Chapter 3 (7 MARKS) – The Merits And Limitations Of The Main Investment Theories

Question 1

What is Modern Portfolio Theory?

Answer 1

Modern Portfolio Theory (MPT) focuses on optimizing investment portfolios to maximize returns for a given level of risk.

The main points it includes are:

It is includes the Efficient Frontier: Identifying portfolios that offer the highest return for a given risk level.
.

Answer 2

Question 3

When the results are spread apart, and the bell curve is relatively flat, that tells you that you have a relatively large standard deviation.

Answer 3

When the results are pretty tightly bunched together, and the bell-shaped curve is steep, this means that the standard deviation is small.

Most results are pretty near the average.

Standard deviation establishes the level of risk of a certain investment by plotting investment performance that investment from previous years and then plotting it on a graph. It generally follows the shape of a normal distribution curve

Question 4

The ‘rules’ of SV are:

In normally distributed data…

68% of outcomes will be within 1 standard deviation of the mean

95% of outcomes will be within 2 standard deviations of the mean

99%+ of outcomes will be within 3 standard deviation of the mean

Answer 4

This means that, if we know the standard deviation, we can estimate that any value is:

likely to be within 1 standard deviation (68 out of 100 should be).

very likely to be within 2 standard deviations (95 out of 100 should be).

almost certainly within 3 standard deviations (997 out of 1000 should be).

If this curve were flatter and more spread out, each standard deviation would have to be wider in order to account for those 68 percent or so of the data. The bigger the standard deviation, the wider the range, and therefore the more volatility and risk. If you plotted cryptocurrencies you would find that there is massive volatility shown by the size of the standard divations

Investments that stay close to their expected return are said to be low-risk and have a low standard deviation

An investment with wildly fluctuating returns that achieves the same end result will be described as high risk. It would have a higher standard deviation.

The more volatile the return, the greater the risk, and the greater the standard deviation.

To monitor standard deviation, you need to understand what an investment is expected to achieve, what it has achieved and the fluctuations it has experienced in achieving the returns.

Question 5

Example of standard deviation being using to assess the risk level of a made up investment to show how it is applied in the real world

Answer 5

Made up investment:
The BTS UK equity OEIC.

The first figure to establish is the expected return of the BTS fund.

To achieve this, we’ll take its average return, or mean as it is referred to.

For our example, we’ll assume that the BTS fund has a mean of 9% and a standard deviation of 2%.

Image right is more risky and volatile than the left image because the standard deviation in return is higher.

As you can see Standard deviation uses historic data…to monitor standard deviation, you need to understand what an investment is expected to achieve, what it has achieved and the fluctuations it has experienced in achieving the returns.

Question 6

How standard deviation is applied to an investment to measure its risk

Answer 6

Remember, for normally distributed data, the returns can therefore be expected to lie:

within one standard deviation roughly 68% of the time.

within two standard deviations 95% of the time and

within three standard deviations 99.7% of the time.

It shows that you would expect to achieve receive somewhere between 5-13%, 95% of the time for example.

This only works for investments though IF returns are distributed normally (like a typical normal ditribution curve. It would work if results were all over the place for example

Question 7

Answer 7

Question 8

Example of diversification in action

What does diversification not protect against?

Answer 8

It cannot remove market risk or systematic risk.

Question 9

Diversification is best achieved by combining assets that move in different directions. Ie how they are correlated.

There are 3 types of correlation. What are they, what do they mean?

Answer 9

NOTE the example in the image is correlation between investing in companies but it applies to all assets classes and investments

History shows that mixing negatively correlated assets achieves the best diversification. But, whilst this could help reduce the overall risk profile, a pessimist could say that this could simply mean that the losses of one asset offset the gains of another.

Question 10

Having assets that are negatively correlated (where one grows whilst the other falls) within your portfolio is a great way to achieve diversification.

Is achieving negative correlation of your assets within your portfolio easy or hard?

Answer 10

It is not an easily-achievable investment strategy, because finding negatively-correlated assets in todays world is difficult for a variety of factors, such as globalisation

It is a good method of diversification though, and should be aimed for

Question 11

Tell me ways you can maximise diversification in your portfolio

Answer 11

Having assets that are negatively correlated (a big one but hard to achieve)

Holding different asset classes within a portfolio.
Not all asset classes respond in the same way to changes in the economic cycle.

Choosing companies from different sectors.
It may be better to combine a bank with a petroleum company and a retailer, rather than choosing three similar retailer for example

Including overseas assets.
All assets in the UK will suffer from the same domestic systematic issues that could occur. By having overseas investments, you may be protected from any domestic issues. Although, in such a globalised world where economies now commonly experience the same business cycles at the same time (or in other words are possibly correlated), you may still not be protected because other countries are likely to be suffering from the same issues at the same time.

