What are the 2 alternative investment theories?
The main methods are Modern Portfolio Theory and the pragmatic approach.
MPT is based on efficient markets and the theory that an "optimum portfolio" can be produced. Backwards looking.
Pragmatic approach is based on judgemental assumptions about what will happen in the future. Forward looking.
If the average return of an asset is 7% and the standard deviation is 3% what are the probabilities of:
i) return being between 4% and 10%
ii) return being between 1% and 13%
iii) return being greater than 1%
iv) return being below 13%
Modern Portfolio Theory
This theory states that there is a perfect portfolio based on the balance between which two factors?
What is the critical feature of the investment within the portfolio that allows the construction of this portfolio?
Risk and Return
MPT states that for a given level of risk there is an optimal portfolio which offers the greatest possible return. The higher the level of risk the higher return can be achieved. This creates a series of points on the efficient frontier.
The key feature of the portfolio is diversification. By choosing assets which have negative correlation (or low/zero correlation) volatility can be reduced whilst still receiving good returns.
The image shows the correlations between four stocks.
If I want to minimise my risk by diversifying my portfolio, which two stocks will I invest in and why?
Stocks A and C
They have a big negative correlation which means that they move in opposite directions. So if I buy both of them I get benefit from their growth but with smaller swings in my fund every day (when one falls the other rises).
I might also invest in stocks A, B and C together, since B and C have negative correlation and A and B have very low correlation. The answer depends on exactly how the question is worded.
What is systematic (and non-systematic) risk?
Systematic risk is market wide risk that affects all investments.
Non-systematic risk is that which only affects your individual asset/investment.
So anything to do with the economy, exchange rate, market, changes to tax rates are systematic.
Anything specific to your company, strong profits, management change, problem with production, new patent is non-systematic.
What is beta?
What do the following beta values imply?
0, 1, greater than 1, -1
Beta relates to the correlation between a stock and the market.
Note that this is different to the correlation between two different stocks. In particular, two stocks must have correlation between -1 and 1. Beta however can be ANY number.
Beta of zero means the share moves independently of the market (no correlation).
Beta of 1 means if the market gains 1% so does the stock.
-1 means if the market gains 1% the stock falls 1%.
Greater than 1 means the stock moves with the market but is more volatile.
What beta values would an aggressive or a defensive stock have?
An aggressive stock moves a lot, so it will have a beta of greater than 1.
A defensive stock has low volatility but still moves in the same direction as the market, so it will have a beta of between 0 and 1.
If I want to diversify my portfolio or eliminate systematic risk, which of the following assets will I invest in base on the betas?
A - Beta of 0.5, B - Beta of 2, C - Beta of -0.5, D - Beta of 0
Investing in A and C equally will eliminate systematic risk entirely.
D has a zero beta so you can also invest in this and it will not introduce any systematic risk.
If you wish to include stock B to increase diversification you will need to add four times as many shares in stock C to keep zero systematic risk.
What does the CAPM equation tell you?
Is it a single or multi-factor model?
CAPM predicts the return on a security based on it's beta (correlation with the market).
It is a single factor model (correlation with the market is the only factor).
What are they?
Multi-factor models are likely to be computer simulations which create expected returns based on a large number of variables (i.e. facors).
So whilst CAPM just calculates one factor (market return), a multi factor model could take into account interest rates, inflation, employment, the weather, anything really!
Efficient Market Hypothesis
What is it?
Efficient market hypothesis is that the prices of investments reflect all the information available about them (weak form says only historical price information is reflected but things like analysing the company aren't reflected).
The main implication is that you can't create alpha, you can't make extra returns by analysing the market, might as well just track the market.
Many investment theories (such as modern portfolio theory) rely on this hypothesis being true.
What is this?
Behavioural finance is about the mistakes that people make when investing due to human nature.
Loss aversion - People get more upset about their losses than their gains make them happy, so they will avoid risks (even if they could result in big profits).
Regret - Holding onto losing stocks longer than you should because you don't want to sell at a loss.
Overconfidence - Kind of the opposite of loss aversion, people tend to think trends will continue (booms will carry on forever, so will crashes).