502-3 Modern Portfolio Theory and Behavioral Finance

Question 1

Explain how each of the tools listed might be used by an investor who is constructing an investment portfolio: capital asset pricing model

Answer 1

to determine the required return for a security when the risk-free rate, the market return, and the security’s beta are known

Question 2

Explain how each of the tools listed might be used by an investor who is constructing an investment portfolio: capital market line

Answer 2

The macro version of Capital Asset Pricing Model (CAPM)

A graph showing the relationship between total risk (standard deviation) and return for a portfolio of securities in which risky securities are combined with a risk-free asset. As riskier securities are added, and standard deviation goes up, then required return also goes up

Question 3

Explain how each of the tools listed might be used by an investor who is constructing an investment portfolio: efficient frontier

Answer 3

to plot the various combinations of security portfolios that represent the optimal combination of assets for any specific level of risk that an investor is willing to bear

Question 4

Explain how each of the tools listed might be used by an investor who is constructing an investment portfolio: optimal portfolio

Answer 4

to determine the specific combination of assets that will have the greatest probability of maximizing an investor’s expected return at the investor’s given level of risk

Question 5

Explain how each of the tools listed might be used by an investor who is constructing an investment portfolio: security market line

Answer 5

The micro version of Capital Asset Pricing Model (CAPM)

A graph showing the relationship between systematic risk (measured by beta) and the required return for an investment for any given level of risk. The CAPM determines the SML

Question 6

Explain how each of the tools listed might be used by an investor who is constructing an investment portfolio: arbitrage

Answer 6

to identify mispriced securities, especially when a single security is selling at different prices in different organized markets

Question 7

What does an indifference curve indicate?

Answer 7

An indifference curve indicates an investor’s willingness to bear risk. The investor has the same level of satisfaction from any of the combinations of risk and return shown by all the alternatives on the curve.

Question 8

In the CAPM formula, what is the term (Rm – Rf) called?

Answer 8

It s called the market risk premium.

Question 9

Explain how portfolio risk (σp) is used to develop the efficient frontier in the Markowitz model.

Answer 9

A graph is constructed in which the horizontal axis measures the risk associated with the portfolio (σp) and the vertical axis measures the expected return of the portfolio. Various combinations (portfolios) of securities are plotted on the graph, and a curve emerges that defines the efficient set (frontier) of portfolios, which are those portfolios that offer the highest return for any given level of risk. No single portfolio on the efficient frontier is superior to any other single portfolio on the frontier. Each portfolio has a different risk level and a return consistent with that risk level.

Question 10

What is an unattainable or non feasible portfolio?

What is an attainable but inefficient portfolio?

What is an efficient portfolio?

Answer 10

Unattainable or nonfeasible portfolios do not exist (i.e., there is no such combination of risk and return that is achievable for an extended period of time). Attainable but inefficient portfolios offer an inferior return for a given amount of risk; they are inefficient because the investor can get a higher return without increasing risk or get the indicated return at a lower risk level. Efficient portfolios are those that offer the highest return for a given level of risk (or the lowest risk for a given level of return).

Question 11

Can the Markowitz model by itself be used to select an optimal portfolio for an investor? Explain your answer.

Answer 11

Rational investors want an optimal portfolio that offers the highest return for a given level of risk or the least amount of risk for a given level of return. By itself, the Markowitz model does not identify the optimal portfolio; it only identifies the efficient frontier of portfolios. The optimal portfolio occurs at the point of tangency of the indifference curve and the efficient frontier. The optimal portfolio for an investor is determined by combining the efficient frontier and the investor’s willingness to bear risk.

Question 12

When the CFP Board refers to the CAPM and does not specify which form is being addressed, is it referring to the Security Market Line (SML) or the Capital Market Line (CML)

Answer 12

When the CFP Board refers to the CAPM and does not specify which form is being addressed, it is the security market line (SML) that is being referred to.

Question 13

Using the explanations for a security’s return distinguish the arbitrage pricing theory from the capital asset pricing model. - Variables affecting stock prices

Answer 13

Arbitrage Pricing Theory: It is a multivariate model that recognizes that variables other than market return and beta can affect stock prices.

Capital Asset Pricing Model: It assumes that only a market return and a beta with respect to that market are necessary to explain all stock returns.