Question 12

What is the Capital Asset Pricing Model?

A crucial part of your exam preparation is to understand the CAPM concept and formula.

You are almost certain to get at least one calculation question.

Answer 12

It states that ‘For an investor to consider a risky asset, the investor will want a return that equals the risk-free return, plus an additional return which is a form of compensation, for the higher risk taken. SEE IMAGE

It uses a formula and keep in mind when using the CAPM formula, all you are doing is establishing a return that has been adjusted for the risks being taken.

Looking at our definition, and applying Chris’ thoughts, he wants a return that equals:

the risk-free return (the 2% he’s getting in his building society)

plus, as a form of compensation,
an additional return (another 3%) that takes account of the risks taken.

Question 13

What does β (Beta) measure in relation to investments?

Answer 13

It measures the volatility of that asset compared to the market it sits in. This Beta value is then used used by the Capital Asset Pricing Model to assess the riskiness of the asset

The market itself always has a Beta of 1

If the asset is LESS volatile than the market, it will have a beta of less than 1

If the asset is MORE volatile than the market, it will have a beta of more than 1

Question 14

Which would you say has been the most volatile?

So which of these markets have the highest beta figure?

Answer 14

Market A!

Investing in market A shares looks like it would have been a much more bumpy ride for investors than Market B

This is a trick question.

All markets have a Beta of 1 no matter how volatile it is…it is the investable asset within the market that has a figure of less than 1 Beta (if it is less volatile than its market) or a figure of more than 1 Beta (if it is more volatile than its market) (Look at image)

Question 15

CAPM measures the riskiness of a security by comparing it to the market itself. What symbol does it use for this comparable measure.

Answer 15

It uses beta (β)

The market itself always has a Beta of 1

If the asset is LESS volatile than the market, it will have a beta of less than 1

If the asset is MORE volatile than the market, it will have a beta of more than 1

REMEMBER: The higher the beta of a security; the higher the risk, and the higher return investors should expect, so that they are rewarded for taking the added risk.

Question 16

In relation to the Capital Asset Pricing Model (CAPM), The higher the beta of a security; the higher the risk, and the higher return investors should expect, so that they are rewarded for taking the added risk.

What Beta value would you expect from shares of companies in areas that are not essential?

What Beta value would you expect from shares of companies in areas that are essential?

Answer 16

Companies with a beta of more than 1 tend to be in areas that are not essential, such as luxury goods and restaurant chains.

A security with a Beta between 0 and 1 would be more stable. Often utility company stocks or supermarket chains fall into this category, as they are dealing with the supply of life’s essentials.

Question 17

What kind of investment has a Beta of exactly1 (ie, therefore meaning has the exact same volatility of the market it is in)

Answer 17

A tracker fund

Question 18

The Capital Asset Pricing Model in context

Answer 18

Question 19

What is the CAPM formula

(You will get atleast one calculation in the exam)

Answer 19

With the formula keep in mind that you are trying to establish a return that has been adjusted for the risks being taken.

See image for formula (dont use this. Use below as it is easier)

Or use: (Risky X Beta) + Risk Free

Question 20

CAPM calculation

(You will get atleast one calculation in the exam)

Answer 20

Easy formula to use is

(Risky X Beta) + Risk Free = expected return

Risky = market expectation - risk free

Question 21

USE:

(Risky X Beta) + Risk Free = expected return

Risky = market expectation - risk free

Answer 21

Question 22

What are some restrictions to the CAPM formula?

Answer 22

Finding a risk-free rate for the formula is difficult. Therefore, common practice is to use 91-day Treasury Bills.

Choosing a market portfolio is sometimes easier said than done. The FTSE 100 index is commonly used in the UK but assessing the return on an inappropriate market portfolio can lead to incorrect assumptions.

Beta must be assumed to be stable and is calculated on historic data. Future validity of the formula is questionable

Question 23

What are multi factor models (MFMs)

Answer 23

They are models that calculate returns by taking into account several risk factors

They basically expand on the CAPM model, so more factors of taken into account

You have the arbitrage pricing theory model & Fama and French model as some examples of MFMs

Question 24

What is the Efficient Market Hypothesis?

READ 3.4 for the theory behind this. It is a very quick read

Answer 24

Basically it should be impossible to achieve returns higher than the market average over the longer term so people are better off investing in a tracker fund rather than pay for expensive fund managers

This is because share prices react to new relevant information, such as a companies profits announcement or external events, instantly so the shareprice you see is always the optimum it can be so there is no way to find an ‘undervalued share’ and capitalise on it.

