Main investment theories

Question 1

Which investment theory looks for the optimum return for a given level of risk?

Answer 1

Modern portfolio theory

Question 2

What is the best way to diversify to decrease non-systematic risk?

Answer 2

By having a portfolio of negatively correlated assets

Question 3

What does beta measure?

Answer 3

The sensitivity of an individual security relative to the whole market. If it is greater than 1, it is more volatile than the market as a whole.

Question 4

What does the capital asset pricing model derive?

Answer 4

The expected return of an asset as a combination of the risk-free return, plus the risk premium.

Question 5

Dissect and explain the CAPM formula as below:

E(R_i )=R_f+β_i (R_m-R_f)

Answer 5

E(R_i ) is the expected return on the risky investment
R_f is the risk-free rate of return
R_m is the expected return of the market portfolio
β_i is the measure of the sensitivity of the investment to movements in the overall market
(R_m-R_f) is the market risk premium
β_i (R_m-R_f) is the risk premium of the risky investment

Question 6

Why do proponents of the efficient markets hypothesis tend to prefer tracker funds?

Answer 6

Because the theory states that in an open and efficient market, security prices fully reflect all available information, therefore active managers are highly unlikely to be able to outperform the market consistently.

Question 7

Which behavioural finance theory describes the idea that investors put different weights on gains and losses?

Answer 7

Loss aversion

Question 8

If a portfolio has shares with a beta of 0.87, expected risk-free return of 0.4% and expected market return of 5.8%, what will be the expected return of this portfolio based on CAPM?

Answer 8

5. 8% - 0.4% = 5.4%
6. 4% x 0.87 = 4.7%
7. 7% + 0.4% = 5.1%