MODERN INVESTMENT THEORY: A TRAVELOGUE

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MODERN INVESTMENT THEORYA TRAVELOGUE

• BY
• PROF. SANJAY SEHGAL
• DEPARTMENT OF FINANCIAL STUDIES
• UNIVERSITY OF DELHI SOUTH CAMPUS
• NEW DELHI-110021
• PH. 0091-11-24111552
• Email sanjayfin15_at_yahoo.co.in

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THE INVESTMENT DECISION PROCESS

• Setting investment objectives
• Determining acceptable risk level
• Allocation strategy
• - Asset mix
• - Market mix
• Security analysis and evaluation
• Forming portfolios
• Evaluating portfolio performance
• Portfolio revision

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PROMINENT INVESTMENT OBJECTIVES

• Regular Income
• Income on income
• Capital appreciation
• Tax incentives
• Safety of capital
• Maintaining liquidity
• Hedging inflation

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THE INVESTMENT DECISION FRAMEWORK

• Maximize expected utility through wealth creation
• Utility is an increasing function of return
• Utility is a decreasing function of risk.

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CONCEPT AND MEASUREMENT OF EXPECTED RETURN

• Return for a single period
• Capital appreciation Income flow
• -------------------------------------------
• Initial investment
• Expected Return is measured as the average of
  single holding period returns.

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CONCEPT AND MEASUREMENT OF RISK

• NO. CONCEPT MEASURE
• 1. Non-realization of expected return Standard
  deviation of returns
• 2. Realized returns are lower than Semi-deviation
  of returns
• expected returns
• 3. Fear that initial investment will
  erode- Probability of obtaining negative
• safety first returns

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SYSTEMATIC SOURCES OF TOTAL RISK

• Market index acts as a proxy for key macro
  economic shocks such as political upheavals, GDP
  growth rate, changes in the level of interest
  rate, inflation etc.
• Systematic risk is owing to the sensitivity of
  stock returns to market returns.
• Beta is the measure of systematic risk and is
  popularly known as the sensitivity co-efficient.

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UNSYSTEMATIC SOURCES OF TOTAL RISK

• Unsystematic risk by definition can be
  diversified away in a large portfolio.
• Unsystematic risk may be caused by
• - industry factors
• - group factors
• - common characteristics
• - firm specific factors

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COMBINING ASSETS TRADITIONAL PORTFOLIO THEORY

• Portfolio managers should have a large number of
  securities across
• sectors, groups and firm characteristics to
  destroy unsystematic risk
• without sacrificing expected returns.

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COMBINING ASSETS MODERN PORTFOLIO THEORY (MPT)
MARKOVITZ (1952, 1959)

• Portfolio Managers should emphasize on quality
  and not the quantity of securities.
• Quality is reflected by the interactive risk
  measured as correlation between security returns.
• High quality is reflected by negative or at least
  low positive correlations.

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MPT MAIN ASSUMPTIONS

• Players
• Investors are risk-averse and utility maximizers
• They select investments on the basis of return
  and risk (the two parameter framework)
• Securities
• Risky securities
• Playground
• Perfect capital market
• State of competitive equilibrium

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THE PORTFOLIO SELECTION FRAMEWORK

• MPT generates an efficient frontier which
  comprises of best portfolios.
• Best portfolios provide highest returns within a
  given risk class and lowest risk within a given
  return class.
• High risk-averse investors choose low return-risk
  portfolios, while low risk-averse investors
  choose high return-risk portfolios.

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THE CAIPTAL MARKET THEORY (CMT)

• Combinations of risk-free asset and the market
  portfolio (optimal risky assets) provide higher
  utility than MPT efficient portfolios.
• High risk-averse investors by both the index fund
  and the risk-free assets (government bonds),
  while low risk-averse investors buy only the
  index fund by using personal as well as borrowed
  resources at risk-free rate of interest.
• The market portfolio is proxied by the index fund.