There are 3 forms of EMH: See image
These are:

Weak Form Efficiency
Semi Strong Efficiency
Strong Form Efficiency

Question 25

There is a part of investment theory called behavioural finance. What is this?

behavioural finance categorises many psychological factors and behavioural biases that affects someone’s investment performance. Tell me some.

Wha

Answer 25

It concerns itself with how an investor’s decisions are affected by emotional and psychological factors.

It categorises many psychological factors and behavioural biases that affects someone’s investment performance. These are the main one

Prospect Theory and Loss Aversion:

Investors don’t act rationally when facing potential gains or losses. For example, losses cause more emotional distress than the satisfaction from equivalent gains or that Investors are more likely to take risks to avoid realizing a loss, hoping the asset will recover.

Regret:

Investors often keep their losing investments to avoid admitting they made a poor decision

Overconfidence and over and under reaction:

Investors overestimate their own skills and underestimate the likelihood of bad outcomes.

All the above investment behaviours have an effect on investment performance. Critics of behavioural finance state that it is impossible to predict the effect of human behaviour on the markets, however it is fair to say that investors could learn from the mistakes of others and be open about any fears in communications with advisers.

Question 26

Modern Portfolio Theory (MPT):

What does Modern Portfolio Theory suggest about constructing portfolios to maximize returns and minimize risk?

How is risk commonly measured in Modern Portfolio Theory, and what does a higher standard deviation indicate?

Explain how diversification can reduce risk in a portfolio and what can be done to achieve this

What is the difference between systematic risk and non-systematic risk in the context of MPT?

How does the efficient frontier help in portfolio management?

Answer 26

MPT suggests that portfolios can be constructed that maximise returns, and minimise risk, by carefully choosing different investments.

The most commonly used measure of risk is standard deviation. The higher the standard deviation, the higher the volatility and therefore the higher the risk. It is based off a ‘normal curve distribution’ in statistics

Diversification can be used to reduce risk and the effectiveness of diversification depends on how the assets correlate with each other. Combining different asset types, in different sectors, over different geography, can all help the effective diversification of a portfolio.

There are two component risks. Systematic or market risk, which you cannot diversify against, and Non-systematic or investment risk, which can be removed with carefully diversified (using un-correlated assets) fund selection.

The efficient frontier plots funds with the ultimate portfolio sitting on the efficient frontier line. .

Question 27

Capital Asset Pricing Model (CAPM):

What is the Capital Asset Pricing Model (CAPM) and what does it aim to provide?

What are the main components of the theoretical expected return according to CAPM?

Answer 27

CAPM is a model that provides the theoretical expected return for a security as a combination of the return on a risk-free asset and the added return of risky assets.

It is based on assumptions, some of which hold more sway than others.

It uses Beta as its measure

Multi-factor models add more factors to the equation of CAPM in arriving at their assumptions.

Question 28

Efficient Market Hypothesis (EMH):

What does the Efficient Market Hypothesis (EMH) state about the availability of information and its effect on security prices?

Describe the three forms of the Efficient Market Hypothesis.

If EMH is correct, why might investors prefer passively-managed tracker funds over actively-managed portfolios?

Answer 28

EMH argues that active fund management is more about luck than judgement

It states that information about companies is freely available and, as such, the prices of securities always reflects the companies’ true worth because shares react instantly to new presented info

There are three forms: Weak, Semi-strong and Strong.
If EMH is correct, investors would be best served by passively-managed, tracker funds, as opposed to expensive fund managed portfolios.

Question 29

Behavioural Finance:

How does behavioural finance differ from traditional technical analysis in understanding investor behaviour?

Explain the concept of loss aversion in behavioural finance.

Why might investors be reluctant to sell an asset at a loss, according to behavioural finance?

How do investors’ behaviours differ when trying to protect gains versus when attempting to recover from losses?

Answer 29

Contrary to technical analysis, believers in behavioural finance put more emphasis on psychological factors.

Investors are more upset by losses than they are happy with gains.

And some investors find it difficult to decide to sell at a loss when, actually, they would be better off cutting those losses.

Investors also tend to try to protect gains but are far more adventurous when trying to make up losses.

Question 30

An investor plans to build a portfolio on the principles of CAPM. What key factor needs to be considered?

Alpha

Beta

Covariance

Standard deviation

Answer 30

BETA

CAPM uses the expected market portfolio return, the risk-free return and Beta in its calculation. (remember formula)

Question 31

Adam is a high rate taxpayer and has a medium attitude to risk. He is considering what assets he should choose and has asked you to explain the efficient frontier. You explain that the efficient frontier shows the optimum balance between:

Risk and return

Taxation and risk

Return and diversification

Correlation and inflation

Answer 31

Risk and return

The efficient frontier shows the optimum portfolio for every unit of risk, which is measured by standard deviation.

