Investment Risk and Uncertainty: Advanced Risk Awareness Techniques for the Intelligent Investor

CHAPTER 19

R-Squared

Jason MacQueen

There are a number of domestic and international multifactor equity risk models now available to investors. This chapter reviews the three main methods currently used to build multifactor equity risk models. The main part of the chapter is theoretical and generic, and is intended to highlight the strengths and weaknesses of the different methods, but it also concludes with a review of R-Squared Risk Management’s Short-Term Global Equity Risk model, available on FactSet.

WHY BUILD STOCK RISK MODELS?

The first important point to make is that no one builds stock risk models because they care about individual stock risk. If they did, they almost certainly wouldn’t use the same model for, say, 40,000 different stocks, but would perhaps go to the extent of building 40,000 different models, one for each stock.

Security analysts, for example, sometimes build simple spreadsheet models for each of the stocks they follow, in order to capture the idiosyncrasies of particular stocks. More typically, they build a series of models for companies in different industries, on the grounds that stocks within a particular industry will be subject to much the same common factor effects as one another, so that one generic model for each industry will be sufficient. They would use something like the dividend discount model and/or cash flow return on investment (CFROI, a metric used by Credit Suisse First Boston) to evaluate a stock or company individually. They most ...