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What is Risk?
Markowitzs key insight: risk can be proxied by volatility. But in general, risk is not simply the volatility of cash return
Example: comparing 1 month bills to 10 year zeros What is risky depends on your economic circumstances, in particular on your liabilities Two steps for dealing with this issue: (1) find the minimum variance portfolio, which depends on your liabilities; then (2) calculate portfolio risk as the volatility around this minimum variance portfolio
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Dont forget that alpha production is a zero sum game in the best case
Beware of beta being repackaged and offered by your manager as pseudo alpha.. If so, you need to adjust his results to find what his real alpha is, and how much alpha risk and beta risk you actually bear
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Co-variances among active and passive risks may matter Partitioning risk by source is non-trivial
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The sum of the three components is the total risk; the three components tell you which sources the risk is coming from
Notice that if H is risk-free, then the risk in the portfolio is all attributed to the active portfolio, as we would expect
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Conclusions
Are you measuring risk appropriately? Your liabilities matter and they define your risk free asset Start with this risk free asset, or at least the minimum variance portfolio, as the core of your portfolio To earn extra return, you may wish to add a beta portfolio to reap the harvest of risk premiums the market offers. But in theory, this will not help your stock price. [MM] (So, why are we doing this ?)
If you think you can identify managers who can beat the market, then you can earn extra return by constructing a risky alpha portfolio. But in theory, this may not help your stock price. [MM again]
Pension plans would do best to focus on defeasing liabilities
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