Chapter 4 - Merits & Limitations Of The Main Investment Theories Flashcards
Modern Portfolio Theory - way in which portfolios can be constructed to (returns and risk), important to consider how what changes in what relative to what, assumes that investors are what and when higher risk chosen, implies what (invest and alternative), diversified port can provider (returns and volatility).
Risks - Standard Deviation
- measures what (actual return variation around)
- greater SD = what
- how calc’d
- rough rule (within one and two and average return % for each)
E.g. - mean 8% and SD 5%
When is SD acceptable (distribution of returns and what it forms), and mean how is distribution of what spread and what shape
Way in which portfolio’s can be constructed to maximise returns and minimise risks. According to this theory, important to consider how each investment changes in price relative to other investments in portfolios.
Assume that investors are risk averse with higher risk investment only chosen if offering a higher return. Implies that investor would not invest in a portfolio if an alternative more favourable risk-return port existed. Diversified portfolio of imperfectly correlated asset classes can provide higher returns with lower volatility.
Risk - Standard Deviation;
- measures how widely the actual return on investment varies around average or expected return.
- the greater the SD, greater the volatility and risk.
- calc’d on difference between mean and actual returns
- rough rule, return can be expected to fall within one SD of average return 68% of the time and within two 95% of the time when data normally distributed.
E.g. - mean 8% and SD 5%
- 68% of returns will fall between 3% and 13% (8+/-5)
- 95% will fall between -2% and 18% (8%+/- 2*5%)
SD is acceptable if distribution of returns forms what is called normal distribution. This means the distribution of expected returns is spread symmetrically around the mean in a bell-shaped distribution.
Modern Portfolio Theory - reduction of risk - what need to include to gent higher returns and two ways to reduce risk
Hedging - what is it (protecting investment by doing what), can be achieved using what and example (UK equities - contract and put options)
Diversification - how are fluctuations smoothed out, can remove what risk but not what risk and can also be achieved by (sectors and overseas)
Correlation - effectiveness of above depends on what, positive (profits and shares), negative (as before) and which one is most effective way of diversifying
To get higher returns, need to include riskier assets and then reduce risk through - hedging out risk or diversifying portfolio holdings.
Hedging - protecting an existing investment position by taking another position that will increase in value should existing investment fall in value. Can be achieved using derivatives.
- UK equities can be hedged by - selling future FTSE100 contracts
- buying FTSE100 put options.
Diversification;
- different types of assets react differently to certain conditions therefore fluctuations are smoothed out.
- Can remove investment specific risk but not market risk
- can also be achieved by choosing companies from different sectors and including overseas companies.
Correlation;
- effectiveness of diversification depends on the degree of correlation between returns on investments within portfolio.
- positive - profits and shares can move up and down together as effected by same things
- negative - profits move in opposite directions and most effective way of diversifying.
Modern Portfolio Theory - The efficient frontier - describes relationship between what (return and risk measured), plots what profiles of various what and shows what that can be expected for what (risk or lowest risk) to achieve what and rational investors will have what.
Inputs to model? - what of each asset (2) and c
Limitations - assumed what is correct measure of risk and assets have been what, ATR and other factors, historical data stability, correlations rise when and means (risk and diversify), transaction costs and affect on investors decision and assumed what (underlying portfolio is what and input data)
Describes the relationship between the return that can be expected from a portfolio and the risk of the portfolio as measured by standard deviation.
Plots the risk-reward profiles of various portfolios and shows the best return that can be expected for given level of risk or lowest level of risk to achieve an expected return. Rational investor will only have portfolio that lies somewhere on scale.
Inputs to the model are;
- return of each asset
- standard deviation of each assets returns
- correlation between each pair of assets returns
Limitations;
- assumed SD is correct measure of risk and assumes assets have been normally distributed.
- difficult to say which portfolio is best based solely on ATR as other factors may play a role on how portfolio is invested.
- inputs for risk and correlation rely on historical data which may not be stable.
- Correlations usually rise in financial crisis, meaning less risk will be diversified away than in indicated model.
- does not include transaction costs and investors may not want to change portfolio as often as model suggests due to this.
- assumes underlying portfolios in each asset class are index funds with same characteristics as the input data.
Modern Portfolio Theory - Systematic and non-systematic risk - what is it
Non-systematic or investment specific risk;
- uniqueness, independent of what, examples (3), how can risk be eliminated, how many securities to eliminate what and rate of risk reduction and market risk
Risk that markets go up and down due to news or events.
Non-systematic or investment specific risk;
- unique to particular company.
- independent of economic, political or other factors
- e.g. new competitor, technology breakthrough or change in credit rating.
