Comments (0)

By Tai, September 2, 2010 9:57 am

It is well argued that idiosyncratic risks are not desired and can be diversified away (Bodie et al 2007). While this knowledge dominates introduction to finance courses (subjects/modules), idiosyncratic risk is in other most circumstances the key to wealth.

Firm-specific and industry-specific characteristics are key to capture excess returns from CAPM expected return. For example, retail industry, food industry, metal industry etc. fluctuate to business cycles, and business cycles are not captured in CAPM.

Next, idiosyncratic volatility is useful for speculation purpose, especially when you do not have a concrete target on where to exit the investment. Volatile means holding through (or even shorting during) dip and exit during peaks. You earn steady income through dividends and small gains on stable stocks, but you make fortune on volatile-but-fundamentally good investments.

Treynor Black model for alpha specifies that on the Single Index Model

Active portfolio A should receive investment weight

where the rest of the portfolio should be invested in market index. This is one example in the academic world where idiosyncratic is, indeed, good.

Practical relevance: for smaller stocks and international investments, particularly emerging markets, ‘beta’ approach almost does not work. These are the cases where idiosyncrasy comes to play.

Bodie Z, Kane A, Marcus A, 2007, ‘Investments’, McGraw-Hill, 2007

Treynor, J. L. and F. Black, 1973, ‘How to Use Security Analysis to Improve Portfolio Selection’, Journal of Business, January, pages 66–88

Comments (0)

By Tai, August 4, 2010 9:11 am

I’m currently bearish toward VNI.

Financial sector: highly volatile and facing heavy pressure from interest rate risk and the recent credit rating downgrade.

Food industry: business cycle shouldn’t lie, but fundamental has been a big fallacy.

I’m longing REE.

Comments (1)

By Tai, May 15, 2010 12:38 am

Nassim Taleb and his classic metaphor of a turkey

My extension attempt from it:

A sheep is fed and combed for a 1000 days, every day confirms to his statistical department that the human race cares about his welfare and fur on his body. On the 1001st day, the sheep is shaved.

At least, the sheep is alive. He has hints to determine when they will want lamb meat (e.g. Easter).

Does he?

How does one get to being a sheep from the state of a turkey?

Comments (0)

By Tai, April 17, 2010 7:29 pm

In markets where index funds are a feasible investment channel, investors can undertake strategies to hedge their position in such funds.

1. Investor, depending on their bargain power, may require installment of liquidity reserve. An increasingly popular calculation of a reserve is with Value at Risk (VaR). Reserve = VaR * multiplier

The more volatile the market is expected to be, the higher the multiplier is used.

Read more of VaR on JP Morgan and Benninga & Wiener 1998 ¹.

2. The position can be further hedged by entering a credit default swap.

Given these instruments, further concern of index fund service provider liquidity risk (default event on the commitment to investors when index rockets) might be attributed to other factors beyond the scope of this technical argument.

¹ Benninga S. and Wiener Z., 1998, ‘Value-at-Risk (VaR)’, Mathematica in Education and Research, vol. 7 no. 4, 1998