8. Investment theories Flashcards
Correlation between asset classes
Correlation looks at the linear relationship between two types of asset in terms of
performance, measured in numbers from +1 to ‑1: the extent to which asset classes tend
to rise and fall together.
How is correlation between asset classes expressed? What do each mean?
4 types of correlation
- A correlation above 0 is said to be a positive correlation, getting stronger the
nearer it gets to +1. - A correlation below 0 is said to be a negative correlation, getting stronger the
nearer it gets to ‑1. - A correlation of +1 will be a perfect positive correlation, while a correlation of ‑1
will be a perfect negative correlation. - A correlation of 0 would indicate no correlatation - they would move up of down independantly of each other.
A well diversified portfolio should ideally have a correlation of…
- Close to 0, or slightly negative
- The ideal portfolio would look for low correlation between assets.
Assets with a perfect correlation cancel each other’s benefits out - as one rises by X, the other falls by X
4 broad asset class categories
8.4 Asset allocation
- Cash
- Fixed-interest securities (Gilts & Bonds)
- Equities
- Property
The investor’s (or manager’s) objectives will dictate which of the classes are appropriate
for them. If their objective is primarily income, a significant part of the investment portfolio will be allocated to…
8.4 Asset allocation
- Fixed-interest securities (bonds&gilts)
- Cash
Additionally:
* Income-producing shares (dividends)
* Collectives
To provide potential for capital growth, otherwise the income will remain static and inflation will errode it’s value
The investor’s (or manager’s) objectives will dictate which of the classes are appropriate
for them. If their objective is capital growth, a significant part of the investment portfolio will be allocated to…
- Equities
- Properties
Would not choose Cash or fixed-interest securities as they do not provide significant captial growth
How many shares do experts suggest a portfolio should contain to provide a high level of diversification?
8.4.1 Further diversification
most experts agree that a portfolio of 30 shares will give a high level of protection
Trade off for Hedging
Reduced risk but lower returns.
Modern Portfolio theory key point about investment decisions…
What should investment decisions be based around?
Investment decisions should be based on the investor’s overall attitude to risk and reward rather than on selecting individual shares or assets that might be attractive in terms of risk and reward.
The underlying principles of the modern portfolio theory
- Beating the stock market by selecting specific shares (stock picking) is very hard.
- Achieving such an outcome involves taking an above‑average degree of risk.
- Taking the additional risk would result in higher losses if the market were to fall.
- Even a share offering long‑term growth potential could be in danger from volatility, particularly if the investor’s investment objective has a relatively short time span.
- Volatility can be reduced effectively through diversification.
- The total volatility of a diversified portfolio of shares will be lower than the averagevolatility of the individual shares in it.
What does the efficient frontier help with?
8.6.1 The efficient frontier
Helps to identify the optimum level of diversification in a portfolio.
It states that the perfect investment portfolio would combine assets so that:
* Individual volatility is balanced out
* The total package has a lower standard deviation thatn its individual componets
* Carries the lowest level of risk for the return they require
Key points of the Efficient market hypothesis
States that
* Its impossible to outperform the market because all the relevant information requrire to analyse shares is in the public domain and relfected in the prices
* Shares therefore always trade for a fair value
* Implies fund managers are obsolete; a tracker fund would produce similar results with a much lower cost.
Three version of the efficient market hypothesis
Weak - assumes that prices on the markets reflect all past publicly
available information including past volume and price data. Basing decisions on past performance will not earn additional returns, and that technical analysis is of little use.
semi-strong - assumes that prices reflect all publicly available information
and instantly change to reflect new information.
Strong - Even those with ‘insider-knowledge’ (i.e. insider trading) can ‘beat the market’
Capital asset pricing model
what is it used to determine?
The CAPM is a model used to determine the expected return on an asset based on its risk, establishing the appropriate price or return for the risk taken.
Key Factors:
- Asset Sensitivity to Systematic Risk: Measure of how much the asset’s returns move with the market.
- Expected Market Return: Average historical return of a market portfolio (e.g., FTSE All Share, S&P 500).
- Risk-Free Rate: Return on an investment with minimal risk (e.g., UK Treasury bills).
Terms:
- Risk-Free Rate: Returns from very low-risk investments, such as T-bills, which are government-issued and short-term.
- Expected Market Rate of Return: Calculated from average historical market returns.
- Risk Premium: Difference between the expected market return and the risk-free rate, adjusted for the asset’s systematic risk (beta).
Arbitrage pricing theory
Definition: APT is a model that relates expected risk premium to multiple independent factors impacting asset returns, using fewer assumptions than the Capital Asset Pricing Model (CAPM).
Categories of Factors:
- Macro Factors: Economic growth, unemployment, interest rates.
- Company-Specific Factors:New contracts, loss of contracts, supply and demand, management changes, legal issues.
Key Differences from CAPM:
* Risk Measurement: APT uses multiple betas for various factors, while CAPM uses a single beta for systematic risk.
* Focus: APT relates share prices to factors directly influencing the asset rather than the overall market.
Challenges:
Identifying relevant factors and calculating individual betas for each can be complex, making APT harder to apply than CAPM.