Question 14

Using the explanations for a security’s return distinguish the arbitrage pricing theory from the capital asset pricing model. - Relationship between risk and return

Answer 14

Arbitrage Pricing Theory: The relationship between a stocks return and risk is not a straight line.

Capital Asset Pricing Model: Assumes a straight line between risk and return.

Question 15

Using the explanations for a security’s return distinguish the arbitrage pricing theory from the capital asset pricing model. - Factors that affect return

Answer 15

Arbitrage Pricing Theory: Factors that affect return fall into the categories of sector influences and systematic influences.

Capital Asset Pricing Model: The only factor that explains return is a stocks beta.

Question 16

Under Arbitrage Pricing Theory (APT), research suggests that four unanticipated factors have the greatest impact on stock returns. What are these four factors?

Answer 16

• changes in inflation
• changes in interest rates
• changes in industrial production/gross domestic product
• changes in risk premiums

Question 17

Under APT, when a factor has a numerical value of zero, what impact on return does that factor have?

Answer 17

That factor has no impact on the return.

Question 18

How would a casino operator or forest products company be affected if inflation unexpectedly rises?

Answer 18

The casino operator would experience little impact when inflation rises; people tend to gamble regardless of economic conditions. They may be more inclined to try to increase their net worth when inflation eats into their paychecks.

Forest products companies have the majority of their net worth tied up in their trees; any rise in inflation tends to substantially increase the value of their tree inventories.

Question 19

How would am electric utility or food retailer when be affected when interest rates unexpectedly increase?

Answer 19

People must purchase food regardless of interest rate levels.

Electric utilities are very highly leveraged, and increased interest rates have a direct impact on their net profit. The value of the utilities’ securities would decrease.

Question 20

Hou would telephone utility or durable goods manufacturer be affected when when consumer spending unexpectedly decreases?

Answer 20

People will use their telephones regardless of the condition of the economy.

When people believe their incomes are in jeopardy, they will likely cut back on all but essential consumer products, such as food and clothing; they will defer purchases of durable goods, such as furniture.

Question 21

List some of the major characteristics of each of these life cycle phases.- accumulation phase

Answer 21

Early career phase with career and family beginning. Income low and growing, limited amount of assets, home most significant asset, long-term time horizon for investments and retirement.

Question 22

List some of the major characteristics of each of these life cycle phases.- consolidation phase

Answer 22

Mid-to-late career phase with income exceeding expenses. Home equity and retirement account balances may result in large net worth. Investment time horizon is still long.

Question 23

List some of the major characteristics of each of these life cycle phases. -spending phase

Answer 23

After retirement. Earned income decreases or ceases, expenses funded by Social Security, pensions, retirement accounts. Investment time horizon can still be long from beginning of retirement.

Question 24

List some of the major characteristics of each of these life cycle phases. -gifting phase

Answer 24

Assuming a high net worth and more than enough for retirement costs, may begin to give away assets to relatives and charity.

Question 25

For each of the following types of asset allocation decisions made, which kind of asset allocation strategy is being employed?

-the decision to reallocate 40% of fixed income to intermediate-term bonds and 60% to short-term bonds

Answer 25

tactical allocation

Question 26

For each of the following types of asset allocation decisions made, which kind of asset allocation strategy is being employed?

-the decision to maintain an allocation of 60% stocks and 40% fixed income

Answer 26

strategic allocation

Question 27

What is the relevant risk measured in CML?

Answer 27

The standard deviation is the relevant risk.

Question 28

What does mean variance optimization approach refer to?

Answer 28

Building a portfolio on the efficient frontier.

Question 29

What is an efficient market?

Answer 29

• One in which prices fully reflect all known information quickly and accurately.
• In an efficient market, investors are competitive, information is widely available, new information is generated randomly, and investors react quickly to the new information.
• A security’s equilibrium price is a true valuation of what the market believes the security is worth; thus, an investor cannot expect to consistently beat the market (i.e., earn excess returns) over time.
• What the investor can expect to earn is a return that is consistent with the market return and the amount of risk borne.
• A security can never be overvalued or undervalued, so analysis undertaken to discover mispricing is useless

Question 30

Explain the random walk hypothesis

Answer 30

• The random walk hypothesis holds that price movements are unpredictable and that a price movement today is unrelated to a price change yesterday or any other day. This does not mean that security prices are randomly determined.
• It does mean that trading rules cannot lead to superior security selection and that changes in prices occur randomly.
• However, even though security price changes occur randomly, prices do exhibit a tendency to rise over long time periods.

