seeking when presented with a loss frame
of reference.
▪ Focus on short-term price fluctuations, which may result in long-
run considerations being ignored in the decision-making process.
Solutions ▪ Creating questions to assess an investor’s risk tolerance.
▪ Focus on the future prospects of an investment and try to be as
neutral and open-minded as possible when interpreting investment-
related situations.

99
LM 5: The Behavioral Biases of Individuals
3. Framing Bias

Example: (Framing as a gain)

The United States is preparing for the outbreak of an unusual disease, which is expected to kill
600 people. Two alternative programs have been proposed. If Program A is adopted, 200
people will be saved. If Program B is adopted, there is a one-third probability that 600 people
will be saved and a two-thirds probability that no one will be saved. Which program will
people choose?

Answer:
Program A is typically selected. Although the expected value of both Program A and Program
B is 200 lives saved, the majority choice is risk averse. The prospect of saving 200 lives with
certainty is more attractive than the risky option with the same expected value.

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LM 5: The Behavioral Biases of Individuals
3. Framing Bias

Example: (Framing as a loss)

A different group of individuals is given the same issue, but the two programs are framed
differently. If Program A is adopted, 400 people will die. If Program B is adopted, there is a
one-third probability that nobody will die and a two-thirds probability that 600 will die. Which
program will people choose?

Answer:
In this situation, Program B is typically selected. The majority choice is now risk-taking, with
the certain death of 400 people being less acceptable than a two-thirds chance that 600 people
will die.

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LM 5: The Behavioral Biases of Individuals
4. Availability bias

Occur when Putting undue emphasis on information that is readily available, easy
to recall, or based narrowly on personal experience or knowledge.
▪ Attaching too much significance to events that have occurred
recently (easier to recall) and too little to events that occurred
further in the past.
▪ Assume that if something is easily remembered, it must occur with
a higher probability.
Consequences ▪ Limit their investment opportunity set → inappropriate asset
allocations and lack of diversification.
▪ Choose an investment, investment adviser, or mutual fund based on
advertising or the quantity of news coverage.
Solutions ▪ Develop an appropriate investment policy strategy, carefully
research and analyze investment decisions before making them.
▪ Focus on long-term historical data.

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LM 5: The Behavioral Biases of Individuals
4. Availability bias
Example:
A portfolio manager asks an analyst to research and present a list of companies that have
“strong growth potential.” The manager suggests looking for companies that sell a product or
service different from its competitors—but with a compelling value proposition for
customers—and that have a small share of a large market.
The analyst is familiar with technology companies, software in particular, based on prior work
experience. The analyst has also seen a lot of news articles covering various software
companies that, he believes, fit the criteria. The analyst begins screening among technology
companies that have high revenue growth rates for the last two quarters. Although the analyst
is aware that other companies in other sectors probably fit the criteria as well, the criteria are
qualitative and vague such that they cannot be easily translated as screening input.

Answer:
The analyst’s behavior exhibits availability bias from by considering only technology
companies in the search because he is familiar with them. The analyst should consult
colleagues and/or external resources to widen his search to include all sectors and for help with
creatively specifying screening criteria.
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LM 5: The Behavioral Biases of Individuals

Emotional Biases

Overconfidence Status quo Regret-aversion

02 04 06

01 03 05

Loss-aversion Self-control Endowment

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LM 5: The Behavioral Biases of Individuals
1. Loss-aversion bias

Occur when ▪ Feeling more pain from a loss than pleasure from an equal gain.

▪ Investors tend to accept more risk to avoid losses than to achieve

gains.
Consequences ▪ Disposition effect: Holding losers too long and selling winners too
soon → hoping the losers to return to breakeven and the winners
not to evaporate gains.
Solutions ▪ Carefully analyzing investments and realistically considering the
probabilities of future losses and gains.
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LM 5: The Behavioral Biases of Individuals
1. Loss-aversion bias

Example: (Scenario 1)
An individual is given $10. The individual is then given the following options:
▪ Take an additional $5 with certainty.
▪ Flip a coin and win an additional $10 if it lands heads up or nothing if it lands tails up.

