Advertisement

Markowitz and the Expanding Definition of Risk: Applications of Multi-factor Risk Models

  • John B. GuerardJr.

Abstract

In Chap. 1, we introduced the reader to Markowitz mean–variance analysis. Markowitz created a portfolio construction theory in which investors should be compensated with higher returns for bearing higher risk. TheMarkowitz framework measured risk as the portfolio standard deviation, its measure of dispersion, or total risk. The Sharpe (1964), Lintner (1965), and Mossin (1966) development of the Capital Asset Pricing Model (CAPM) held that investors are compensated for bearing not only total risk, but also rather market risk, or systematic risk, as measured by a stock’s beta. Investors are not compensated for bearing stock-specific risk, which can be diversified away in a portfolio context. A stock’s beta is the slope of the stock’s return regressed against the market’s return. Modern capital theory has evolved from one beta, representing market risk, to multi-factor risk models (MFMs) with 4 or more betas. Investment managers seeking the maximum return for a given level of risk create portfolios using many sets of models, based both on historical and expectation data. In this chapter, we briefly trace the evolution of the estimated models of risk and show how risk models enhance portfolio construction, management, and evaluation. Starting from the path-breaking risk estimations of Bill Sharpe (1963, 1964, 1966), and going on to the MFMs of Cohen and Pogue (1967), Barr Rosenberg (1974, 1982), Farrell (1974, 1998), Blin and Bender (1998), and Stone (1974, 2008), estimations of risk have complemented the risk and return analysis of Markowitz. Several of these MFMs are commercially available and well known by institutional investment advisors.

Keywords

Tracking Error Risk Index Excess Return Earning Forecast Sharpe Ratio 
These keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.

Preview

Unable to display preview. Download preview PDF.

Unable to display preview. Download preview PDF.

