Here are 10 of the most common pitfalls made by candidates in study session 12 of the CFA level 1 on portfolio management.
1. MIXING UP THE LINES
All three charts show the relationship between risk and return. CAL and CML uses standard deviation,
which measures total risk while the SML uses Beta which measures only systematic risk.
The SML aims at valuating a security relative to the market portfolio. The CML aims at allocating capital between the market and the risk free. The CAL aims at allocating capital between the optimal risky portfolio and the risk free.
Most of the confusion is between the CAL and CML. Since the CAL is based on the optimal risky portfolio which is the best possible portfolio given the securities available, it would make sense that everyone would want to invest in that exact portfolio. After all, if we know the composition of the “perfect” portfolio, what would be the point in investing in a different combination of securities? As all investors in the market buy the optimal risky portfolio, this portfolio will eventually become the market portfolio. Therefore, the CAL would become the CML. This also mean that the CML is a specific occurrence of the CAL where the optimal risky portfolio is also the market portfolio.
2. MISINTERPRETING CORRELATION
Correlation gives you information on the relative direction of two securities. For instance, if two securities
have a correlation coefficient of -1 and one security goes up by 6%, it does NOT mean the other
security will go down by 6%, it just means the other security will go down. In other words, the coefficient
does not tell you how much it will move, just if will go up or down.
3. FAILING TO UNDERSTAND ETFS
ETFs trade like stocks on exchanges such as NYSE. They can be sold short or purchased on margin
unlike mutual fund units. They are therefore more liquid. Since they only replicate the index, management
fees are very low but you must pay a commission when you buy and sell. The reason why theyclosely replicate the index is that arbitrageurs are allowed to exchange the ETF for the shares of the
4. CONFUSING HIGH RISK TOLERANCE WITH RISK-SEEKING (RISK LOVER)
Every investor is risk averse. The concepts of risk-seeking and risk neutral are more theoretical and
never really apply. A risk lover would go for as much risk as possible even if the potential for return is
meagre. High risk tolerance means a person that has a lower level of risk aversion (while still being
risk averse) which means he will take on more risk in order to earn a higher return.
5. MISSCLASSIFYING AN EVENT AS SYSTEMATIC OR UNSYSTEMATIC
For example, if the government passes legislation on car emission, it will definitely affect automotive
manufacturers but not necessarily the whole economy. Sector specific risk, from the context of a
broad portfolio, can easily be diversified away by investing in other sectors. Therefore, it would be
classified as unsystematic risk. You should not worry too much about the grey area for this topic
since in exam questions, it is usually very clear which type of risk it is.
6. MUDDYING THE VARIOUS SYNONYMS FOR SYSTEMATIC VS. UNSYSTEMATIC RISK
|Market risk||Firm specific risk|
|Non-diversifiable risk||Idiosyncratic risk|
7. MIXING UP EXPECTED RETURN AND RISK PREMIUM IN RETURN MODELS
The expected return is the full/total return you expect to realize from an investment. The risk premium
is the return in excess of the risk free rate. In other words, it is your compensation for incurring risk
relative to investing in risk free assets such as T-Bills.
The CAPM formula can be written in terms of its market risk premium (MRP):
E(Ri) = Rf + βi(MRP)
8. BEFUDDLING ABNORMAL RETURN AND EXCESS RETURN
Excess return is the return of a stock, portfolio or market in excess of the risk free rate. Excess return
is also called the risk premium (see above). Abnormal return is the difference between the actual return
of a security and what it was required from it given its risk (measured by Beta).
9. NOT KNOWING WHY A SECURITY PLOTTING ABOVE THE SECURITY MARKET LINE IS ACTUALLY UNDERPRICED
Candidates often have the intuition that when a security plots over the security market line, it is overvalued
and vice versa. Well, that wrong! Candidates should think of an overvalued asset as one that
is too expensive and an undervalued one as too cheap. If an item is too expensive for the value it provides
its owner, it will not be purchased and if possible it will be shorted. When you find an item that
is too cheap relative to its benefits, it usually makes good business sense to purchase it.
The cheapness of an investment can be determined relative to its earnings, dividend yield or many
other performance measure. In the context of the capital asset pricing model, the cheapness is in relation
to its systematic risk, as measured by Beta. The SML will tell you what is a fair return for the
stock. If your stock plots above the line, it means it is expected to return more for its level of Beta. If
you recall the holding period return formula: Return= (Pt + Divt – P0)/P0
Which means that for a given Pt, and dividend, the only way to explain a higher return is that P0 is
too low, hence the stock is too cheap and should be purchased. This seems to be the case for Pfizer
in the graph above. The reverse is true when a security plots below the line, P0 is then too high and
the stock should be shorted.
• Above the SML => Higher return than required => Security is underpriced (too cheap)
• Below the SML => Lower return than required => Security is overpriced (too expensive)
10. HOW TO FIND A CLIENT’S OVERALL RISK TOLERANCE IF SHE HAS HIGH WILLINGNESS AND LOW ABILITY OR VICE-VERSA?
The ability to take risks has priority over the willingness to take risks. It would not make sense to have
a policy statement that allows high risk if the investor does not have a financial position to support
this level of risk. This is why investors with low ability to take risk will be considered to have a low risk
tolerance regardless of their willingness to take risks.
On the other hand if and investor has a high ability to take risk and a low willingness to take risk, the
risk tolerance will be considered medium in most cases.
Hopefully, this will help you avoid these common mistakes and clarify some of the fuzzier topics. These common pitfalls can be found on our CFA Level 1 eBook which is currently available!
Let us know if you have questions about this material or if you have uncover other pitfalls on this topic!