The Main Investment Theories

Question 1

Modern portfolio theory

Answer 1

Portfolio construction to maximise returns and minimise risks (assumes investors are risk averse)

Professor Harry Markowitz: portfolio diversification can reduce risk and increase returns

Standard Deviation: how widely investment returns vary around its average or expected return
useful tool in identifying range of likely returns. (68% of the time returns within 1 standard deviation, 95% of the time returns are within 2 standard deviations)

Question 2

Efficient Frontier

Answer 2

Relationship between return from portfolio and risk of portfolio

Set of portfolios to show maximum rate of return for given levels of risk

Limitations: assumes standard deviation is best measure of risk and assets have normal distribution of returns (investor’s portfolio is dependent on their risk profile)

Question 3

CAPM assumptions / limitations

Answer 3

Assumptions

Information is free and available

Investors are risk averse/rational

No individual can affect market price
Identical holding period

No taxes, transaction costs

Limitations

Totally risk-free return required

True market portfolio required

Beta suitability (needs to be stable and predictable)

Question 4

Arbitrage Pricing Theory

Answer 4

security returns can be predicted using relationship between security and common risk factors - able to correctly price a security

Question 5

4 factors influencing security if returns

Answer 5

Unanticipated inflation

Changes in expected level of industrial production

Changes in default risk premium on bonds

Unanticipated changes in return of long-term government bonds over treasury bills

Question 6

Efficient Market Hypothesis

Answer 6

Market prices always correct as fully reflect all available information

So not possible to outperform markets consistently

Bulk of evidence supports EMH but behavioral economists now question validity

Question 7

EMH weak form, semi strong and strong form

Answer 7

Weak form

Technical analysis (historical
data) cannot predict future
prices

Semi-strong form

Fundamental and technical
analysis can identify if stock
overvalued

Strong form

Prices reflect all informationi

Question 8

Prospect theory/Loss aversion

Answer 8

people do not always behave rationally; they are more

distressed about a prospective loss than being happy about gains