Module 5: Constructing an Investment Portfolio—Part 2

Question 1

Briefly describe a passive investment strategy.

Answer 1

A “passive investment strategy” is a portfolio decision that avoids any direct or indirect security analysis. No resources are devoted to acquiring information on any individual stock or group of stocks, leading to a neutral diversification strategy. Such a strategy may result in the selection of a diversified portfolio of stocks that mirror the value of the corporate sector of the Canadian economy. The most widely used value-weighted stock portfolio in Canada is the Toronto Stock Exchange’s index of the largest capitalization Canadian corporations, the S&P/TSX Composite Index.

A passive strategy involves investing in two passive portfolios—one of virtually risk-free, short-term T-bills (or a money market fund) and a second portfolio comprising a fund of common stocks that mimics a broad market index such as the S&P/TSX Composite Index.

Question 2

Explain the relationship between the “capital market line” (CML) and a passive investment strategy.

Answer 2

The CML is the capital allocation line provided by the short-term T-bill rate and a fund of common stocks that mimics a broad market index. A passive strategy generates an investment set that is represented by the CML.

Question 3

Compare the costs and benefits of an active investment strategy with a passive investment strategy.

Answer 3

Construction of an active portfolio is more expensive than construction of a passive one. It requires either an investment of time and money by the individual investor to acquire the information needed to generate an optimal active portfolio of risky assets or delegation of that task to a professional. Each approach involves a cost, resulting in fees higher than what would be associated with a passive strategy. Passive management entails only negligible costs to purchase T-bills and very modest management fees associated with an exchange-traded or mutual fund.

Passive strategies also reflect the “free rider benefit”. If we assume there are many active, knowledgeable investors quickly bidding up prices of undervalued assets and bidding down overvalued assets by selling them, we can conclude that at any time, most assets are fairly priced. Therefore, a well-diversified portfolio of common stock may be a reasonably fair buy and may not be inferior to that of the average active investor.

Question 4

Describe the Markowitz efficient frontier and explain the importance of risk and expected return trade-off in applying this theory.

Answer 4

The Markowitz efficient frontier model assumes that an investor wants to maximize a portfolio’s expected return contingent on any given amount of risk, with risk measured by the standard deviation of the portfolio’s rate of return. It is the set of portfolios with the maximum return for a given standard deviation.

For portfolios that meet this criterion (i.e., satisfy the condition that no other portfolio exists with a higher expected return but with the same standard deviation of return, known as “efficient frontier portfolios,”) achieving a higher expected return requires taking on more risk, so investors are faced with a trade-off between risk and expected return. This means that individual investors should determine how much risk they are willing to take on, and then they can allocate or diversify their portfolios according to the results of that decision.

Question 5

Use the following graph of a Markowitz efficient frontier to explain the significance of portfolios that lie on the efficient frontier, those that lie below it and those that cluster to its right.

Answer 5

Portfolios that comprise the efficient frontier tend to have a higher degree of diversification than the suboptimal ones, which are typically less diversified.

Portfolios that lie below the efficient frontier are suboptimal—They do not provide enough return for the level of risk.

Portfolios that cluster to the right of the efficient frontier are suboptimal—They have a higher level of risk for the expected rate of return.

Question 6

Explain the limitations of the Markowitz efficient frontier.

Answer 6

There are some limitations of the Markowitz efficient frontier, including the assumptions that:

(1) Asset returns follow a normal distribution at all times. Actually, securities may experience returns that are abnormal.

(2) Investors are rational and avoid risk when possible; large investors are not able to influence market prices, and investors have access to borrowing and lending of funds at the risk-free interest rate. However, the market includes irrational and risk-seeking investors, large market participants who could influence market prices and investors who do not have unlimited access to borrowing and lending money.

(3) All investors will have the same expectations regarding inputs used to develop efficient portfolios such as expected returns, variances and covariances; that is, all investors are the same. However, some investors will simply choose the portfolio with the highest expected return or if shown portfolios with the same returns but different risk levels, choose the portfolio with the lowest risk.

Question 7

Define diversification and briefly outline its role in portfolio construction.

Answer 7

“Diversification” is the process of including various type of assets within a single portfolio. Diversification across many assets will eliminate some of the risk associated with individual assets. The basic idea is that the good performance of some assets in a portfolio will outweigh the poor performance of other assets.