Question 31

Explain the implications of each of the following forms of the efficient market hypothesis: weak form

Answer 31

The weak form of the EMH suggests that historical price data and other technical indicators of the market are of no value in predicting future price changes (i.e., technical analysis will not produce superior results). Fundamental analysis, however, may produce superior investment results.

Question 32

Explain the implications of each of the following forms of the efficient market hypothesis: semi-strong form

Answer 32

The semi-strong form of the EMH asserts that all publicly known and available information (historical price data, earnings, dividends, new product development, financing problems, etc.) is fully reflected in stock prices. This suggests that neither technical analysis nor fundamental analysis can produce superior results over time on a risk-adjusted basis. Only private or inside information can produce superior results.

Question 33

Explain the implications of each of the following forms of the efficient market hypothesis: strong form

Answer 33

The strong form of the EMH asserts that stock prices fully reflect all information, both public and private. Not even access to inside information can be expected to result in superior investment performance over time.

Question 34

What is a market anomaly?

Answer 34

A market anomaly is a strategy or situation that cannot be explained away and that would not be expected to occur if the efficient market hypothesis were completely true.

Question 35

Briefly explain each of the following market anomalies: P/E ratio

Answer 35

Stocks with low P/E ratios outperform stocks with high P/E ratios.

Question 36

Briefly explain each of the following market anomalies: small-firm anomaly

Answer 36

The stock of small firms outperforms the stock of large firms. The relative size of the firm is measured by the market value of the firm’s outstanding equity. One definition of a “small” firm is one whose total market value is in the lowest 20% of all stocks on the NYSE.

Question 37

Briefly explain each of the following market anomalies: January effect

Answer 37

Small stocks outperform the market in January, especially during the first five days.

Question 38

Briefly explain each of the following market anomalies: neglected-firm anomaly

Answer 38

Firms that are neglected by security analysts tend to generate returns that are higher than those of firms that are covered by analysts. Indirectly, low analyst coverage leads to lower institutional ownership of a security.

Question 39

Briefly explain each of the following market anomalies: Value Line rank

Answer 39

Stocks rated “1” in “timeliness” by the Value Line Investment Survey outperform those rated “5” by the survey

Question 40

Briefly explain each of the following market anomalies: BV/MV effect

Answer 40

Stocks with high book values relative to their market value tend to outperform stocks with low book values relative to their market value.

Question 41

Analyze each of the following situations to distinguish factors that support a specific form of the EMH or an anomaly to the EMH:
an investor studies corporate annual reports before making decisions about buying a stock

Answer 41

When an investor uses fundamental information to make decisions about companies, he or she believes in the weak form of the EMH.

Question 42

Analyze each of the following situations to distinguish factors that support a specific form of the EMH or an anomaly to the EMH: an investor concentrates on small-cap stocks for investment

Answer 42

Considering their risk, small-cap stocks perform better than can be expected. They have been identified as EMH anomalies.

Question 43

Analyze each of the following situations to distinguish factors that support a specific form of the EMH or an anomaly to the EMH: an investor in Starbucks is concerned about the company’s inventory costs, and he takes a trip to South America to investigate coffee production

Answer 43

This investor is obtaining information that is private and not generally available to all investors; therefore, he believes in the semi-strong form of the EMH.

Question 44

Analyze each of the following situations to distinguish factors that support a specific form of the EMH or an anomaly to the EMH: an investor focuses on companies that are not followed by many analysts

Answer 44

Companies that are not covered much by analysts may be undervalued and thus may be good sources of investment opportunities. This investor believes in the neglected-firm anomaly.

Question 45

Evaluate the relationship of the efficient market hypothesis to the concepts listed: arbitrage pricing theory

Answer 45

According to the principles of the EMH, security prices reflect all information available about each individual security and about the economy and the market. Under the APT, analysts who can anticipate information about a company, the economy, or the direction of interest rates may be able to achieve superior risk- adjusted investment results. The EMH, however, suggests that no analyst can consistently expect to use APT principles to achieve such superior results. An analyst may be able to do so periodically, but cannot achieve these results over a long period.

