Chapter 3: The merits and limitations of the main investment theories Flashcards
In exam - 7 questions, standard multiple choice
What is standard deviation
Standard deviation measures how widely the actual
return on an investment varies around its average or mean return.
The greater the standard deviation, the more it varies from its average return.
In investment terms, this means that a higher standard deviation means that the investment has higher volatility, and therefore a greater risk
What are the standard deviation rate (%) within:
* 1 Standard deviation
* 2 Standard deviation
* 3 Standard deviation
- 68%
- 95%
- 99%
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 the standard deviation is bigger, what does this mean for the volatility/risk?
The bigger the standard deviation, the wider the range, and the more volatility and risk.
Fund A has a mean of 9%, and a standard deviation of 2%, what would the range be for 2 standard deviations?
5% &13%
(9-2-2 & 9+2+2)
What are the two main methods that an investor can use to construct a low risk portfolio?
- They could simply buy low risk assets, but this will almost certainly result in low returns.
- They could buy risky assets, and then combine them in a way that collectively reduces the risk. This is achieved either by diversification and/or hedging the risk.
For 2, think Umbrellas & ice creams. When umbrella sales go up (bad weather) ice cream sales go down, and vice versa
What is ‘positive correlation’
Where values and share prices move in the same direction (generally) as they are influenced by the same things. Usually companies in the same sector (i.e. Nike, Adidas & Puma).
They may perform slighty differently. but they will experience similar seasonal performances and taxation
What is ‘negative correlation’
Where profits of companies move in opposite directions. They are in completely different sectors and experience different types of challenges.
A sun cream manufacturer and a raincoat company will have wildly different profits in November, for example.
What is ‘No correlation’
Where profits of companies have no relationship to each other at all. They are affected by different things at different times with no similarities or difference.
A car company in Japan & an American ice cream firm have no correlation. You would not be able to assess the market using their profit/loss at any time of the year
What are some ways to maximise diversification?
- 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 retailers.
- Including overseas assets. The UK isn’t always in economic sync with the rest of the world. Currency exchanges can also have a positive or negative influence on performance.
What is the ‘efficient frontier’
It explains the relationship between the return that can be expected from a portfolio and the portfolio’s risk. Using the portfolio’s standard deviation to measure risk
Capital Asset pricing model (CAPM)
CAPM states that ‘in order to consider a risky asset, an investor would want a return that equals the risk-free return plus, as a form of compensation, an additional return that takes account of the risks taken’.
If a client is getting 2% interest in their bank account, they would want that 2% plus extra in order to take the risk.
CAPM measures the riskiness of a security by comparing it to the market, using ‘beta’ as part of its measure. The market has a ‘beta’ of 1, which is the benchmark to compare a security against.
CAPM
What is the ‘beta’ in relation to CAPM?
The beta of an individual security is a historical measure of the risk associated with it, compared to the market as a whole.
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.
How would you calculate the CAPM formula?
Subtract the risk-free off the market return, multiply it by the Beta,
and then add the risk-free back in, or: ‘(Risky x Beta) + Risk free’. Figure is expressed as a percentage.
Example -
What is the expected return for Johnson’s Sweets if it has a beta of 1.4, the expected return on a Treasury Bill is 2.6% and the expected return on the market portfolio is 7%?
Subtract the risk free (2.6%) from the risky (7%) = 4.4%
We only apply the beta calc to the risky element - (4.4 x 1.4) +2.6 = 8.76%
Modern portfolio theory (MPT)
- Consideration of how each investment changes in price relative to the others in the portfolio, rather than looking at risk and returns of the fund individually
- Idea that investors would always chose the portfolio with less risk if the returns were the same, risk is only taken to achieve higher reward
Hedging
Protecting existing investment by adding another that will increase if the existing fund falls
