Investments Topic 8 - Investment Theories

Question 1

Correlation looks at the linear relationship between 2 types of asset classes in terms of performance, measured from +1 to -1 these are shown as

Answer 1

• Correlation above 0 is said to be positive correlation
• Correlation below 0 said to be negative correlation
• Correlation of +1 is said to be perfect positive correlation
• Correlation of -1 is said to be perfect negative correlation
• Correlation of 0 is said to have no correlation

Question 2

Investment professionals tend to use… asset classes in their investments to achieve diversification

Answer 2

9 to 15

Question 3

To achieve further diversification, investors should try to pick assets that have… correlation

Answer 3

little or no

Question 4

Hedging

Answer 4

Hedging is essentially like matched betting or each way bets – you cover yourself by gambling on both outcomes. The example of this is investing in shares and then using a derivative (put option) for the same share in case it goes down, reducing the impact of the loss if the market falls.

Question 5

Modern portfolio theory (MPT) was the work of Harry Markowitz, as US economist who published an article in 1952. The basics of this theory are as follows:

Answer 5

• Beating the stock market by selecting specific shares is very hard
• Achieving such an outcome involves taking an above average risk
• Taking the additional risk would result in higher losses if the market were to fall
• Even a share offering long-term growth potential can be in danger of volatility
• Volatility is best reduced by diversification
• The total volatility of a diversified portfolio will be lower than the volatility of the average individual share within it

Question 6

The ‘efficient frontier’ is

Answer 6

an essential part of the theory and identifies the optimum level of diversification in a portfolio

Question 7

According to the efficient market hypothesis (EMH) it is impossible to outperform the market because

Answer 7

all relevant information required to analyse shares is in the public domain and is shown in the prices. This basically means that it is impossible to buy undervalued shares as the market price is what the public think it is worth.

Question 8

There are 3 versions of the efficient market hypothesis

Answer 8

Weak version – prices on the market reflect all past data, and basing decisions on past data will not increase returns
Semi-strong – prices on the market reflect all publicly available information and can change instantly due to new information on the provider (i.e. public statements, earnings etc.)
Strong version – not even those with insider information can outperform the market.

Question 9

The capital asset pricing model (CAPM) is a more modern theory that allows the investor to

Answer 9

assess what the return on riskier investments needs to be to account for the risk taken.

Question 10

CAPM considers 3 factors:

Answer 10

• Asset’s sensitivity to systematic risk
• Expected return of the market
• Expected return of risk-free asset

Question 11

Risk free rate

Answer 11

rate of risk-free products such as treasury bills

Question 12

Expected market rate of return

Answer 12

established by taking the average historical returns of a market portfolio

Question 13

The risk premium

Answer 13

difference between expected market rate of return and the risk-free rate, multiplied by the asset’s systematic risk (beta)

Question 14

Beta

Answer 14

the extent to which an asset or portfolio follows the market or a specific benchmark – its sensitivity to market risk

Question 15

Several basic assumptions made when creating the CAPM model

Answer 15

• Investors have preferences on risk and return and are generally risk averse
• Investors make decisions only on the basis of risk and return
• No individual buyer or seller can affect the market because there are many traders
• The risk inherent in a share is a combination of non/systematic risk
• Non-systematic risk can be almost eliminated by diversification

Question 16

Arbitrage pricing theory (APT) is

Answer 16

another way to look at risk and return

Question 17

Based on the theory (Arbitrage Pricing Theory) that certain independent factors will impact on the expected risk premium, with 2 broad categories:

Answer 17

• Macro factors – economic growth, unemployment and interest rates
• Company-specific factors – new contracts, loss of contracts, S&D, changes of management etc.

Question 18

Behavioural finance

Answer 18

considers human behaviour aspect of price changes and financial markets, considers social, cognitive and emotional factors

Question 19

Three main aspects to behavioural finance:

Answer 19

• Heuristics – people make investment decisions using a general rule of thumb rather than analysis, for example the herd mentality or cognitive bias
• Framing – people react differently and reach different conclusions according to how a problem is expressed
• Market inefficiency – investors and the market ignore the expertise and expert economists

Question 20

2 more new measurements of share pricing are

Answer 20

• Earnings before interest and tax (EBIT) margin
• Return on capital employed (ROCE)

Question 21

• Earnings before interest and tax (EBIT) margin

Answer 21

assesses company’s operating profitability. Calculated by taking the firm’s earnings before interest and tax as a percentage of its turnover. E.g. turnover of £100k and earnings of £10k has an EBIT of 10%. The higher the EBIT, the lower the effect of operating costs on the bottom line.

Question 22

• Return on capital employed (ROCE)

Answer 22

assesses company’s operating profitability as well and how effectively it is using assets at its disposal to create income for the company. Calculated by adding all the company’s profits, interest and other income and dividing it by the funds available for investment. Higher the ROCE, the more efficiently the company is using its capital.