Chapter 4 - Investment theory

Question 1

What is standard deviation?

Answer 1

It measures how widely the actual return varies around its average or expected return. The higher the standard deviation, the greater the volatility.

An investment with returns staying close to its expected return is said to be low risk and has a low standard deviation.

Question 2

What are the standard deviation rates (%) within:
* 1 Standard deviation
* 2 Standard deviation
* 3 Standard deviation

Answer 2

• 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).

Question 3

If the standard deviation is bigger, what does this mean for the volatility/risk?

Answer 3

The bigger the standard deviation, the wider the range, and the more volatility and risk.

Question 4

Fund A has a mean of 9%, and a standard deviation of 2%, what would the range be for 2 standard deviations?

Answer 4

5% &13%

(9-2-2 & 9+2+2)

Question 5

What are the two main methods that an investor can use to construct a low risk portfolio?

Answer 5

1. They could simply buy low risk assets, but this will almost certainly result in low returns.
2. 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. So to reduce risk, you could invest in both umbrella and ice cream shares.

Question 6

Diversifying can remove either:
* systematic risk
* unsystematic risk
Which one?

Answer 6

Unsystematic risk

Systematic risk (market risk) affects the whole market, this cannot be removed by diversification
unsystematic risk is investment specific

Question 7

What is ‘positive correlation’ ?

Answer 7

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).

Question 8

What is ‘negative correlation’ ?

Answer 8

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.

Question 9

What is ‘No correlation’ ?

Answer 9

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 waffle company have no correlation. You would not be able to assess the market using their profit/loss at any time of the year

Question 10

What are some ways to maximise diversification?

Answer 10

• 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 petrol 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.

Question 11

What is the ‘efficient frontier’ ?

Answer 11

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.

Question 12

Go to page 122 of the Cii book, compare the following portfolio’s on the efficient frontier graph:

• Portfolio A vs. portfolio B
• Portfolio B vs. portfolio C
• Portfolio C vs. portfolio D
• Portfolio D vs. portfolio E
• Portfolio A vs. portfolio C vs. portfolio E

Answer 12

• Portfolio A is a better choice because it offers the same return as portfolio B, but at a lower level of risk.
• Portfolio C is a better choice because it offers a higher return for the same level of risk as portfolio B.
• Portfolio C is a better choice because it offers the same return as portfolio D, but at a lower level of risk.
• Portfolio E is a better choice because it offers a higher return for the same level of risk as portfolio D.
• It is difficult to choose between these portfolios. Portfolio A offers a low-risk, low-return strategy, while both portfolios C and E offer higher levels of risk but with higher returns. The portfolio selected will depend on the risk preference of the individual investor.

Question 13

What is Capital Asset pricing model (CAPM)

Answer 13

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.

Question 14

If an investment has a beta of 1.4, is this more or less volatile than the market?

Answer 14

More volatile, the market has a beta of 1 so a higher beta would mean that if the market goes up, the investment will go up more. The same as if the market was to drop.

Question 15

What does beta measure?

Answer 15

Beta measures the sensitivity of a security to a market

Question 16

How would you calculate the CAPM formula?

Answer 16

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%

Question 17

What is Modern portfolio theory (MPT)?

Answer 17

• 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

Question 18

What is hedging?

Answer 18

Protecting an existing investment by adding another that will increase if the existing fund falls.

Question 19

Why, in theory, should investment managers construct portfolios to lie on the efficient frontier?

Answer 19

The efficient frontier represents the set of portfolios that have the best risk reward trade-off, so for any level of risk the portfolio on the frontier with that level of risk will give the best return for the investor.

Question 20

What is the difference between Arbitrage pricing theory (APT), and CAPM?

Answer 20

• APT is based on the belief that there is more than one type of risk to a securities returns. Different securities have different sensitivites to each risk
• CAPM is based on the systematic risk the security is exposed to, rather than the total risk

Question 21

What is the most common risk fee asset used in the CAPM equation?

Answer 21

Common practice is to pick the return on UK Government Treasury bills. These are 91-day money market instruments issued by the Government; there is virtually no default risk and, because of their short life, the interest rate and inflation risks are minimised.

Question 22

What are the 3 forms of Efficient market hypothesis (EMH)?

Answer 22

1. weak-form efficiency;
2. semi-strong efficiency;
3. strong-form efficiency.

Question 23

Explain weak-form efficiency. (In terms of Efficient market hypothesis)

Answer 23

This states that the current security price is fully reflective of all past price and trading volume information, and future prices cannot be predicted by analysing this type of historic data

Question 24

Explain semi-strong efficiency. (In terms of Efficient market hypothesis)

Answer 24

This states that security prices adjust to all publicly available information very rapidly and in an unbiased way, so that excess returns cannot be earned by trading that information.

Question 25

Explain strong-form efficiency. (In terms of Efficient market hypothesis)

Answer 25

This states that security prices reflect all the information that any investor can acquire. Both public and private information, typically held by corporate insiders such as executives of a company

Question 26

What is behavioural finance and how does it affect the market?

Answer 26

It is an area of research that explores how emotional and psychological factors affect investment decisions.

it highlights inefficiency is caused by the irrational way in which investors react to new information, which causes market trends inspect of bubbles.

Think how people react when certain companies make headlines, usually negative

Question 27

What does the effectiveness of diversification depend on?

Answer 27

The effectiveness of diversification in reducing a portfolio’s risk depends on the degree of correlation between assets.

Pointless having 15 funds/stocks if they are all positively correlated