Question 32

Amanda and Claire have shares in companies that operate in the same sector. Amanda’s shares have a beta of 1.4 whilst Claire’s have proved to be 30% more volatile than the market. This confirms that…

Claire’s shares have under-performed those of Amanda’s

Claire’s shares have over-performed those of Amanda’s

Claire’s shares are more volatile than Amanda’s

Claire’s shares are less volatile than Amanda’s

Answer 32

Claire’s shares are less volatile than Amanda’s

Explanation:

‘30% more volatile’ equates to a beta of 1.3.

So, Claire’s shares have a beta of 1.3, lower than Amanda’s at 1.4, so less volatile and less risky.

The market has a beta of 1 so anything about that is above average risk and anything below this is below average risk.

Question 33

When reviewing a customer’s collective investments, you notice that they have negatively correlated assets within them. This should ensure that…

they outperform positively correlated assets

they are offering a good amount of diversification

the beta of the fund is kept high

they have a high standard deviation

Answer 33

they are offering a good amount of diversification

There are 3 types of correlation, negative (which provides the widest diversification model), positive and no correlation.

High beta and high standard deviation = high risk, and you cannot say that they would outperform positively correlated.

Question 34

Ben asks you to explain the principles behind the efficient market hypothesis (EMH). You can tell him that…

the availability of information in a large-cap developed market means that it is likely that active managers will outperform the market over the long term.

it is possible to outperform over the long term by selecting undervalued equities in smaller companies.

in a semi-strong market the prices of securities reflects all known information, including private.

weak form EMH is due to the effect of irrational human behaviour on the market.

Answer 34

it is possible to outperform over the long term by selecting undervalued equities in SMALLER companies

Explanation:

Smaller companies tend to have fewer analysts researching them and as there is less information available the market is less efficient than that of larger companies. This means that it may be possible to identify undervalued securities and outperform over the long term.

Developed markets in large companies are efficient making it unlikely that active managers will outperform.

Private information being reflected in security prices would define strong form EMH, not semi-strong.

EMH is based on the principle that investors act rationally. (one of its criticisms) Behavioural theory is when investors act irrationally

Question 35

What is the expected return for Smith Consultancy if it has a beta of 1.4, a standard deviation of 6%, the expected return on the market portfolio is 14% and the expected return on a Treasury Bill is 5%?

24.60%

21.00%

26.60%

17.60%

Answer 35

CAPM formula is: (risky* x beta) + risk free

*Risky = expected return - risk free

The risky element is calculated by deducting the risk-free element from the expected market return. So, in this case 14 – 5 = 9%

So, (9 x 1.4) + 5 = 17.60%

The standard deviation is not required and is provided in the question to throw you off the scent!

Question 36

An investment portfolio consists of three assets which are correlated as shown in the table below.

Asset X / Asset Y / Asset Z

Asset X / 1.0 / 0.6 / 0.4

Asset Y / 0.6 / 1.0 / -0.2

Asset Z / 0.4 /-0.2 / 1.0

Based on this information you deduce that: Select correct answer

If asset X rises by 5% asset Y will rise by 3%

If asset Y rises by 8% asset Z will rise by 1.6%

If asset Z rises by 4% asset Y will fall by 1.0%

If asset X rises by 9% asset Z will rise by 3.2%

Answer 36

The way to approach these questions is to use the percentage quoted first in the question. So, in answer A: 5%, B: 8%, C: 4%, and D: 9%. Then multiply this by the figure in the line for the relevant asset you are comparing it with, so…

A: 0.6 x 5 = 3 (correct)

B: -0.2 x 8 = -1.6 (Z will fall)

C: -0.2 x 4 = -0.8 (no)

D: 0.4 x 9 = 3.6 (no)

Note:

This is the first time we have shown correlation relationships expressed in a table format.

It was a little unfair of us to introduce it via a question, but we hope it got you thinking!

We’ll re-visit correlation matrices later in this Study Guide!

Question 37

According to the efficient market hypothesis why is it sometimes better to invest in smaller companies over a long term than larger companies

Answer 37

Less public info is available for smaller companies so you may be able to find undervalued shares. With biggers companies this is said to be impossible because all relevant info is disclosed so their shares will be its optimum value at any given time

Smaller companies tend to have fewer analysts researching them and as there is less information available the market is less efficient than that of larger companies. This means that it may be possible to identify undervalued securities and outperform over the long term