Question 8

Contrast systematic risk with nonsystematic risk.

Answer 8

“Systematic risks” are characteristic of an entire market, a specific asset class or a portfolio investment in that asset class. Systematic risk is also called “market risk” or “nondiversifiable risk.”

“Nonsystematic risk” is the opposite of systematic risk; and is specific to individual assets. Nonsystematic risk is diversifiable. It is also called “company-specific risk,” “unique risk” or “diversifiable risk.”

A “diversifiable risk” means that risk can be reduced through proper diversification. However, because systematic risk is nondiversifiable, diversification cannot reduce risk altogether.

Question 9

Explain how the “law of diminishing returns” impacts diversification in a portfolio.

Answer 9

Risk reduction from adding securities drops off as more and more securities are added to a portfolio. With ten securities, most of the diversification effect is already realized, and with 30 or so, there is very little remaining benefit to adding additional securities. The benefit of further diversification increases at a decreasing rate. The “law of diminishing returns” applies to this situation. It is an application of the principle that a continual increase in effort or investment does not lead to a continual increase in output or results.

Question 10

Define “correlation” and explain how correlation coefficients are interpreted.

Answer 10

“Correlation” can be defined as the degree of similarity between two random variables, for example, the changes in returns on two different assets. That is, if a change in one stock affects a change in the other, the two stocks are “correlated.” Correlation can be expressed as a value known as the correlation coefficient. The correlation coefficient value falls within the range of -1 and 1 (that is, if the correlation coefficient is represented by r, −1≤r≤+1)
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Question 11

Interpret the implications of correlation coefficients by describing the possible relationships between Asset A and Asset B assuming a correlation coefficient of +1; a correlation coefficient of 0, and a correlation coefficient of −1.

Answer 11

(a) If Asset A and Asset B have a correlation coefficient of +1, they have a perfect positive correlation. Should the return of Asset A move, either up or down, the return of Asset B will move in lockstep in the same direction. Perfect correlation does not necessarily mean their returns move by the same amount.

(b) If Asset A and Asset B have a correlation coefficient of 0, there is no relationship between the movements experienced by the two assets.

(c) If Asset A and Asset B have a correlation coefficient of -1, they have a perfect negative correlation. Their returns will again move in lockstep but in different directions. That is, if the return of Asset A moves up, the return of Asset B will move down, and vice versa.

Question 12

Describe the diversification benefits of combining two highly correlated assets and two negatively correlated assets in portfolio construction.

Answer 12

Combining two highly correlated assets (correlation is near to +1) offers a limited diversification benefit. For example, two stocks from the same oil and gas industry—Suncor and Exxon—will tend to be relatively highly correlated since the companies are in essentially the same business. A portfolio of two such stocks is not likely to offer diversification benefits.

However, if the two assets are negatively correlated, whenever the return on one zigs, the other tends to zag. For two assets that are highly negatively correlated, there will be a substantial diversification benefit because variation in the return on one asset tends to be offset by variation in the opposite direction from the other. If two assets have a perfect negative correlation, then it is possible to combine them in such a way that all risk is eliminated. However, perfect negative correlation is mostly only found in synthetic financial instruments such as futures contracts. These instruments, and skills in their use, can provide near-perfect negative correlation and therefore can be useful tools to reduce portfolio volatility.

Question 13

Explain how covariance is interpreted.

Answer 13

Covariance is closely related to correlation coefficient. “Covariance” is a measure of the extent or degree to which returns on two risky assets change in tandem. Positive covariance indicates that higher-than-average values of one variable tend to be paired with higher-than-average values of the other variable. Negative covariance indicates that higher-than-average values of one variable tend to be paired with lower-than-average values of the other variable.

Holding assets that provide returns that have a high covariance with each other does not provide very much diversification. For example, if Suncor stock return is high whenever Exxon stock return is high, and the same can be said for low returns, then these stocks are said to have a positive covariance. Greater diversification can be achieved by investing in assets that have low covariance to each other.

Question 14

escribe the predictions made by the efficient market hypothesis (EMH) and its implications for investors who accept that EMH is a valid way to understand an investment market.

