Main Investment Theories Flashcards
What is the Modern Portfolio Theory (MPT)?
Maximise returns while minimising risk
Considers how each investment changes in price relative to other investments - correlation
Can’t eliminate market risk
Can eliminate unsystematic risk
Standard Deviation
Beta - sensitivity to market risk
What is Standard Deviation?
Measure of volatility therefore risk
Measures how widely the actual return on an investment varies around its average (mean) return
What does a correlation of +1 mean?
Perfectly positive correlation
Returns move in the same direction
Directly affected by same factors
What does a correlation of -1 mean?
Perfectly negative correlation
Returns move in the opposite direction
Affected by same factors
What is the efficient frontier?
Key concept of MPT
Plotted on graph with expected returns and risks on the axis
Aims to plot optimum return for a given level of risk
Correlation
What is Systematic risk?
Risk affecting the whole market
Cannot be removed by diversification
What is non-systematic risk?
The risk unique to a particular company
Can be eliminated by diversification
What is beta?
A measure of volatility of a stock/fund relative to a market/benchmark
What beta does the market have?
1
What does a beta more than 1 mean?
Stock/fund is more volatile than the market
What does a beta less than 1 mean?
The stock/fund is less volatile than the market
What does CAPM attempt to do?
Derive a theoretical expected return for a security
What variables does the Fama-French model use?
Beta
Plus added factors for company and size
Small cap tends to outperform large cap
High book to market ratio (value) tend to outperform growth stocks
High book to market = market valuing the company’s shares cheaply compared to its book value
What does Arbitrage Price Theory use?
Risk premium based on a number of independent factors - multi factor
Can be market or industry related
Can include macroeconomic variables - interest rates, inflation, industrial production
Takes into account factors and extent risk will affect security
Traders take advantage of disparity in prices in similar securities/between markets to take advantage of such inefficiencies
What does Efficient Market Hypothesis argues?
It should be impossible to achieve returns in excess of the market through stock selection and or market timing
A share price reflects the information that is available about the company
Supports development and use of index tracking funds
What 3 form types are there in EMH?
Weak
Semi-strong
Strong
What do believers of EMH advocate?
Use of tracker funds
What is behavioural finance?
Explores how emotional & psychological factors affect investment decisions
Believes investors place more weight on losses than gains of the same value
In EMH what does weak form mean?
Current share price fully reflects all past trading information about the company that has so far been released
Can’t predict prices by analysing historic data
In EMH what does semi-strong form mean?
Share prices react very quickly to incorporate new information as it is released
In EMH what does strong form mean?
Share prices reflect insider information as well as public information.
What is loss aversion?
The unwillingness to let go of a valued possession
Reluctance to sell shares where a potential loss is involved
What is Contrarian investing?
Try to profit from herd mentality that sometimes affects prices
Believe markets overreact and price swings are exaggerated
Sell when others are buying and vice versus
Usually long term view
Undervalued
How is efficient frontier used in investment planning?
To set optimum asset allocation
To show best return for given level of risk
What are the drawbacks of efficient frontier?
Uses standard deviation as sole measure of risk
Does not include costs or tax
Assumes underlying funds are index linked, can’t factor in alpha
Relies on historic data which may no longer be accurate
Doesn’t take I to account ATR/CFL
What are the benefits of using CAPM?
Easy to calculate/uses widely available information
Takes account of systematic risk
Reflects fact most portfolios are diversified to remove unsystematic risk
Robust/trusted
Gives an expected return/benchmark
Behavioural Finance Concepts
Loss aversion - Investor feels losses more than the equivalent gains - can explain reluctance to sell with a loss
Anchoring - Anchor on numbers, fixated on a price or round number
Overconfidence - Overestimate abilities - over confident in rising market
Hindsight bias - Feel let down by advisers as feel that events were obvious, something has performed well in the past
Herding - follow the crowd (FOMO) rather than good advice or research - can cause a bubble and overvalued shares
Endowment effect - Value investments because they own them and reluctant to lose them, e.g. not changing inherited assets even though don’t match needs
Mental Accounting - Compartmentalise money - spend income only and not capital
Misunderstanding of probability
What is Arbitrage?
Technique used by traders to take advantage of a disparity in prices in similar securities/markets to take advantage of inefficiencies.
Momentum investing
Identify a trend
Trend accelerating
Sell before trend ends
Ignores intrinsic value
Short term
