CONSULTIVA international, inc.

1. CONSULTIVAinternational, inc. “Understanding and Managing Risk and Risk Tolerance” Irene Marom November, 2002

2. Growth of $100 1995-1999 $351 (28.5%) $144 (7.6%) $129 (5.2%)

3. Growth of $100 2000-9/2002 $132 (10.8%) $112 (4.1%) $57 (-18.2%)

4. The Headlines Are Frightening • FBI says further terrorist attack likely. • Tech stock meltdown--dot.com to dot.gone. • Impending war with Iraq. • U.S. economy in recession. • Mid East ready to erupt in full scale war. • Fraudulent conduct by corporate executives. • Analysts’ recommendations investigated by Attorney General. • Record numbers apply for unemployment.

5. Discussion of Risk • Risk: • What is Risk? • Why is it so important? • How do we measure Risk? • Risk Tolerance: • What is Risk Tolerance? • How do we quantify it? • How Do We Manage Risk?

6. Why Discuss Risk Now? • 43% decline in stock prices since 2000 • “Under-funding” and “liability” issues are surfacing once again. • Sophisticated investment strategies to manage risk have become prolific. • Investors want, and need, to be more knowledgeable about investment concepts and topics.

7. Concepts of Risk Definition of Risk - The possibility of some adverse event. Risk Tolerance – The attitude of an investor towards risk. The ability or willingness to accept increasing amounts of uncertainty about future investment returns given commensurate increases in the level of return anticipated. Risk Management – A scientific approach to the problem of dealing with the risks facing an individual or an organization.

8. Examples of Risk The possibility of some adverse event Pension funds: making unplanned contributions. Individual: unable to retire when planned. Endowments: unable to make grants. Municipalities: having insufficient funds for community needs.

9. How Do Investors Perceive Risk? • “I don’t want to lose money.” Probability of Negative Returns • I want to be with the top performing manager.” Probability of Significant Underperformance • “Just give me 10% per year and I’ll be happy.” Consistency of Annual Returns • “ I feel comfortable with IBM, GE….” Quality of Companies

10. How Do Investors Perceive Risk? • “No small cap companies, high tech or internationals.” Style Characteristics • “ I want to invest with a large, well known manager.” Investment OrganizationRisk • “We don’t want to have to make annual contributions.” Funding Risk • “I need to keep pace with inflation.” Purchasing Power Risk

11. How Do We Measure Risk? “ Before the investment is made, one can only guess at what the risks might be. One approach is to couch the guess in statistical terms.”

12. Modern Portfolio Theory • Developed in the 1950’s by Harry Markowitz and fellow Nobel Prize winner William Sharpe. • Developed a quantitative approach to measuring risk and return. • Investment professionals can classify, quantify and control sources of risk and return. • Optimal portfolios should incorporate measures of risk, expected returns and the correlation of one asset to another.

13. Investment Returns 13.2% 9.9% 5.9%

14. Investment Risk SB 3-Month Treasury Bills 1982 1987 1992 1997 2002

15. Investment Risk LB Gov/Corp 1982 1987 1992 1997 2002

16. Investment Risk S&P 500 1982 1987 1992 1997 2002

17. The Risk/Return Tradeoff Oct 1982 to Sep 2002 15 S&P 500 13 11 Annualized Compound Average (%) LB Gov/Corp 9 7 SB 3-Month TBills 5 0 5 10 15 20 Standard Deviation (%)

18. Expected Return 0 Risk (Variability) The Risk/Return Tradeoff More Aggressive More More Conservative Less Less More

19. Key Risk Measurements of MPT • Standard Deviation: measure of variability of returns. • Time Horizon:risk is reduced as time horizon is extended. • Correlation: relationship of two assets. • Sharpe Ratio: return-per-unit of risk where risk is standard deviation.

20. What does Standard Deviation Look Like?

21. Standard Deviation – An Example Goal Expected Return 15% -10.0 0.0 10.0 20.0 30.0 40.0 Return (%)

22. Time Horizon and Risk(1 Year Rolling Periods) Standard Deviation for S&P 500 1973-2001

23. Time Horizon and Risk(5 Year Rolling Periods) Standard Deviation for S&P 500 1973-2001

24. MPT Assumptions • Measured by Standard Deviation • Risk = Uncertainty • Requires symmetry of return distribution • Upside volatility penalized same as downside volatility • Measures risk relative to average • Same risk for all goals • T-bills considered riskless asset

25. Post-Modern Portfolio Theory: Downside Risk • Downside Risk: The risk associated with failing to meet an investor’s goal. • An extension of MPT. • Preferred by Markowitz but no computing capabilities at the time. • Differentiates between risk and uncertainty. • Gaining popularity among investment professionals.

26. What Does Downside Risk Look Like?

27. Post-MPT Assumptions • Distinguishes between “good” and “bad” returns; only “bad” returns represent risk. • Measured by Downside Deviation. • Return distributions may be symmetrical or asymmetrical.

28. Post-MPT Assumptions • Recognizes that upside volatility is better than downside volatility. • Measures risk relative to the investor’s goal. • No such thing as a risklessasset. • Risk is in the eye of the beholder.

29. Case Study MPT vs. Post-MPT • Performance of two value managers • 10 years ending September 30, 2001 • Measure and Compare: • MPT (Standard Deviation and Sharpe Ratio • Post-MPT (Downside Deviation and Sortino Ratio)

30. Manager B Manager A Case Study

31. Manager B Manager A Case Study

32. Comparison

33. What Is Risk Tolerance? • The attitude of an investor towards risk. • Subjective in nature. • Quantifies the emotional or behavioral aspects of an investor.

34. Why Is It So Important? • If you underestimateyour tolerance for risk, the portfolio may be too conservative and you may never reach your goals. • If you overestimate your tolerance for risk, you may invest in unsuitable investments and miss your goals through investment losses. • If you are a fiduciary, you may be exposed to liability.

35. Modeling Investor Behavior • Behavioral Finance models how individuals actually behave under conditions of uncertainty. • Psychometrics is the science of quantifying the psychological attitudes of individuals. • Computer technology is a powerful tool for designing effective risk-assessment instruments.

36. How Do We Manage Risk? • Work with investment professionals. • Assess Risk Tolerance. • Proper Planning • Investment Goals and Objectives • Asset Allocation • Incorporate Investment Time Horizon • Proper Due Diligence • Review Performance • Review investment policy periodically • Become Knowledgeable and Informed.

37. “On the plus side, if this were a roller coaster, we’d be at the very most exciting part of the ride!”

38. Behavioral Assumptions Researchers have found… • More aversion to risk than attraction to pleasures of gain. • Decisions sometimes based on anticipation of regret. (Example: Choice of $1,000 for sure and $2,000 based on flip of a coin.) • Reliance on intuition, experiences, and feelings,leading to “satisfactory” rather than “optimal” decisions.

39. Measuring Risk Tolerance Use questionnaire that incorporates psychometrics and behavioral finance to effectively assess individuals’ risk tolerance. • Wealth scaling. • Adaptive questioning. • Downside reference points. • No transference of attitudes across risk domains. • No relationship between investment experience and risk tolerance.

40. Summary of Risk Measurements • Risk can be quantified and measured for making and evaluating investment decisions. • An understanding of risk measurement is critical to the investment process. • Standard Deviation and Downside Risk are the two most common risk measures. • Standard Deviation measures a portfolio’s variability; Downside Risk measures the risk of not achieving an investor’s goal. • Sharpe and Sortino Ratios measure return-per-unit of risk.