Answer 14

The efficient market hypothesis (EMH) makes two predictions:

(a) That security prices properly reflect whatever information is available to investors (hence the use of the term “efficient”) and
(b) That active traders will find it difficult to outperform passive strategies such as holding market indexes.

Investors who accept the validity of the EMH are therefore accepting that:

(a) The information available to them about securities is accurate and complete, and,
(b) The value of “expert” stock selectors and market timing is questionable since it won’t be possible for those activities to lead to investment returns beyond those provided by the overall market, and,
(c) An active approach to investment management is unlikely to provide superior returns after considering the costs associated with active management (e.g., technical and fundamental analysis.)

Question 15

Identify the general approach to testing market efficiency, and the success of that testing.

Answer 15

It is difficult to devise measures of the true or intrinsic value of a security and to test whether prices match those value. Therefore, most tests of market efficiency have focused on the performance of active trading strategies, and have been of two kinds:

(a) The examination of strategies that apparently would have provided superior risk-adjusted returns (known as the “anomalies literature”), and
(b) Tests that ask whether professional managers have been able to beat the market based on the results of their actual investments.

Neither class of tests has proven fully conclusive.

Question 16

Describe “market anomalies” and identify some that are commonly observed.

Answer 16

“Market anomalies” are predictable continuing trends that ought to be impossible in an efficient market. They are called “anomalies” for a reason—they should not occur, and they definitely should not persist. Anomalies are generally “small,” in that they do not involve many dollars relative to the overall size of the market, and many anomalies are fleeting and tend to disappear when discovered. Anomalies are not easily used as the basis for an investment strategy because transaction costs make them unprofitable.

Some common market anomalies include:

(a) Price/earnings (P/E) effect
(b) Size effect, or small-firm effect
(c) Neglected-firm effect
(d) Liquidity effect
(e) Low price/book (P/B) ratio
(f) Post-earnings-announcement price drift
(g) January effect
(h) Reversal effect

Question 17

Describe the premise of behavioural finance as it relates to conventional financial theory

Answer 17

The premise of “behavioural finance” is that conventional financial theory ignores how real people make decisions and that people make a difference. Some economists interpret the anomalies literature as being consistent with irrationalities that characterize individuals making complicated decisions. These irrationalities include:

(1) Investors do not always process information correctly and therefore infer incorrect probability distributions about future rates of return, and
(2) Investors often make inconsistent or systematically suboptimal decisions even if given a probability distribution of returns.

Question 18

Identify and briefly describe types of information processing biases exhibited by investors that psychologists have discovered in other fields.

Answer 18

Errors in information processing can lead investors to misestimate the true probability of possible events or associated rates of return. These include:

(1) Limited attention, underreaction and overreaction can result in investors relying on rules of thumb or intuitive decision-making known as heuristics.
(2) Overconfidence, occurs when people tend to overestimate the precision of their forecasts and tend to overestimate their abilities.
(3) Conservatism, occurs when investors are too slow (too conservative) in updating their beliefs in response to new evidence.
(4) Extrapolation and patterns recognition based on limited or illusory evidence can be used to characterize an entire population. Not taking into account the size of a sample, that is acting as if a small sample is just as representative of a population as a large sample is called “representative bias.”

Question 19

Briefly describe the behavioural biases that studies have concluded result in decision making that is less than fully rational and provide examples.

Answer 19

Many studies conclude that individuals tend to make decisions that are less than fully rational despite using perfect information processing. These “behavioural biases” include framing, mental accounting, and regret avoidance:

(1) “Framing” refers to how decisions can be affected by how the available choices are described, or “framed.” Using the example of a defined contribution retirement plan where members choose investments from a menu of options, the way that the investment options, and information about each, are presented can have a large, unintended effect on member choices and therefore on their portfolio risk. Research suggests that if investors are presented with a list of options of which the majority is equity funds, they will allocate a higher percentage of their portfolio to equity than if presented with a list where there are few equity funds.
(2) “Mental accounting”, a specific sort of framing, contends that rather than rationally viewing every current and future dollar as identical, individuals divide their current and future funds into separate, nontransferable categories and then assign different levels of utility to each category of funds. For example, an investor may take a lot of risk with one investment account but establish a very conservative position with another account dedicated to their child’s education. Rationally, it might be better to view both accounts as part of their investment portfolio with the risk-return profiles of each integrated into a unified portfolio.
(3) “Regret avoidance”, which occurs when individuals who make decisions that turn out badly have more regret (blame themselves more) when their decisions were more unconventional. For example, an investor may not experience a loss in their blue chip portfolio as painfully as they experience the same loss in their investment in an unknown start-up.

