Tools

To get returns, we need to find people that will compensate us for things other than labor

• Companies: stocks, corporate bonds
• Governments: bonds, especially with longer duration
• Insurance clients: insurance linked securities
• Producers, consumers: strategies of buying low and selling high

The main thing that all these have in common is financial risk. If there was no risk, then competition would drive the compensation to zero. In a perfect market all these risks would have the same relative compensation. However, markets are not perfect. especially a macro level (“Samuelson’s dictum”).

Note that while almost all compensation requires risk, not all risk gets compensated:

• Concentration: nobody will pay you to not own other assets
• Gambling: taking risks for fun costs money

A main objective will be to estimate the compensation (excess return) and risk (volatility) of each asset. Excess return means the return above the so called “risk free rate”, the return for cash. Volatility is the standard deviation of excess returns. We will generally ignore the further moments (skew, kurtosis) except when relevant.

Many institutions will publish their understanding as “Capital Market Assumptions”. However they often do so in nominal terms, and/or only show returns.

Two further thing we will need to construct our portfolio are:

• Correlations between the assets, in general and where relevant condional on potential scenarios
• The uncertainty in our estimates

In general, the ideal asset is:

• Highly compensated (high excess return)
• Low risk (low volatility)
• Low or negative correlation to the rest of our portfolio
• Low uncertainty in our estimates

Of course, such ideal assets tend to not exist or have other problems.