The Main Investment Theories Flashcards
Describe Modern Portfolio Theory (MPT)
- Portfolio construction to maximise returns and minimise risk
- Assumes investors are risk averse
- Diversification can reduce risks and increase returns
- Standard Deviation can be used to identify range of likely returns
How to reduce risk?
Hedging: protecting investment position by taking out another position that will increase in value if the existing position falls in value - can achieve this by using derivatives
Diversification - hold range of different types of assets, broaden portfolio’s exposure to smooth out financial and economic fluctuations
Describe the 3 types of correlation
Positive correlation (1) - affected by the same things (e.g. US and UK equities) - higher the number, stronger the positive relationship
Negative -correlation (-1) - move in opposite direction (most efficient diversification) e.g. Equities and UK Gilts - lower the number, stronger the negative relationship
No correlation - not related (e.g. UK Equities and US traded life policies)
How to diversify
- Hold different asset classes
- Choose companies in different sectors
- Include overseas companies
- Negative correlation
What is the efficient frontier and what is it used for?
Relationship between return from portfolio and risk of portfolio
Used to find optimum asset allocation and to show best return for given level of risk
Limitations of Efficient Frontier?
- Assumes standard deviation is best measure of risk and assets have normal distribution of returns
- Excludes impact of costs and charges
- Doesn’t account for attitude to risk or capacity for loss
Describe systematic and non-systematic risk
Systematic risk - affects market as a whole e.g. interest rates, tax
Non-systematic risk - unique to a company e.g. credit rating, can be eliminated through diversification
Describe beta
- Measure of market risk by measuring volatility relative to market
- Beta equal to 1 expected to move up and down exactly with market
- Beta of more than 1 exaggerates market movement - more volatile than market
- Beta of less than 1 but more than 0 is more stable than market - a market defensive security
Beta vs Standard Deviation
Beta - measures market risk by measuring volatility relative to market
Standard Deviation - measures fund risk by measuring total risk based on actual return
What is CAPM and formula?
- Single factor model - only concerned with Beta
- Derives risk premium - compensation for holding risky asset
ER = RF + B(ERM - RF)
Benefits and limitations of CAPM?
Benefits:
- Easy to calculate
- Accounts for market risk
- Trusted
- Gives expected return
- Reflects that most portfolios are diversified to eliminate non-systematic risk
Limitations:
- Totally risk free return required
- True market portfolio required
- Beta suitability (needs to be stable and predictable)
What are multifactor models and how are they applied? Give 2 examples
- Employs multiple factors in its calculations to explain asset prices
- Application of multifactor models - active management index tracking funds, risk management and performance attribution analysis
- Examples: Fama & French / Arbitrage Pricing Theory (APT)
What is the Arbitrage Pricing Theory?
Security returns can be predicted using relationship between security and common risk factors - able to correctly price a security
4 factors influencing security of returns
- 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
What is efficient market hypothesis?
- Market prices always correct as fully reflect all available information
- So not possible to outperform market consistently
- Bulk of evidence supports EMH but behavioural economists now question validity
