Chapter 10 - Investment Theory Flashcards
Modern Portfolio Theory
Portfolios can be constructed to maximise returns and minimise risks.
Standard Deviation
Measures how widely the actual return on an investment varies around its average or expected return. The greater the standard deviation, the greater the volatility/risk.
Hedging
Hedging means protecting an existing investment position by taking another position that will increase in value if the existing position falls in value. One way that this can be achieved is by using derivatives.
Positive Correlation
The profits and share values of many companies move up and down together. They are affected by the same thing.
Negative Correlation
The profits and share values of some companies move in opposite directions and therefore have a negative correlation.
No Correlation
The profit and share values of some companies are not related to each other in any way.
Limitations to using efficient frontier
Assumes standard deviation is the correct measure of risk and assumes assets have normally distributed returns
Difficult to say which portfolio fits clients attitude to risk
Inputs for risk and correlation rely on historical data, which is not stable.
Does not include transaction costs
Assumptions for CAPM
Investors are rational and risk averse
All Investors have identical holding period
No taxes, transaction costs and restrictions on short-selling
Information is free
Arbitrage Pricing Theory
General theory of asset pricing that has become influential in the pricing of securities. It is based on the idea that a securities returns can be predicted using the relationship between the security and a number of common risk factors.
Efficient Market Hypothesis
It is impossible to achieve returns in excess of average market returns consistently through stock selection.
Three forms of EMH
Weak-form efficiency
Semi-strong efficiency
Strong-form efficiency
Weak-form efficiency
Only uses historic information for technical analysis
Semi-strong efficiency
Uses historical financial data and also public information to base analysis
Strong-form efficiency
Uses all information, historical data, public information and private company information
Behavioural finance
How emotional and psychological factors affect investment decisions.
Prospect theory/loss aversion
Deals with the idea that people do not always behave rationally in respect to their risk tolerance when facing a loss or making a profit.
