10. Portfolio Theory - Principles & Limitations Flashcards

Question

E2A. Efficient market hypothesis (pages 13 & 14)

Answer 1

In an open and efficient market, security prices reflect all available information and prices rapidly adjust to any new information. For this reason market prices are always the correct prices for any given security. Therefore not possible to outperform the market by picking undervalued securities because there are none. EMH says that it is impossible to achieve consistent returns in excess of average market returns through stock selection or market timing. Only way to achieve higher returns is through riskier investments.

Answer 2

Three forms of EMH: 1. Weak-form efficiency (prices fully reflect past price data and future prices cannot be predicted by analysing this) 2. Semi-strong efficiency (prices adjust to all publicly available data, which includes past prices and information reported in a company's financial statements) 3. Strong-form efficiency (prices reflect all information that any investor can acquire. This includes all public information plus private information typically held by corporate insiders)

Answer 3

1. Weak-form efficiency (generally, strong and consistent evidence supports this) - so buying/selling shares based on past performance does not lead to outperformance 2. Semi-strong efficiency (strong factual support) - markets are generally semi-strong 3. Strong-form efficiency (evidence to support that company directors and their advisers can outperform other investors, however, investment managers do not) - market is therefore not strongly efficient

Answer 4

Critics of EMH see that the evidence shows that investors are affected by: - tendency to make decisions based on what other investors are doing (the herd investor) - tendency to 'churn' their portfolios - tendency to under-react/over-react to news - asymmetrical judgements about causes of previous profits and/or losses

Answer 5

Principle theories within behavioural finance that often contradict the basic assumptions of traditional financial theory: PROSPECT THEORY/LOSS AVERSION - people do not always behave rationally, particularly in respect of their risk tolerance when they face a loss or make a profit - people take losses harder than they do enjoy making gains on their investments - loss aversion is taking risker decisions to reduce losses, such as holding onto an investment for longer than they should REGRET - avoid selling an investment because of the regret of having made an error of judgement - avoid selling stocks that have gone down OVERCONFIDENCE & OVER/UNDER REACTION - people have a tendency to overestimate their own skills and predictions for success - they also underestimate the likelihood of bad outcomes over which they have no control

Answer 6

- that it has little use in forecasting the markets, since the many factors of human behaviour cannot be quantified and so will not enable an individual investor to earn abnormal returns - critics believe that behavioural finance is a collection of explanations and anomalies which will eventually be priced out of the market

Answer 7

MANAGEMENT OF PORTFOLIO RISK - MPT suggests that portfolios can be constructed that maximise returns and minimise risk by carefully choosing different investments - most commonly used measure of risk is volatility. This is measured by standard deviation - the greater the SD the greater the risk (and visa versa) - the overall risk of a portfolio can be reduced by diversification such as 1. combining different asset classes within a portfolio 2. holding a variety of investments in each asset class - the effectiveness of diversification in reducing a portfolio's risk depends on the degree of correlation between the investments - the risk for individual securities has two components: 1. systematic or market risk (can't be diversified away) 2. non-systematic or investment specific risk - the sensitivity of an investment in relation to the market can be measured by Beta

Answer 8

THE EFFICIENT FRONTIER - represents a set of portfolios which have the maximum rates of return for each given risk level CAPM - is a model that derives the theoretical expected return for a security as a combination of the return on a risk-free asset and compensation for holding the risky asset - CAPM is based on a number of assumption MULTIFACTOR MODELS - allow for different sensitivities to different macro-economic and fundamental factors and the identification of each factor's contribution to the security's return - Arbitrage Pricing Theory (APT) is based on the assumption that there are a number of major macro-economic and fundamental factors that influence security prices LIMITATIONS OF MODELS - Models based on MPT have failed to explain investor and market behaviour, especially in extreme conditions - according to the Efficient Market Hypothesis (EMH), in an open and efficient market, security prices fully reflect all available information and prices rapidly adjust to any new information - if the EMH is correct, it makes sense to invest in tracker/index funds which mirror the performance of the market - behavioural finance is an area of financial research that explores how emotional and psychological factors affect market decisions - it attempts to explain market anomalies and other market activity that is not explained by the traditional finance models - behavioural finance highlights certain inefficiencies caused by the irrational way in which investors react to new information as being causes of market trends, and in extreme cases, of speculative market bubbles and crashes