Risk Analysis in the Sixties

Abstract

by David A. West DURING THE 1960's investment portfolio managers have faced a twist in financial analysis due to the increased significance of interest-rate risk and inflation risk as compared to financial risk (or business or credit risk). With interest rates reaching forty-year highs in 1966, the significance of interest-rate risk was greater than any time since at least 1957. Furthermore, with inflation occurring at almost 4% in 1966, inflation risk increased to a degree more significant than it had been for at least the last ten years. Of course financial risk always exists and selectivity always is essential to successful portfolio management. However, during periods of stimulated economic growth, the risk of across-the-board financial difficulties must be recognized as significantly less than during periods of economic decline, whereas the risk of portfolio loss due to interest-rate increases and inflation is significantly greater. Sensitivity to these factors is being intensified by the increasing pressures placed on portfolio managers for comparatively favorable market performance. As a result, more consideration is being given the intermediateterm market risks; i.e., the risk of loss due to declines in market prices which may be quite apart from any immediate change in the rate of economic growth or any reduction in inflation risk or interest-rate risk. That mutual fund portfolio managers have tended to act as though they recognized these risks is indicated by the quarterly data shown in Figure 1.1 In earlier studies, conclusions are conflicting regarding the success of this group in responding to these divergent risks. Donald Farrar concluded that investment company portfolio management had been fairly efficient in minimizing variances for various levels of expected return, noting particularly that the balanced funds had been successful in minimizing variance for their somewhat lower required expected return.2 In contrast, Jack Treynor's studies led him to conclude that mutual fund portfolio managers had not been successful in experiencing more than average success.3 Nevertheless, in analyzing the aggregate data and certain individual funds included in it, five specific points became apparent.