Answer:
Both options represent a gain relative to the original $10, and the expected value of the gain is
$5 for either option. Option 1 creates a guaranteed outcome of $15. Option 2 introduces
uncertainty, with equal probabilities of an outcome of $10 or $20. Most individuals chose the
riskless Option 1 over the riskier Option 2.

106
LM 5: The Behavioral Biases of Individuals
1. Loss-aversion bias

Example: (Scenario 2)
An individual is given $20. The individual is then given the following options:
▪ Take a $5 loss with certainty.
▪ Flip a coin and lose nothing if it lands heads up, but lose $10 if it lands tails up.

Answer:
Both options represent a potential loss relative to the original $20, and the expected loss is $5
for either option. Most individuals chose risky Option 2 over the riskless certain loss of
Option 1.

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LM 5: The Behavioral Biases of Individuals
2. Overconfidence bias

Occur when Market participants overestimate their own intuitive ability or

reasoning → Illusion of knowledge: when they think they do a better
job of predicting than they actually do.
▪ Self-attribution bias: Individuals may give themselves personal
credit when things go right (self-enhancing) but blame others or
circumstances when things go wrong (self-protecting).
▪ Prediction overconfidence: Individuals underestimate uncertainty
and the standard deviation of their predictions.
▪ Certainty overconfidence: Individuals overstate the probability
they will be right.
Consequences ▪ Underestimate risks and overestimate expected returns.
▪ Hold poorly diversified portfolios → significant downside risk.
Solutions ▪ Review their trading records, identify both the winners and losers,
and calculate portfolio performance over at least two years.
▪ Be objective when making and evaluating investment decisions.

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LM 5: The Behavioral Biases of Individuals
2. Overconfidence bias

Example:
An analyst estimates that the price of oil will increase by 40% over the next 12 months because
prevailing prices are lower than many oil producers’ cost of production. Unprofitable
producers reducing production will eventually put upward pressure on prices so long as oil
demand remains stable or increases. Based on this forecast, the analyst recommends several
high-yield bonds of oil producers to a portfolio manager.
The portfolio manager asks the analyst for an estimate of downside risk: “How much could we
lose if, say, the oil price falls another 10%?” The analyst replies, “That is unrealistic. The
current oil price is as low as it can go, and yields on these bonds are as attractive as they will
ever be. We must make the investment now. There is no credible downside case.”

Answer:
The analyst is exhibiting overconfidence bias by placing excessive certainty in his prediction
and not considering the likelihood or impact of variance from that prediction.

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LM 5: The Behavioral Biases of Individuals
3. Self-control bias

Occur when ▪ Individuals lack self-discipline and favor short-term satisfaction

over long-term goals.
▪ Individuals favor small payoffs now at the expense of larger
payoffs in the future → hyperbolic discounting.
Consequences ▪ Insufficient savings for the future → accepting too much risk in
portfolios in an attempt to generate higher returns.
▪ Borrow excessively to finance present consumption.
Solutions ▪ Establishing an appropriate investment plan (asset allocation) and a
personal budget to achieve sufficient savings.
▪ Both should be reviewed on a regular basis.

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LM 5: The Behavioral Biases of Individuals
3. Self-control bias

Example:
Some investors may prefer income-producing assets in order to have the income to spend and
meet short-term needs.

Answer:
This behavior can be hazardous to long-term wealth because income-producing assets may
offer less total return potential, particularly when the income is not invested, which may inhibit
a portfolio’s ability to maintain spending power after inflation.

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LM 5: The Behavioral Biases of Individuals
4. Status quo bias

Occur when ▪ People choose to do nothing (i.e., maintain the “status quo”) instead
of making a change, even when change is warranted (because of
inertia)
Consequences ▪ Holding portfolios with inappropriate risk
▪ Not considering other, better investment alternatives.