- can be eliminated by holding diversified portfolio
- 15-20 securities should eliminate most of investment risk in portfolio
- rate of risk reduction diminished as more securities are added due to market risk remaining (levels out and some risk remains due to market risk)
Capital Asset Pricing Model - says that what is more appropriate measure of risk (sensitivity and market risk)
Beta
- market has beta or what number
- beta of security reflects what (return)
- how does security with beta equal to one move with market
- as above for security with beta with one or more, volatility and referred to as?
- security with beta less than one and more than zero are more what unless what (specific) and movement with market. Referred to as?
CAPM says that sensitivity of security to market risk is more appropriate measure of risk.
Beta;
- market has a beta of one
- beta of security reflects extent to which a security’s return will move up and down.
According to CAPM;
- a security with beta equal to one is expected to move up and down exactly with the market.
- a security with a beta of one or more exaggerates market movement and is more volatile than the market. If market goes up, security will go up and vice versa. Often referred to as aggressive securities.
- a security with a beta less than one and more than zero usually more stable (unless high level of specific risk) and move less than the market but in same direction. Referred to as defensive securities
Capital Asset Pricing Model Equation - formula
Then explanation of individual part, then brackets then second half of equation
Example - treasury bills 3%, market portfolio return 7% and beta of 1.3
- what does percentage tell us
E(Ri) = Rf + Bi (Rm - Rf)
E(Ri) - expected return on the risky investment
Rf - rate of return on a risk-free asset
Rm - expected return of market portfolio
Bi - measure of sensitivity of investments to movement in overall market
(Rm-Rf) - market risk premium i.e. excess return of the market over risk-free rate
Bi(Rm-Rf) - risk premium of risky investment
3+1.3(7-3) = 8.2% expected annual return
Assumptions for the CAPM
- rational and risk and decision making
- holding period
- market comprises of many who (2) and individuals affect on market price
- assumed no (3)
- information is what for investors
- borrowing and lending and risk
- quantity of risky securities is what and liquidity
Although assumptions may be what, can still provide what that illustrates what (returns and risk)
- investors are rational and risk averse and make decisions based on risk and return alone.
- all investors have identical holding period.
- market comprises of many buyers and sellers and no one individual can affect market price.
- no taxes, transaction costs and no restrictions on short selling.
- information is free and simultaneously available to all investors.
- investors can borrow and lend unlimited amounts of money at the risk free rate.
- quantity of risky securities in the market is fixed, and are fully marketable (meaning liquidity of asset can be ignored)
Whilst assumptions may be flawed, can still provide relative data that illustrates expected returns and their relationship to risk.
Limitation of CPM
- risk free return difficulty and usually use what as risk free asset
- market portfolio is usually what, indices beta, may not represent what (portfolio), beta and reliability, studies have shown no relationship between what (return, risk free and beta) but more support over what term
- assumptions
- finding a risk free return is difficult and usually treasury bills picked as risk free asset.
- market portfolio usually national share market such as FTSE 100 and each indices beta is different. Question whether these represent true market portfolio.
- beta of a security must be stable and predictable which questions their reliability for estimating future risk.
- Some studies have found no relationship between excess return on a security over risk-free rate and its beta. More support for models over long term.
- assumptions may be unrealistic
Multi Factor Models - allows for different what and identifies factors contribution to what, difficulty and variants share two ideas (extra return and risk and diversification)
Farma & French model - how expanded CAPM (adding what factors) and found two types of securities do what compared to market - small cap stocks and value stocks outperforming what (two separate points)
These models make more detail prediction of what (2) and improve understanding of
Allows for different sensitivities to different factors (inflation, business cycles etc) and identifies each factors contribution to the security’s return. Difficult to know what factors to add. All variants of model share two basic ideas;
- investors require extra return for taking risk
- they appear to be predominantly concerned with risk that cannot be eliminated by diversification.
As such, Farms & French Model expanded CAPM by adding factors for company size and value in addition to market risk. And found that two types of company securities tended to do better than market as a whole;
- small cap stocks outperformed large cap
- value stocks tended to outperform growth stocks
These models are able to make a more detailed prediction of risk and return, while improving our understanding of security returns.
Arbitrage Pricing Theory - based on idea that what can be predicted using relationship between what (security and risk) where sensitivity to changes represented by what (beta). Model used to correctly do what? (Price) and if diverges what brings it back in line and why (yield and sensitivity)
Arbitrage meaning - taking advantage of what to make what
- argues that returns are based on what
- how different to CAPM in terms of asset prices and market risk
- expected returns determined how (risk free rate and risk premium)
- portfolio
- assumptions
Limitations - generality and factors
- factors, time and economy
Based on idea that security’s returns can be predicted using the relationship between the security and number of common risk factors where sensitivity to changes in each factor is represented by a factor specific beta. Model can be used to correctly price the security and if it diverges then arbitrage activities should bring it back in line so it is not possible for security to yield better returns that indicated by sensitivity to factors.
