Active management offers a potential for superior reward when superior information is available, but it also increases portfolio risk. In gauging the benefits of active management, investors must consider the additional risks introduced. How much additional risk will an investor wish to bear?
Depending on their willingness to bear risk, investors will choose to hold different mixes of stocks and bonds. Thus the stock-bond ratio that an investor chooses as a matter of normal, long-run policy tells us something about his willingness to bear the extra risk incurred by active management.
In order to estimate the risk-reward tradeoff implicit in an investor’s choice of stock-bond ratio, however, we need to know his expectations of return. Consensus forecasts, which aggregate the attitudes of all investors, are a common guide to the expectations that serve as the basis for such allocations.
The author shows how one can deduce from the investor’s normal allocation of funds between stocks and bonds the essential features of his preferences regarding risk-reward tradeoffs. He also shows how to cope with investors who show more aversion to the specific risk arising from active management than to the systematic risk arising from a diversified portfolio.