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Excess Kurtosis is what happens when large events, both positive and negative, are more common than the “bell-curve.”
The “bell-curve” (also known as the Gaussian or Normal distribution) has a kurtosis of 3.
Historic returns have kurtosis of between 4 and 6.
Kurtosis above 3 is BAD .
Market Risk Premium: Consumption Models Economists have attempted to estimate what the market risk premium should be using consumption based models. Their conclusion is that the historic risk premium is higher than it should be, That’s a “puzzle” The 2007-2008 might have solved the puzzle – risk is higher and returns are lower when we include these years!
Equity Risk Premium: Consumption Models Economists sometimes call this the equity risk premium and it’s the same thing. Regardless of what you call it, it’s still a “puzzle”
The Relation between Return and Risk Another name for the equity risk premium is “the market price of risk.”
Historic Excess Returns vs. Risk Cash, Bond, Stock 1970 to 2009
The previous slide shows that for a historic portfolio holding stocks, bonds and cash, return increased with risk.
The developers of the Capital Asset Pricing Model was awarded the Nobel Prize in Economics.
If you can borrow at the “risk-free rate” (you can’t, but some people can), then the relation between risk and return is a straight line.
A Bit More Math: Excess Return: Return higher than the risk free rate. Slope: Increased in return for an increase in risk L : leverage. : the annualized volatility S : skewness of returns. K : kurtosis of returns
If your leverage is equal to 3, then your financial needs (liabilities) is twice your discretionary wealth!
You plan to spend all of your dividends and income and 2/3 rd of the principal, leaving 1/3 rd in your estate.
Our system would classify you as conservative.
There are HNW prospects and clients that are conservative, but generally this characteristic better fits the “mass affluent.” These are bad HNW clients because they want good results but they get upset in down markets.