Main Investment Theories

Question 1

What is the Modern Portfolio Theory (MPT)?

Answer 1

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

Question 2

What is Standard Deviation?

Answer 2

Measure of volatility therefore risk

Measures how widely the actual return on an investment varies around its average (mean) return

Question 3

What does a correlation of +1 mean?

Answer 3

Perfectly positive correlation

Returns move in the same direction

Directly affected by same factors

Question 4

What does a correlation of -1 mean?

Answer 4

Perfectly negative correlation

Returns move in the opposite direction

Affected by same factors

Question 5

What is the efficient frontier?

Answer 5

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

Question 6

What is Systematic risk?

Answer 6

Risk affecting the whole market

Cannot be removed by diversification

Question 7

What is non-systematic risk?

Answer 7

The risk unique to a particular company

Can be eliminated by diversification

Question 8

What is beta?

Answer 8

A measure of volatility of a stock/fund relative to a market/benchmark

Question 9

What beta does the market have?

Answer 9

1

Question 10

What does a beta more than 1 mean?

Answer 10

Stock/fund is more volatile than the market

Question 11

What does a beta less than 1 mean?

Answer 11

The stock/fund is less volatile than the market

Question 12

What does CAPM attempt to do?

Answer 12

Derive a theoretical expected return for a security

Question 13

What variables does the Fama-French model use?

Answer 13

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

Question 14

What does Arbitrage Price Theory use?

Answer 14

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

Question 15

What does Efficient Market Hypothesis argues?

Answer 15

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

Question 16

What 3 form types are there in EMH?

Answer 16

Weak

Semi-strong

Strong

Question 17

What do believers of EMH advocate?

Answer 17

Use of tracker funds

Question 18

What is behavioural finance?

Answer 18

Explores how emotional & psychological factors affect investment decisions

Believes investors place more weight on losses than gains of the same value

Question 19

In EMH what does weak form mean?

Answer 19

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

Question 20

In EMH what does semi-strong form mean?

Answer 20

Share prices react very quickly to incorporate new information as it is released

Question 21

In EMH what does strong form mean?

Answer 21

Share prices reflect insider information as well as public information.

Question 22

What is loss aversion?

Answer 22

The unwillingness to let go of a valued possession

Reluctance to sell shares where a potential loss is involved

Question 23

What is Contrarian investing?

Answer 23

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

Question 24

How is efficient frontier used in investment planning?

Answer 24

To set optimum asset allocation

To show best return for given level of risk

Question 25

What are the drawbacks of efficient frontier?

Answer 25

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

Question 26

What are the benefits of using CAPM?

Answer 26

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

Question 27

Behavioural Finance Concepts

Answer 27

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

Question 28

What is Arbitrage?

Answer 28

Technique used by traders to take advantage of a disparity in prices in similar securities/markets to take advantage of inefficiencies.

Question 29

Momentum investing

Answer 29

Identify a trend

Trend accelerating

Sell before trend ends

Ignores intrinsic value

Short term