Are You Compensated For Your Risk?

Despite the fact that financial theory suggests stocks with high volatility should have higher expected returns—because investors cannot fully diversify away from the firm-specific risk in their portfolios—a growing body of empirical evidence demonstrates a negative return premium in higher-volatility stocks (the low-volatility/low-beta anomaly).

Research also documents that investor preferences for more volatile stocks are directly associated with preferences for stocks that look like lottery tickets (they have positive skewness and excess kurtosis, or fat tails). The negative premium associated with such stocks persists because of limits to arbitrage.

These findings on volatility and kurtosis are important because extreme positive and/or negative returns happen far more regularly > SEE MORE

An Alternative Approach to Alternatives: Investing With Even More Style

 

Traditionally, most portfolios have been dominated by public equities and bonds. The risks associated with the equity portion of those portfolios are typically dominated by exposure to market beta. And because equities are riskier than bonds, market beta’s share of the risk in a traditional 60/40 portfolio is actually much greater than 60%. In fact, it can be 85% or more.

The severe financial crisis of 2008 led many investors, including institutions, to search for alternatives. Among the usual suspects were private equity and hedge funds. Unfortunately, the evidence demonstrates that the correlation to equities of both these alternatives has been quite high.

For example, Niels Pedersen, Sebastien Page and Fei He—authors of the study “Asset Allocation: Risk Models for Alternative Investments,” which appeared in the May/June 2014 issue of the CFA Institute’s Financial Analysts Journal—found that the correlation of private equity and hedge funds to stocks was 0.71 and 0.79, respectively.

Most of the returns to those types of alternative investments are explained by the returns to stocks (in other words, the same market beta risk they are trying to diversify). This is the same conclusion that Cliff Asness, Robert Krail > SEE MORE

Financial Spring Cleaning: Life Insurance Audit

 

So much of the maintenance of our personal finances falls into the category of “boring, but important.” But when it comes to life insurance, our subconscious resistance to the topic is further compounded because, unlike retirement or career planning, your pot of gold at the end of the life insurance rainbow is actually a headstone.

We don’t like to talk about life insurance for numerous reasons, but especially because it requires acknowledgment of the fragility of our own lives, and of those we love. But considering the extremely high probability of our mortality, life insurance is one of the most important topics to include in your financial spring cleaning.

To ensure your life insurance planning is on track, ask and answer these five questions:

1. Where are your policies? Yes, it’s important to know where your original, physical policies are (and it’s a good idea to communicate that information to the Personal Representative in your will). But you also want to ensure that all of the policies you think you own are, indeed, active.

> SEE MORE

How Correlations Are Influenced

It’s been said diversification is the only free lunch in investing, with the largest benefits of diversification coming from adding assets with low, or—even better—negative correlations.

However, when designing portfolios, investors also need to be aware that correlations are not constant—they are averages of the relationships of returns. Thus, it’s important to understand not only that correlations can drift, but also under what circumstances the correlation of returns are likely to increase and decrease.

For example, while the correlation of high-yield bonds to stocks tends to be low, during bear markets caused by recessions, their correlation tends to rise toward 1 (at exactly > SEE MORE

It’s been said diversification is the only free lunch in investing, with the largest benefits of diversification coming from adding assets with low, or—even better—negative correlations.

However, when designing portfolios, investors also need to be aware that correlations are not constant—they are averages of the relationships of returns. Thus, it’s important to understand not only that correlations can drift, but also under what circumstances the correlation of returns are likely to increase and decrease.

For example, while the correlation of high-yield bonds to stocks tends to be low, during bear markets caused by recessions, their correlation tends to rise toward 1 (at exactly > SEE MORE