Question 20

From a behavioural finance perspective, explain “affect” and its influence on how investors evaluate risk vs. return. Provide examples.

Answer 20

“Affect” is a feeling of “good” or “bad” that investors may attach to a stock. For example, firms with reputations for socially responsible policies may generate higher affect in public perception. If investors favour stocks with good “affect”, that might drive up prices and drive down average rates of return.

Evidence provides an example of how affect influences security pricing. Stocks ranked high in surveys of most admired companies (i.e., with high affect) tend to have lower average risk-adjusted returns than the least admired firms, suggesting that their prices have been bid up relative to their underlying profitability and, therefore, their expected future returns are lower. Affect may also explain the “home country” bias, which is the tendency for investors to overweight shares in their home markets, rather than use efficient diversification strategy. Psychologists have documented that people prefer familiar settings about which they feel they have more information. This may cause them to give up some diversification to focus on their home markets where they subjectively perceive less uncertainty.

Question 21

Explain how prospect theory affects how investors evaluate risk vs. return and illustrate with an example.

Answer 21

“Prospect theory ” is also known as “loss-aversion theory.” It describes how people make decisions when presented with alternatives that involve risk, probability, and uncertainty. One of the key concepts in prospect theory is the idea that people evaluate potential outcomes relative to a reference point (usually their current situation) rather than in absolute terms. Prospect theory assumes that investors value gains and losses differently and as a result, make decisions based on perceived gains instead of perceived losses.

For example, imagine an individual is offered two options for a monetary gain:

• Option 1: A guaranteed gain of $1,000
• Option 2: A 50% chance to gain $2,000 and a 50% chance to gain nothing

From a purely rational perspective, both options have the same expected value ($1,000), so a rational decision-maker would be indifferent between the two. However, according to prospect theory, people tend to be risk-averse when faced with potential gains. In this case, most individuals would prefer Option 1, the certain gain of $1,000, over the uncertain outcome of Option 2, even though the expected value is the same.

Now, let’s consider a scenario with potential losses:

• Option 3: A guaranteed loss of $1,000
• Option 4: A 50% chance to lose $2,000 and a 50% chance to lose nothing

In this case, prospect theory suggests that people become risk-seeking when confronted with potential losses. They may be more inclined to take the gamble of Option 4, hoping to avoid any loss at all, even though the expected value is still a loss of $1,000.

This example illustrates the asymmetric way in which people often evaluate gains and losses, with a tendency to be risk-averse in the domain of gains and risk-seeking in the domain of losses.

Question 22

Explain how efficient market hypothesis (EMH) proponents view fundamental and technical analysis.

Answer 22

The existence of an efficient market puts into question the value of such activities as “technical analysis” (the search for recurring and predictable patterns in stock prices) and “fundamental analysis” (the determination of an appropriate stock price based on the characteristics of the firm’s financial statements, management interviews and market position). All of these activities (which are not applicable when a passive investment strategy is implemented) entail costs that reduce the net investment returns. Hence the attitude of EMH “believers” is that an active approach to investment management is unlikely to provide superior returns after considering the costs of active management.

Question 23

Comment on the validity of the behavioural finance approach to investor behaviour

Answer 23

There is considerable debate among financial economists concerning the strength of behavioural finance as it relates to investing. The behavioural approach is considered too unstructured for some financial economists, allowing virtually any anomaly to be explained by some combination of behavioural biases.

The anomalies literature is criticized for its focus on behavioural explanations for a particular anomaly and lack of consistent or unified behavioural theory that can explain a range of anomalies. Moreover the statistical significance of many of these results is hard to assess.

Acceptance of the EMH implies that security prices serve as reliable guides to the allocation of real assets. If prices are distorted, capital markets will give misleading signals (and incentives) as to where the economy (and investors) may best allocate resources. The extent to which limited rationality affects asset pricing remains controversial. However behavioural finance makes important points about portfolio management. Investors who are aware of the potential pitfalls in information process and decision making should be better able to avoid such errors.