Question 46

Evaluate the relationship of the efficient market hypothesis to the concepts listed: fundamental analysis

Answer 46

Studies of the EMH generally do not support the strong form— only the weak and semi-strong forms. Fundamental analysis of securities is considered valuable under the weak form of the EMH; analysts using fundamental analysis may be able to uncover mispriced securities that other analysts have overlooked.

Question 47

Evaluate the relationship of the efficient market hypothesis to the concepts listed: foreign investing

Answer 47

The factors that may make the markets for many listed stocks efficient in the United States may not exist in foreign markets or in the U.S. markets for real estate, art, etc. The information about such investments is often limited and inaccurate, and the dissemination of such information is narrow in scope. The EMH does not apply universally to all assets in all markets.

Question 48

Describe the following behavioral concepts, and why they may be harmful to an investor: loss aversion

Answer 48

Investors do not like to lose, and there is a tendency to keep losing investments (in the hopes of breaking even) and selling winners, which in the long run will create a portfolio of losers. Some stocks may never get back to the investor’s purchase price, or may take a long time to do so. In the meantime the money could have been invested more productively elsewhere.

Question 49

Describe the following behavioral concepts, and why they may be harmful to an investor: fear of regret

Answer 49

Investors don’t want to miss out on what may be an opportunity, so fear of regret can drive them to invest without much thought or research, or they may hold on to an investment trying to break even so they don’t feel bad about making the investment in the first place. Regret can also be experienced when a stock takes off and the investor either did not buy it or sold it before the price increase.

Question 50

Describe the following behavioral concepts, and why they may be harmful to an investor: overconfidence

Answer 50

We all overestimate our abilities, and with investments it can lead to decisions based upon our limited knowledge. There are often many factors about an investment that the investor knows little or nothing about, and has no control over. In bull markets, investors often credit themselves for returns based on what they believe are their smart decisions and savvy stock-picking ability. Overconfidence is strongest in male investors.

Question 51

Describe the following behavioral concepts, and why they may be harmful to an investor: framing

Answer 51

Framing is how something is presented to an individual, such as buying a “$50” shirt for $35. With investments, individuals will often choose a guaranteed positive outcome (while avoiding a chance of a greater gain that also carries the possibility of no gain at all), but they will take a chance to avoid a negative outcome (rather than take a certain smaller loss).

Question 52

Describe the following behavioral concepts, and why they may be harmful to an investor: hindsight bias

Answer 52

Hindsight is 20-20 and, looking back, events seem more predictable than they were. If a financial professional recommends an investment and it turns out well, the client tends to think they liked it from the start. However, if an investment turns out poorly, the client thinks they had doubts to start with.

Question 53

Describe the following behavioral concepts, and why they may be harmful to an investor: anchoring

Answer 53

Anchoring refers to holding certain beliefs and then not changing those beliefs even with new information. For example, it may cause an investor to underreact to new information (such as poor earnings) with the expectation that it is just a glitch, when in fact it may be the beginning of a string of bad earnings because of a fundamental change in that industry.

Question 54

Describe the following behavioral concepts, and why they may be harmful to an investor: recency

Answer 54

Recency involves putting too much weight on current events and not taking into account enough past or historical trends. For example, in the bull market in the 1990s some investors were projecting 20% returns into retirement, while historical returns are half that amount.

Question 55

Describe the following behavioral concepts, and why they may be harmful to an investor: mental accounting

Answer 55

Mental accounting is when individuals divide their assets into different pockets. A gift of $500 (which may be treated as found money) is not treated the same as $500 of earnings, but in each case the individual has the same amount. Mental accounting also occurs when an investor treats each of their accounts separately rather than looking at them as part of their overall portfolio.

Question 56

Name the behavioral bias being exhibited in the following scenario: a client makes investment decisions based upon stereotypes

Answer 56

representativeness

Question 57

Name the behavioral bias being exhibited in the following scenario: a client believes that the U.S. stock market will always bounce back quickly as it has done in the past

Answer 57

status quo bias

Question 58

Name the behavioral bias being exhibited in the following scenario: a client wants a 5% return and doesn’t take into account what the inflation rate may be

Answer 58

money illusion

Question 59

Name the behavioral bias being exhibited in the following scenario: a client does not have a realistic expectation of what the value is of an investment they want to sell

Answer 59

endowment bias

Question 60

Name the behavioral bias being exhibited in the following scenario: a client blames others for his losses while taking personal credit for any gains

Answer 60

self-attribution bias