Solutions ▪ Quantify the risk-reducing and return-enhancing advantages of

diversification and proper asset allocation.

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LM 5: The Behavioral Biases of Individuals
4. Status quo bias

Example:
Field data from university health plan enrollments, for example, show a large disparity in
health plan choices between new and existing enrollees. One particular plan with significantly
more favorable premiums and deductibles had a growing market share among new employees,
but a significantly lower share among older enrollees.

Answer:
This suggests status quo bias that a lack of switching could not be explained by unchanging
preferences.

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5. Endowment bias

Occur when ▪ People value an asset more when they own or inherit it than when
they do not.
▪ People tend to state minimum selling prices for a good that exceed
maximum purchase prices that they are willing to pay for the same
good.
Consequences ▪ Failing to sell assets that are no longer appropriate for their
investment needs.
▪ Hold assets with which they are familiar because they provide some
intangible sense of comfort.
Solutions ▪ With inherited assets → asking a question such as “Would you
make this same investment with new money today?”
▪ With purchased securities, when an estimated “sell price” is far
higher than reasonable estimated “buy price” → asking a question
such as “Would you buy this security today at the current price?”

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LM 5: The Behavioral Biases of Individuals
5. Endowment bias

Example:
Several of an investment analyst’s recommended stocks have done well for the past five years,
prompting the portfolio manager to ask for a brief update on each, including valuations. For
each stock, the analyst estimates that fair value is at least another 40% above the current price.
The portfolio manager challenges the analyst by pointing out that the fair value estimates
imply valuation multiples that are at least two standard deviations above the five-year average
and are well above even the most bullish sell-side analyst’s target price. The analyst responds
by saying that the market is overlooking these companies’ fundamentals. The portfolio
manager then asks, “Would you buy these shares today?” The analyst answers, “Probably not.”

Answer:
The analyst is likely exhibiting endowment bias by overestimating the value of shares already
owned in the portfolio. This bias is likely the result of having successfully invested in the
shares.

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LM 5: The Behavioral Biases of Individuals
6. Regret-aversion bias

Occur when ▪ People tend to avoid making decisions out of fear that the decision
will turn out poorly.
▪ Regret is more intense when the unfavorable outcomes are the
result of an action taken versus the result of an action not taken.
Consequences ▪ Too conservative in their investment choices as a result of poor
outcomes on risky investments in the past.
▪ Herding behavior: Participants go with the consensus or popular
opinion → choose popular investments in order to limit potential
future regret.
Solutions ▪ Quantify the risk-reducing and return-enhancing advantages of
diversification and proper asset allocation.
▪ To prevent investments from being too conservative → consider the
long-term benefits of including risky assets in portfolios.

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LM 5: The Behavioral Biases of Individuals
6. Regret-aversion bias

Example:
An investor buys stock in a small growth company based only on a friend's recommendation.
After six months, the stock falls to 50% of the purchase price, so the investor sells the stock
and realizes a loss. Afterwards, the investor decides to never take seriously any investment
recommendation made by this friend, regardless of the investment fundamentals.

Answer:
The investor exhibits regret aversion bias. To avoid this regret in the future, the investor could
ask questions and research any stocks that the friend recommends.

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Behavioral Finance And Market Behavior

Bubbles And Crashes

Defining Market Anomalies

Halo effect and Home bias

Defining Market Anomalies
LM 5: The Behavioral Biases of Individuals
Defining Market Anomalies

▪ Market anomalies: Results that do not fit the prevailing model of securities
risks and returns.
▪ Many market anomalies have been explained by small sample size, time period
bias, or inadequacies in the specification of prevailing models of returns.

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LM 5: The Behavioral Biases of Individuals
Defining Market Inefficiencies

▪ Market Inefficiencies: Anomalies that present opportunities to earn positive

risk-adjusted returns.
▪ Some anomalies once considered evidence of market inefficiency have been
explained by the possible misspecification of risk → inaccurate risk adjustment
of returns.

