Geoff Considine

Using Default Risk to Limit Downside in Individual Stock Investing

Quaazy1:

Any Monte Carlo model that does not account for correlation between positions is essentially pointless. QPP has a sophisticated tool for capturing and managing the correlations between all positions. QPP is actually considerably more sophisticated that a tools based on Style Analysis in this regard because it captures all correlation effects and not just correlations due to mutual correlation to indexes.

I have performed long-term out-of-sample tests on portfolios of assets and have shown that QPP does a solid job of generating expected risk and return in total portfolios of correlated assets.

Using Default Risk to Limit Downside in Individual Stock Investing

Hi Quaazy1:

The current version of QPP assumes no serial correlation in return in the simulation. This is measured historically, however. This is okay for investors with time horizons beyond about a year because the dcay time scale for autocorrelation is about a year in most studies. QPP is not intended to be a momentum investing tool.

Using Default Risk to Limit Downside in Individual Stock Investing

Bear Stearns Part 2: The comment above is especially notable given that Moody's had BSC rated at A2 until 3/14/08, at which time Moody's downgraded BSC to Baa1. QPP's projected 1% / 1 year risk as calculated at the end of February is in line with credit ratings right on the edge of junk (see chart in this article).

Using Default Risk to Limit Downside in Individual Stock Investing

FYI: Bear Stearns had a 1-year, 1% ile projected return in QPP of -75% for the period ending 2/29. In the article above, I suggested that individual investors avoid stocks with 1% ile projected return worse than -50% to -60%. BSC would have been avoided on this basis.

Using Default Risk to Limit Downside in Individual Stock Investing

Hi Manhapf:

The idea of using QPP as a leading projection of upgrades or downgrades is an interesting one--and you can look for future articles on this. I have been doing some testing and it appears that QPP has shown very high tail risk prior to some recent downgrades.