References

  1. APT. Inc. 2005. Analytics Guide.Google Scholar
  2. Black, F., M.C. Jensen, and M. Scholes. 1972. “The Capital Asset Pricing Model: Some Empirical Tests.” In M. Jensen (ed.), Studies in the Theory of Capital Markets. New York: Praeger.Google Scholar
  3. Blin, J., M.S. Bender, and J.B. Guerard Jr. 1997. “Earnings Forecasts, Revisions and Momentum in the Estimation of Efficient Market-Neutral Japanese and U.S. Portfolios.” In A. Chen (ed.), Research in Finance 15.Google Scholar
  4. Chen, N-F., R. Roll, and S. Ross. 1986. “Economic Forces and the Stock Market.” Journal of Business 59, 383–403.CrossRefGoogle Scholar
  5. Cohen, K.J. and J.A. Pogue. 1967. “An empirical evaluation of alternative portfolio-selection models.” Journal of Business 40, 166–193.CrossRefGoogle Scholar
  6. Conner, G. and R.A. Korajczyk. 1995. “The Arbitrary Theory and Multifactor Models of Asset Returns.” In R.A. Jarrow, V. Malsimovic, and W.T. Ziemba (eds.), Handbooks in Operations Research and Management Science: Finance 9, 87–144.Google Scholar
  7. Dhrymes, P.J., I. Friend, and N.B. Gultekin. 1984. “A Critical Re-examination of the Empirical Evidence on the Arbitrage Pricing Theory.” Journal of Finance 39, 323–346.CrossRefGoogle Scholar
  8. Dhrymes, P.J., I. Friend, M.N. Gültekin, and N.B. Gültekin. 1985. “New Tests of the APT and Their Implications.” Journal of Finance 40, 659–674.CrossRefGoogle Scholar
  9. Elton, E.J. and M.J. Gruber. 1970. “Homogeneous Groups and the Testing of Economic Hypothesis.” Journal of Financial and Quantitative Analysis 5, 581–602.CrossRefGoogle Scholar
  10. Elton, E.J., M.J. Gruber, S. Brown, and W. Goetzmann. 2007. Modern Portfolio Theory and Investment Analysis. New York: Wiley. Eighth Edition.Google Scholar
  11. Elton, E.J., M.J. Gruber, and M. Padberg. 1978. “Simple Criteria for Optimal Portfolio Selection: Tracing out the Efficient Frontier.” Journal of Finance 33, 296–302.CrossRefGoogle Scholar
  12. Elton, E.J., M.J. Gruber, and M.W. Padberg. 1979. “Simple Criteria for Optimal Portfolio Selection: The Multi-Index Case.” In E.J. Elton and M.J. Gruber (eds.), Portfolio Theory, 25 Years After: Essays in Honor of Harry Markowitz. Amsterdam: North-Holland.Google Scholar
  13. Fabbozi, F., F. Gupta, and H.M. Markowitz. 2002. “The Legacy of Modern Portfolio Theory.” Journal of Investing, Fall 2002, 7–22.Google Scholar
  14. Fama, E.F. and J.D. MacBeth. 1973. “Risk, Return, and Equilibrium: Empirical Tests.” Journal of Political Economy 81, 607–636.CrossRefGoogle Scholar
  15. Farrell, J.L., Jr. 1974. “Analyzing Covariance of Returns to Determine Homogeneous Stock Groupings.” Journal of Business 47, 186–207.CrossRefGoogle Scholar
  16. Farrell, J.L. Jr. 1997. Portfolio Management: Theory and Applications. New York McGraw-Hill/Irwin.Google Scholar
  17. Grinhold, R and R. Kahn. 1999. Active Portfolio Management. New York:. McGraw-Hill/Irwin.Google Scholar
  18. Guerard J.B, Jr and A. Mark. 2003. “The Optimization of Efficient Portfolios: The Case for a Quadratic R&D Term.” In A. Chen (ed.), Research in Finance 20, 213–247.Google Scholar
  19. Guerard, J.B., Jr. M. Gultekin, and B.K. Stone. 1997. “The Role of Fundamental Data and Analysts’ Earnings Breadth, Forecasts, and Revisions in the Creation of Efficient Portfolios.” In A. Chen (ed.), Research in Finance 15.Google Scholar
  20. Guerard, J.B., Jr., M. Takano, and Y. Yamane. 1993. “The Development of Efficient Portfolios in Japan with Particular Emphasis on Sales and Earnings Forecasting.” Annals of Operations Research 45, 91–108.CrossRefGoogle Scholar
  21. Jacobs, B.I. and K.N. Levy. 2009. “Reflections on Portfolio Insurance, Portfolio Theory, and Market Simulation with Harry Markowitz.” This volume.Google Scholar
  22. King, B.F. 1966. “Market and Industry Factors in Stock Price Behavior.” Journal of Business 39, 139–191.CrossRefGoogle Scholar
  23. Markowitz, H.M. 2000. Mean–Variance Analysis in Portfolio Choice and Capital Markets. New Hope, PA: Frank J. Fabozzi Associates.Google Scholar
  24. Mossin, J. 1966. “Equilibrium in a Capital Asset Market.” Econometrica 34, 768–783.CrossRefGoogle Scholar
  25. Mossin, J. 1973. Theory of Financial Markets. Englewood Cliffs, NJ: Prentice-Hall, Inc.Google Scholar