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LM 5: The Behavioral Biases of Individuals
Bubbles and Crashes

Behavioral finance provide some explanation for bubbles and crashes:

▪ Overconfidence → overtrading, underestimation of risk, and lack of
diversification.
▪ Persistently good results combined with self-attribution bias → fuel
overconfidence, as can hindsight bias (as investors give themselves credit for
choosing profitable stocks in a bull market).
▪ Confirmation bias → lead investors to ignore or misinterpret new information
suggesting that valuations will not continue to rise, or to misinterpret initial
decreases in asset values as simply another buying opportunity.
▪ Anchoring → cause investors to believe recent highs are rational prices even
after prices begin their eventual decline.
▪ Fear of regret → keep even very skeptical investors in the market.

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LM 5: The Behavioral Biases of Individuals
Halo effect and Home bias

▪ Value effect (i.e., value stocks have outperformed growth stocks over long
periods) can be explained by Halo effect: A company’s good characteristics, such
as fast growth and a rising stock price → considered as a good stock to own →
overvaluation of growth stocks.
▪ Home bias: Portfolios exhibit a strong bias in favor of domestic securities in the
context of global portfolios.

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LM 1: Portfolio Management: An Overview
Example 17:

1. The advice “Don’t confuse brains with a bull market” is aimed at mitigating which of the following behavioral biases?
A. Self-control
B. Conservatism
C. Overconfidence
2. Status quo bias is least similar to which of the following behavioral biases?
A. Endowment
B. Regret aversion
C. Loss aversion
3. Jun Park, CFA, works at a hedge fund. Most of Park’s colleagues are also CFA charterholders. At an event with recent
university graduates, Park comments, “Most CFA charterholders work at hedge funds.” Park’s remark exhibits which
behavioral bias?
A. Availability
B. Conservatism
C. Framing?
4. Which of the following individual behavioral biases is most strongly associated with market bubbles?
A. Overconfidence
B. Representativeness
C. Framing

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3
LEARNING MODULE 6
INTRODUCTION TO RISK
MANAGEMENT

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LM 6: Introduction to Risk Management
Risk Management Framework

Risk Risk exposure Risk management process

▪ Risk is exposure Risk exposure is the 1) Identify the risk tolerance of the organization
to uncertainty extent to which an 2) Identify and measure the risks that the
▪ Risk is about to entity is exposed/ organization faces
chance of a loss vulnerable to 3) Modify and monitor these risks
or adverse underlying risks
outcome as a
result of an
action, inaction
or external events

▪ RM is not about minimizing risks → actively understanding and embracing

those risks that best balance the achievement of goals
Key notes ▪ RM is not about avoiding risks or predicting risks → the impact of an
unpredictable event on the organization/portfolio would not be a surprise &
would have been quantified and considered in advance

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LM 6: Introduction to Risk Management
Risk Management Framework

EXAMPLE:
An U.S. investor has a long position on the GBP worth £1,000,000. It is expected that an
upcoming economic data release will result in the GBP either appreciating or depreciating by
exactly 1% versus the USD.
▪ The risk here is the uncertain result of the announcement, as the USD-denominated value
of this investor’s GBP position can rise or fall by 1%.
▪ The risk exposure, in this case, is 1% of £1,000,000 or £10,000.
▪ Risk management would include quantifying and understanding this risk exposure,
deciding whether the investor should bear the risk, how much of the risk exposure she
should bear, and then possibly mitigating or modifying this risk.