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TOBINS SEPARATION THEOREM

• The investment and financing decisions of the
  investors are independent.
• All investors decide to invest in the market
  portfolio.
• They take financing decision through risk-free
  borrowing or lending depending on their level of
  risk-aversion.

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LIMITATIONS OF CMT

• CMT provides expected returns only on Sharpes
  efficient portfolios.
• As all investors hold well-diversified market
  portfolio, systematic risk is the only relevant
  part of total risk.
• CAPM is a model for pricing all securities and
  portfolios in the expected return-beta framework.

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SHARPES CAPITAL ASSET PRICIGN MODEL

• THE EQUATION
• Required return of asset i Risk free return
  Market return - Risk free
• return x Beta of asset I.
• Price of time Price of risk x
  Amount of risk
• Assets which provide higher returns than CAPM
  Line are undervalued and should be bought.
• Assets with lower returns than CAPM line are
  overvalued and should be sold.

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USES OF CAPM

• Estimating fair rates of return on public utility
  companies.
• Assessing stock market efficiency.
• Estimating cost of capital and corporate
  valuation.
• Evaluating performance of managed investment
  funds.

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THE EFFICIENT MARKET HYPOTHESIS FAMA (1970)

• Weak form
• Semi-strong
• Strong form

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EFFICIENT MARKET HYPOTHESIS AND CAPM

• EMH implies that all assets must enjoy the
  returns consistent with their risk levels.
• Hence, tests of CAPM are also tests of market
  efficiency.

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ARBITRAGE PRICING THEORY ROSS (1976)

• We lift the veil and observe the economic factors
  that impact the market factor.
• Security returns are generated by common economic
  factors.

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INTER-TEMPORAL CAPM MERTON (1971, 1973)

• There may be dynamic shocks to Markovitz
  efficient frontier owing to
• - Future investment opportunities and rates of
  returns.
• - Wage labour income.
• Securities play a dual role - diversification as
  well as hedging.
• Investors hedge these dynamic shocks resulting in
  a multi-factor framework for generating asset
  returns.

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PROMINENT CAPM ANOMALIES

• Size effect Banz (1981)
• Value or BE/ME effect Chan, Hamao and Lakonishok
  (1989)
• Earnings yield or E/P effect Basu (1983)
• Leverage effect Bhandari (1988)
• Reversal effect De Bondt and Thaler (1985)
• Momentum effect Jegadeesh and Titman (1993)

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FAMA-FRENCH THREE FACTOR MODEL(1993)

• Asset returns are generated by the market, size
  and value factors
• where
• The market factor is defined as the difference
  between market return and risk-free return.
• Size factor is defined as the difference in
  returns on small and big stock portfolios.
• Value factor is defined as return on high BE/ME
  portfolios minus the returns on low BE/ME
  portfolios

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SOURCES OF MOMENTUM PROFITS

• Risk Explanation - Momentum profit may be an
  outcome of a missing risk factor.
• See Fama French (1996), Carhart (1997), Conrad
  and Kaul (1998), Lewellen (2002), etc.
• Behavioral Explanation - Momentum profits result
  owing to investors under-reaction to past
  information.
• See Barferis, Shliefer and Vishny (1998),
  Daniel, Hirshleifer and Subrahmanyam (1998), Hong
  and Stein (1999), Jegadeesh and Titman (2001,
  2002), etc.

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EMERGENCE OF BEHAVIOURAL FINANCE

• Momentum and other behavioural anomalies
  highlight the inter-play of value traders and
  noise traders in financial markets.
• The presence of noise-traders may lead to
  re-definition of existing investment paradigms.

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MODERN INVESETMENT THEORY - THE ROAD AHEAD

• Asset pricing models may have to include noise
  trader risk factor along with the fundamental
  factors.
• The co-existence of value and noise traders may
  imply that stock markets are non-linear dynamical
  or chaotic systems. (Lawerence, Mendalbrotek)