  26. Ramnath, S., S. Rock, and P. Shane. 2008. “The Financial Analyst Forecasting Literature: A Taxonomy with Suggestions for Further Research.” International Journal of Forecasting 24, 34–75.CrossRefGoogle Scholar
  27. Roll, R. 1969. “Bias in Fitting the Sharpe Model to Time Series Data.” The Journal of Financial and Quantitative Analysis 4, 271–289.CrossRefGoogle Scholar
  28. Roll, R. 1977. “A Critique of the Asset Pricing Theory’s Tests, Part I: On Pat and Potential Testability of the Theory.” Journal of Financial Economics 4, 129–176.CrossRefGoogle Scholar
  29. Rosenberg, B. 1974. “Extra-Market Components of Covariance in Security Returns.” Journal of Financial and Quantitative Analysis 9, 263–274.CrossRefGoogle Scholar
  30. Rosenberg, B., M. Hoaglet, V. Marathe and W. McKibben. 1975. “Components of Covariance in Security Returns.” Working paper no. 13, Research Program in Finance. Institute of Business and Economic Research. University of California. Berkeley.Google Scholar
  31. Rosenberg, B. and W. McKibben. 1973. “The Prediction of Systematic and Unsystematic Risk in Common Stocks.” Journal of Financial and Quantitative Analysis 8, 317–333.CrossRefGoogle Scholar
  32. Rosenberg, B. and V. Marathe. 1979. “Tests of Capital Asset Pricing Hypotheses.” In H. Levy (ed.), Research in Finance 1.Google Scholar
  33. Rosenberg, B. and A. Rudd. 1977. “The Yield/Beta/Residual Risk Tradeoff.” Working paper no. 66. Research Program in Finance. Institute of Business and Economic Research. University of California, Berkeley.Google Scholar
  34. Ross, S.A. 1976. “The Arbitrage Theory of Capital Asset Pricing.” Journal of Economic Theory 13, 341–360.CrossRefGoogle Scholar
  35. Ross, S.A. and R. Roll. 1980. “An Empirical Investigation of the Arbitrage Pricing Theory.” Journal of Finance 35, 1071–1103.Google Scholar
  36. Rudd, A. and B. Rosenberg. 1980. “The ‘Market Model’ in Investment Management.” Journal of Finance 35, 597–607.CrossRefGoogle Scholar
  37. Rudd, A, and B. Rosenberg. 1979. “Realistic Portfolio Optimization.” In E. Elton and M. Gruber (eds.), Portfolio Theory, 25 Years After. Amsterdam: North-Holland.Google Scholar
  38. Sharpe, W.F. 1963. “A Simplified Model for Portfolio Analysis.” Management Science 9, 277–293.CrossRefGoogle Scholar
  39. Sharpe, W.F. 1964. “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk.” Journal of Finance 19, 425–442.CrossRefGoogle Scholar
  40. Sharpe, W.F. 1966. “Mutual Fund Performance.” Journal of Business 39, 119–138.CrossRefGoogle Scholar
  41. Sharpe, W.F. 1970. Portfolio Theory and Capital Markets. New York: McGraw-Hill.Google Scholar
  42. Sharpe, W.F. 1971. “A Linear Programming Approximation for the General Portfolio Analysis Problem.” Journal of Financial and Quantitative Analysis. 6, 1263–1275.CrossRefGoogle Scholar
  43. Sharpe, W.F. 1971. “Mean-Absolute-Deviation Characteristic Lines for Securities and Portfolios.” Management Science 18, B1–B13.CrossRefGoogle Scholar
  44. Stone, B.K. 1970. Risk, Return, and Equilibrium: A General Single-Period Theory of Asset Selection and Capital Market Equilibrium. Cambridge, MA: MIT Press.Google Scholar
  45. Stone, B.K. 1973. “A Linear Programming Formulation of the General Portfolio Selection Problem.” Journal of Financial and Quantitative Analysis 8, 621–636.CrossRefGoogle Scholar
  46. Stone, B.K. 1974. “Systematic Interest-Rate Risk in a Two-Index Model of Returns.” Journal of Financial and Quantitative Analysis 9, 709–721.CrossRefGoogle Scholar
  47. Stone, B.K., and J.B. Guerard Jr. 2009. “Methodologies for Isolating and Assessing Potential Portfolio Performance of Stock Return Forecast Models with an Illustration.” This volume.Google Scholar
  48. Stone, B.K., J.B. Guerard Jr., M. Gultekin, and G. Adams. 2002. “Socially Responsible Investment Screening.” Working Paper. Marriott School of Management. Brigham Young University.Google Scholar
  49. Von Hohenbalken, B. 1975. “A Finite Algorithm to Maximize Certain Pseudoconcave Functions on Polytopes.” Mathematical Programming 8, 189–206.CrossRefGoogle Scholar

Copyright information

© Springer Science+Business Media, LLC 2010

Authors and Affiliations

  1. 1.McKinley Capital Management, LLCAnchorageUSA

Personalised recommendations