3 - The merits and limitations of the main investment theories

Question 1

When considering MPT (modern portfolio theory), what are the main assumptions about investors?

Answer 1

They are risk averse
Most would chose a less risky investment if they offered the same rate of return
They would only chose a higher risk investment if the return was higher

Question 2

What was the foundation of MPT thinking?

Answer 2

That a diversified portfolio would reduce risk and increase returns for investors, therefore imperfectly correlated asset classes could provide high returns with the least amount of volatility

Question 3

What is the definition of standard deviation?

Answer 3

How widely the actual return on an investment varies around its average or expected return.

Question 4

What is the difference between low and high deviation?

Answer 4

Low - an investment that stays close to its expected return

High - an investment that fluctuares wildly from its expected return

Question 5

How is standard deviation calculated?

Answer 5

Considering the differences between the average or mean returns and actual returns, based on past experience

Question 6

What is the rule of thumb of standard deviation?

Answer 6

68% of returns will fall between 3% and 5%

95% of returns will fall between -2% and 18%

Question 7

What does hedging mean?

Answer 7

Protecting an existing investment position by taking another position that will increase in value if the existing position falls in value.

Question 8

Describe positive and negative correlation and what would be the most effective in terms of diversification?

Answer 8

Positive - the profits and share values of companies move up and down together
Negative - the profits of companies move in opposite directions

Those that are negatively correlated

Question 9

In what ways can an investor achieve diversification?

Answer 9

Holding different asset class - equities do well in a growing economy, fixed securities outperform equities pending recession, property values are related to earnings
Choosing companies from different sectors
Including overseas companies

Question 10

What does the efficient frontier do?

Answer 10

Plots the risk-reward profiles of portfolios and shows the best return that can be expected for a given level of risk

Question 11

What are the three inputs to the efficient frontier?

Answer 11

Return of each asset
Standard deviation of each assets returns
Correlation between each pair of assets returns

Question 12

What are the limitations to using an efficient frontier?

Answer 12

It assumes standard deviation and normally distributed returns
Other factors might be important to investors other than just attitude to risk
Inputs rely on historical data which may not be stable
It does not include transaction costs and therefore investors might not be willing to change as often as suggested
It assumes the underlying portfolios are index funds with similar characteristics

Question 13

What is the difference between systematic (market) risk and Non systematic (investment specific) risk?

Answer 13

Systematic affects the whole of the market and cannot be avoided - some securities will be more sensitive and therefore have a higher risk
Non-systematic - affects a particular company and is independant of economic, politial and other factors.

Question 14

Can non-systematic risk be avoided?

Answer 14

Yes, by holding a diversified portfolio

Question 15

What is the optimum number of securities within a portfolio to eliminate investment risk?

Answer 15

15-20 (anything above this and the rate reduction flattens)

Question 16

What is the designation for standard deviation?

Answer 16

Sigma a.

Question 17

How is the sensitivity of a security relative to markets expressed as?

Answer 17

Beta B

Question 18

What does CAPM stand for?

Answer 18

Capital asset pricing model

Question 19

If a security has a Beta equal to 1, how is it expected to move?

Answer 19

Exactly with the market

Question 20

If a security has a beta of more than one, how it is expected to move vs the market?

Answer 20

It will be more volatile than the market (known as aggressive securities)

Question 21

What are securities with a beta of less than 1 know as?

Answer 21

Defensive securities

Question 22

What does the CAPM provide?

Answer 22

The relationship betweena security’s systematic risk and its expected return. i.e. a high level of systematic risk can be expect a high return in a rising market

Question 23

What are the assumptions for CAPM?

Answer 23

Investors are rational and risk averse
All have an identical holding period
No one buyer or seller can affect market price
There are no taxes, charges or short selling restrictions
Information is free and available to all
All can borrow unlimited amounts at the risk free rate
The liquidity of an asset is ignored

Question 24

What are the limitations of CAPM?

Answer 24

Finding a risk free return is hard
Beta’s are significantly different depending on which index is used (FTSE/FTSEall share/100)
The suitability of beta - must be stable

Question 25

What is the CAPM often referred to as and why?

Answer 25

Referred to as a single factor model, it only expresses the simple relationship between risk and return

Question 26

What are the two basic ideas of multi factor models?

Answer 26

Investors require extra return for taking risk

They appear to be predominately concerned with the risk that cannot be eliminated by diversification

Question 27

What is the general principle behind APT (arbitrage pricing theory)?

Answer 27

That a security’s returns can be predicted using the relationship between the security and common risk factors, where sensitivity to changes to eachf actor is represented by an individual Beta.

Question 28

How does APT differ to CAPM?

Answer 28

It assumes that each investor holds a unique portfolio with its own particular degree of exposure, rather than indentical market portfolio.

Question 29

What are the four factors that influence security returns?

Answer 29

Unanticipated inflation
Changes in the expected level of industrial production
Changes in the default risk premium on bonds
Unanticipated changes in the returns of long term government bonds over treasury bills (shift in the yield curve)

Question 30

What are the principles behind EMH (efficient market hypothesis)

Answer 30

Security prices reflect all available information and prices rapidly adjust to new information, therefore the market price is always the correct price for any given security.

It is not possible to outperform the market by picking undervalued securities are none are over or under valued.

Question 31

What are the three forms of EMH?

Answer 31

Weak form efficiency
Semi strong form efficiency
Strong form efficiency

Question 32

What is weak form efficiency?

Answer 32

The current price reflects all past and present price and trading volumes, trends will not help determine future prices and will not producde market beating returns

Question 33

What is the difference between semi strong and strong form efficiency?

Answer 33

Semi strong suggests prices adjust based on all publically available information and no analysis will be able to identify whether a stock is over or under valued

Strong indicates that all information any investor can acquire, including private information held by officers, corporate insiders and executives

Question 34

Does EMH support active stock selection or passive investing (i.e. index funds)?

Answer 34

passive investing