8. Investment Theories Flashcards
How is correlation between asset classes measured?
(1) perfect negative
(1)-0 negative
0 no correlation
0-1 positive
1 perfect positive
What is the optimum number of shares for a diverse portfolio?
30
What is the efficient frontier used for?
To identify the portfolio that gives the best potential return for the risk and investor is prepared to take
Or
The lowest level of risk for a desired return
What is the efficient market hypothesis and what are the 3 versions?
Impossible to beat the market as all info is public
Weak; prices reflect historic info so no guide to future
Semi-strong; prices reflect historic info and instantly change but all participants have access to the info
Strong; not even those with insider info can beat the market
What is the random walk hypothesis?
Prices are determined by random factors that cannot be anticipated
What is the purpose and calculation of the CAPM
Calculates the appropriate price to pay for an asset for the risk:
Risk premium = expected return - risk free rate
Or the return to be expected based on the price:
Expected return = risk premium + risk free rate
What are the 3 principles behind CAPM?
Investors want return higher than risk free rate
Non-systematic risk can be reduced by diversification so no premium is required to compensate for it
Investors require higher return from shares with higher systematic risk
What are the 7 assumptions of the CAPM?
- Investors have a preference of risk/return and are naturally risk averse
- Investors make decisions solely on risk/return
- no individual buyer/seller can affect the market
- no transaction costs/taxes
- inherent risk of a share is systematic and non-systematic
- non-systematic risk can be diversified away
- systematic risk is the only relevant risk; the risk premium of an asset is it’s contribution to the diversity of the portfolio
What are the 4 limitations of the CAPM?
- can be difficult to estimate risk free return
- not suitable for periods >12 months
- beta figures are based on historic performance - not reliable for future
- market pricing includes element of non-systematic risk
What is the arbitrage pricing theory?
Independent factors impact the expected risk premium - macro and micro
What are the 3 main examples of investor psychology?
Heuristics; people make decisions based on ideas rather than analysis
- cognitive bias; apply into to own experience or swayed by beliefs
- herd mentality
- confirmation bias
Framing; reacting/concluding according to how a problem is expressed/presented
Market inefficiency; ignoring experts
What is a contrarian investor?
One who goes against the crowd
What are the 2 fair value methods?
Discounted cash flows
Relative value - comparables
Risk premium calculation
(expected return - risk free rate) x beta
