Download Capital Market Expectations

Portfolio Management
Unit – III
Session No. 19
Topic: Capital Market Expectations
Session Plan
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Unit - III Briefing
Capital Market Expectation
Framework on Capital Market Expectation
Challenges in forecasting:
Summarizing and Q & A
Unit Briefing
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Capital Market Expectations
Tools for Formulating Capital Market Expectations
Economic Analysis
Risk and Return
Asset Allocation
Selection of Asset Classes
Optimization
Implementing the Strategic Asset Allocation
Text Book: John L. Maginn et al. (2007), Managing Investment Portfolios: A Dynamic
Process, John Wiley & Sons, Inc, 3rd Edition
Capital Market Expectations
• Capital Market Expectations (CME): the investor’s expectations
concerning the risk and return prospects of asset classes, however broadly or
narrowly the investor defines those asset classes.
• Capital market expectations are an essential input to formulating a strategic
asset allocation.
• For example, if an investor’s investment policy statement specifies and defines
eight permissible asset classes, the investor will need to have formulated longterm expectations concerning those asset classes to develop a strategic asset
allocation.
• Capital market expectations are expectations about classes of assets, or macro
expectations. By contrast, micro expectations are expectations concerning
individual assets.
• Micro expectations are key ingredients in security selection and valuation.
Capital Market Expectations
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A Framework for Developing Capital Market Expectations:
Specification
Research
Specify the model
Sources of information
Current Investment environment
Documentation
Monitoring
Capital Market Expectations
• 1. Specification - Specify the final set of expectations that are needed, including the time horizon
to which they apply. The analyst needs to understand the specific objectives of the
analysis in order to work efficiently toward them. For example, for a taxable investor
with a 10-year time horizon, the portfolio manager would develop long-term after-tax
expectations for use in developing a strategic asset allocation.
• 2. Research the historical record. Most forecasts have some connection to the past.
For many markets, the historical record contains useful information on the investment
characteristics of the asset, suggesting at least some possible ranges for future results.
• 3. Specify the method(s) and/or model(s) that will be used and their
information requirements. Information requirements (economic and financial
market data needs, for example) depend on the decision about method(s).
Capital Market Expectations
• 4. Determine the best sources for information needs
• 5. Interpret the current investment environment using the selected data and
methods, applying experience and judgment. The analyst often needs to apply
judgment and experience to interpret apparently conflicting signals within the data.
• 6. Provide the set of expectations that are needed, documenting conclusions.
These are the analyst’s answers to the questions set out in Step 1. The answers should
be accompanied by the reasoning and assumptions behind them.
• 7. Monitor actual outcomes and compare them to expectations, providing
feedback to improve the expectations-setting process.
*Steps 2 and 3 in the expectations-setting process involve understanding the historical
performance of the asset classes
Capital Market Expectations
• Challenges in Forecasting
• The discussion focuses on problems in the use of data and on analyst mistakes
and biases:
1. Limitations of Economic data - The analyst needs to understand the
definition, construction, timeliness, and accuracy of any data used, including
any biases.
2. Data measurement errors & biases - Analysts need to be aware of possible
biases in data measurement of series such as asset class returns.
3. Limitations of historical estimates - With justification, analysts frequently
look to history for information in developing capital market forecasts
Capital Market Expectations
4. Ex-post risk can be biased measure of Ex-Ante risk - In interpreting
historical prices and returns over a given sample period for their relevance to
current decision making, we need to evaluate whether asset prices in the
period reflected the possibility of a very negative event that did not
materialize during the period.
5. Biases in Analysts methods - Analysts naturally search for relationships
that will help in developing better capital market expectations. Among the
preventable biases that the analyst may introduce in such work are data –
mining biases and Time – period biases
6. The failure to account for conditioning information - The analyst should
ask whether there are relevant new facts in the present when forecasting the
future. Where such information exists, the analyst should condition his or her
expectations on it.
Capital Market Expectations
7. Misinterpretation of Correlations - In financial and economic research, the
analyst should take care in interpreting correlations.
8. Psychological Traps – several psychological traps that are relevant to our
discussion because they can undermine the analyst’s ability to make accurate
and unbiased forecasts.
– anchoring trap, status quo trap, confirming evidence trap, overconfidence trap,
prudence trap, recallability trap
9. Model Uncertainty - The analyst usually encounters at least two kinds of
uncertainty in conducting an analysis: model uncertainty (uncertainty
concerning whether a selected model is correct) and input uncertainty
Summarizing Q & A