Arbitrage - is the practice of taking advantage of security mispricing to make a risk free profit.
- argues that returns are based on systematic risk rather than total risk.
- different to CAPM in that APT is based on belief that asset prices are determined by more than one type of market risk.
- expected return is determined by +ing the risk-free rate to figures representing the risk premium for each risk factor.
- assumes each investor holds unique portfolio
- more flexible assumptions that CAPM
Limitations;
- too general, does not tell us which factors are relevant.
- number and nature of factors likely to change over time and between economies.
Four important factors that influence security returns;
- unanticipated inflation
- changes in expected level of industrial production
- changes in default risk premium on bonds
- shifts in yield curve
Efficient Market Hypothesis - indicated there are no what (securities)and prices represent what (value) and why (information)
Weak form efficiency;
- current security prices reflect what (price and info)
- future prices and historical data
- technical analysis no use in what (prices) and wont do what (returns)
Semi-strong efficiency;
- security prices adjust to what (info) and how (speed and bias) and why (returns)
- financial statements are no help in forecasting what
- analysis and over or undervalued (fundament and technical)
Strong-form;
- prices reflect what
- includes what type of info
- indicates there are no overvalued or undervalued securities and security’s price represents their actual intrinsic value as their prices reflect all available information.
- for this reason, outperforming the market is chance rather than skill.
Weak-form efficiency;
- current security prices fully reflect all past price and trading volume information.
- future prices cannot be predicted by analysing historical data.
- therefore technical analysis no use in determining future prices and won’t be able to consistently produce marker-beating returns.
Semi-strong efficiency;
- security prices adjust to all publicly available information rapidly and unbiased so no excess returns can be made by trading on that information.
- indicates companies financial statements are no help in forecasting future price movements.
- implies that neither historical performance (fundamental analysis) nor historic trading data will reliably be able to help identify if security is over or under valued.
Strong form efficiency
- security prices reflect all information that any investor can acquire.
- included public and private information
Evidence to support the EMH - evidence for weak form has found what (technical analysis and performance after transaction costs)
- semi-storing - strong what but what?
- Strong - evidence suggest that who can outperform other investors but on average what?
Efficient market debate plays a key role in what? and if correct investor should? And less efficient market offers chance to what?
- strong evidence for weak-form efficiency as most have found technical analysis does not lead to out-performance after transaction costs are taken into consideration.
- semi-strong - strong factual support but inconclusive.
- strong - evidence to suggest that company directors and their advisers can out perform other investors. However, investment managers on average do not.
Efficient market debate plays key role in decision between active and passive investment. If correct, one should invest in tracker or index funds. Although where markets are less efficient, chance to outperform them.
Behavioural finance - area of research that explores (straightforward), attempts to explain what that can’t be explained by others models and what else (anomalies and security deviation)
Prospect theory/loss aversion
- biases, weights and loss aversion (research and risk)
Regret;
- selling stocks and loss avoidance
Overconfidence and under-reaction;
- optimism and pessimism with market movements
- overconfidence causes (knowledge, risk and events) which leads to (trading and spec)
Area of research that explores how emotional and psychological factors affect investment decisions. Attempts to explain market anomalies that cant be explained by other financial models and why securities deviate from fundamental values. Argue that psychological factors affect investors and may cause them to reach incorrect conclusions.
Prospect theory/loss aversion
- persistent biases that influence choices and
- people place different weights on gains and losses
- research shows investors often take riskier decisions if there’s possibility of losing money (loss aversion).
Regret;
- investors avoid selling stocks that have gone down to avoid pain of loss.
Overconfidence and under-reaction;
- investors more optimistic when market goes up and more pessimistic when goes down.
- overconfidence causes investors to overestimate the reliability of their knowledge, underestimate risk and exaggerate ability to control events which can lead to excessive trading volumes and speculative bubbles.
Criticisms of behavioural finance - do not predict what (market and human behaviour), factors little us in what and why and argue that this is just what and not true branch + priced out.
However, understanding behavioural finance can do what (investors and advisers)
- do not predict the effect on the market of human behaviour
- behavioural and psy factors little use in forecasting markets as this cannot be quantified.
- argue that this is just explanation of anomalies and not to a true branch of finance and Anamolies eventually priced out.
However, understanding of this can help avoid common mistakes for investors and also help advisers understand behavioural biases and communicate them to clients more effectively.