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LM 6: Introduction to Risk Management
Risk Management Framework

RISK MANAGEMENT FRAMEWORK

Risk governance Defined policies and

Communications
processes

Risk identification
and measurement
Risk monitoring,
Strategic analysis or
mitigation, and
Risk infrastructure integration
management

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LM 6: Introduction to Risk Management
Risk Management Framework

▪ Top-down process and guidance to direct risk

RISK MANAGEMENT FRAMEWORK

management activities
▪ Normally performed at the board level
Governance
▪ Understand firm’s objectives, define risk tolerance to
meet objectives (e.g., invest in high risk stock with
KEY FACTORS OF

high return when focusing on profit)

Risk identification Identify the risks faced by the organization and how to
& measurement measure those risk

People, processes & systems required to track risk

Risk infrastructure
exposures and perform quantitative risk analysis

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LM 6: Introduction to Risk Management
Risk Management Framework

▪ Both day-to-day operation and decision-making processes

▪ Includes measures:
KEY FACTORS OF RISK MANAGEMENT

Defined policies • Limits

and process • Constraints
• Requirements
• Guidelines
SYSTEM/ FRAMEWORK

▪ Pulling together risk governance, identification and

Risk monitoring, measurement, infrastructure, and policies and processes and
mitigation and review
management ▪ Recognizing when risk exposure is not aligned with risk
tolerance → take action to bring them back into alignment

▪ Critical risk issues must be communicated continually and

Communication across all levels of the organization
▪ Risk metrics must be reported in a clear and timely manner

▪ Help turns risk management into a tool to improve

Strategic analysis performance
and integration ▪ Help to better sort out which activities are adding value and
which are not, and improve investment decision
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LM 6: Introduction to Risk Management
Risk Management Framework

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LM 6: Introduction to Risk Management
Risk Governance

RISK GOVERNANCE

Senior management’s Seeks to manage risk in a Provides

determination of: way so that the organization organization-wide
1. Risk tolerance of the can achieve the best guidance on the risks
organization business outcome consistent that should be pursued
2. Elements of its optimal risk with the organization’s in an efficient manner
exposure strategy overall risk tolerance
3. Framework for oversight of
the risk management function

Risk Provide a way for various parts of the organization to bring up issues of
Management risk measurement, integration of risks, and the best ways to mitigate
Committee undesirable risks

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LM 6: Introduction to Risk Management
Risk Tolerance

▪ Determining an organization’s risk tolerance involves setting the overall risk

exposure the organization will take by identifying the risks the firm can
effectively take and the risks that the organization should reduce or avoid.
▪ Factors that determine an organization’s risk tolerance:
• Expertise in its lines of business
• Skill at responding to negative outside events
• Regulatory environment
• Financial strength and ability to withstand losses.

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LM 6: Introduction to Risk Management
Risk Budgeting

The process of allocating firm resources to assets (or investments) by

Risk
considering their various risk characteristics and how they combine to meet
budgeting
the organization’s risk tolerance

Allocate the overall amount of acceptable risk to the mix of assets or

Goal
investments that have the greatest expected returns

A risk budget can be complex and multi-dimensional, or it can be a simple,

one-dimensional risk measure:
▪ Single metric: Portfolio beta, value at risk, portfolio duration, or returns
variance;
Constructing
▪ Based on categories of investments: Domestic equities, domestic debt
risk budget
securities, international equities, and international debt securities;
▪ Identifying and calculating specific risk factors that comprise the
overall risk of the portfolio or organization: Interest rate risk, equity
market risk, exchange rate risk

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LM 6: Introduction to Risk Management
Risks For Organizations

FINANCIAL RISKS – Risks that originate from financial market

Uncertainty about whether the counterparty to a transaction will

Credit risk
fulfill its contractual obligations

Risk of a significant downward valuation adjustment when selling a

Liquidity risk
financial asset

Arises from movements in interest rates, stock prices, exchange

Market risk
rates, and commodity prices

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LM 6: Introduction to Risk Management
Risks For Organizations

NON FINANCIAL - Risks that arise from the operations of the organization and
from sources external to the organization

Operational Human error, faulty organizational processes, inadequate security, or

risk business interruptions will result in losses (e.g., cyber risk)

Risk that the organization will be unable to continue to operate

Solvency risk
because it has run out of cash

Risk that the regulatory environment will change, imposing costs on

Regulatory risk
the firm or restricting its activities

Risk that political actions outside a specific regulatory framework,

Governmental/
such as increases in tax rates, will impose significant costs on an
political risk
organization

