The Main Investment Theories Flashcards

1
Q

Describe Modern Portfolio Theory (MPT)

A
  • 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
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2
Q

How to reduce risk?

A

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

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3
Q

Describe the 3 types of correlation

A

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)

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4
Q

How to diversify

A
  • Hold different asset classes
  • Choose companies in different sectors
  • Include overseas companies
  • Negative correlation
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5
Q

What is the efficient frontier and what is it used for?

A

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

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6
Q

Limitations of Efficient Frontier?

A
  • 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
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7
Q

Describe systematic and non-systematic risk

A

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

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8
Q

Describe beta

A
  • 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
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9
Q

Beta vs Standard Deviation

A

Beta - measures market risk by measuring volatility relative to market

Standard Deviation - measures fund risk by measuring total risk based on actual return

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10
Q

What is CAPM and formula?

A
  • Single factor model - only concerned with Beta
  • Derives risk premium - compensation for holding risky asset

ER = RF + B(ERM - RF)

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11
Q

Benefits and limitations of CAPM?

A

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)

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12
Q

What are multifactor models and how are they applied? Give 2 examples

A
  • 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)
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13
Q

What is the Arbitrage Pricing Theory?

A

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

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14
Q

4 factors influencing security of returns

A
  • 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
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15
Q

What is efficient market hypothesis?

A
  • 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
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16
Q

Describe weak form efficiency (efficient market hypothesis)

A

Current prices fully reflect all past prices

Technical analysis and historical data cannot predict future prices

17
Q

Describe semi-strong form efficiency (efficient market hypothesis)

A

Current prices fully reflect all past prices

Fundamental and technical analysis can identify if stock is overvalued

18
Q

Describe strong form efficiency (efficient market hypothesis)

A

Current prices fully reflect all past prices

Prices reflect all information

19
Q

Behavioural finance - give exampes

A

Emotional and psychological factors affect investment decisions, e.g.:
- Prospect theory / loss aversion - people do not always behave rationally, more concerned about potential loss than being happy about gains
- Regret - less willing to sell investments at a loss
- Overconfidence - overestimates own skills, optimistic in rising markets and pessimistic in falling markets
- Hindsight - “UK equities have done well in the past”
- Mental accounting - known target value
- Endowment affect - already own “equities” - why change?