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LM 6: Introduction to Risk Management
Risks For Organizations

NON FINANCIAL - Risks that arise from the operations of the organization and
from sources external to the organization

Legal risk Uncertainty about the organization’s exposure to future legal action

Risk that asset valuations based on the organization’s analytical models

Model risk
are incorrect

Risk that extreme events (those in the tails of the distribution of

outcomes) are more likely than the organization’s analysis indicates,
Tail risk
especially from incorrectly concluding that the distribution of outcomes
is normal
Accounting Risk that the organization’s accounting policies and estimates are
risk judged to be incorrect

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LM 6: Introduction to Risk Management
Risks For Individuals

Mortality risk Longevity risk

▪ The risk of living longer

▪ Risk of death prior to
than anticipated so that
providing for their families’
assets run out
future needs
▪ Can be reduced by
▪ Most often addressed with
purchasing a lifetime
life insurance
annuity

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LM 6: Introduction to Risk Management
Interactions between Risks

Market risk

Credit risk or
Liquidity risk
counterparty risk

Legal risk Solvency risk

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LM 6: Introduction to Risk Management
Example 18:

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LM 6: Introduction to Risk Management
Example 18:

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LM 6: Introduction to Risk Management
Measuring and Modifying risks

METRICS

Standard deviation Beta Duration

Volatility of asset
Measurement of the
prices or interest Sensitivity of stock’s
interest rate
rates return to market
sensitivity of the
(assume normal portfolio’s return
fixed-income
probability (Market risk)
instruments
distributions)

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 LM 6: Introduction to Risk Management
Measuring and Modifying risks

METRICS

Derivatives risks Scenario Tail risk

Stress test
(the Greeks) analysis (downside risk)

Vega
Delta
Sensitivity of
Sensitivity of
derivatives Examine the
derivatives Conditional
values to the effects of a Value at risk
values to price VAR (CVaR)
volatility of the What-if specific (VaR)
of underlying Expected
price of the analysis of (usually Minimum loss
asset value of a loss,
underlying asset expected loss extreme) over a period
given that the
but incorporates change in a that will occur
loss exceeds a
Rho changes in key variable with a specific
Gamma minimum
The sensitivity multiple inputs such as an probability
Sensitivity of amount
of derivatives interest rate or
delta to changes exchange rate.
values to
in the price of
changes in the
underlying asset
risk-free rate

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LM 6: Introduction to Risk Management
Measuring and Modifying risks

▪ It is difficult to avoid risk completely

Risk ▪ Decision to avoid risk is made at the governance level (setting
prevention risk tolerance)
and avoidance ▪ Decision of how much risk to accept, given the trade–off
between benefits and costs, neither of which is easy to measure

❑ Self-insured
▪ Simply is to bear the risk
▪ Can be used when it is too costly to eliminate by external means
Risk
▪ Might involve establishment of a reserve to cover loss
acceptance
❑ Diversification
▪ Might not be effective if used in isolation
▪ Key way to eliminating nonsystematic risk

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LM 6: Introduction to Risk Management
Measuring and Modifying risks

Insurance policy: Insurers take the risk because they can pool uncorrelated
risks (diversification). Insurers charge a premium
▪ Avoid to write too much coverage for a loss caused by systematic events
▪ An insurance company with highly correlated risks (or a single very
Risk large risk) may itself shift some of the resulting risk by buying
transfer reinsurance from another company
Surety bonds: An insurers promises to pay an insured a certain amount of
money if a third party fails to fulfill its obligations
Fidelity bonds: Pay for losses that result from employee theft or
misconduct

▪ Change the distribution of risk outcome

Risk
▪ Use derivatives (swaps, futures contracts,…) to divert some portion of
shifting
the risk distribution

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LM 6: Introduction to Risk Management
Example 19:

145