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Investment Theories
The search for
True value
Right time to buy or sell
Mix of both ?
Investment theorists seek to answer the question
How much risk is enough ?
How much return to I need ?
How can I balance them?
Investment theorists seek to answer the question
How much risk is enough ?
How much return to I need ?
How can I balance them?
Risk and return
Risk arises from variability of actual returns both below and above expected return. The risk of an investment can be measured by the standard deviation of its expected returns.
Risk arises from variability of actual returns both below and above expected return. The risk of an investment can be measured by the standard deviation of its expected returns.
Yr 1 5% Yr 1 5%
Yr 2 5% Yr 2 -5%
Yr 3 5% Yr 3 15%
Average 5% Average 5%
Utility Theory
Says that the linear relationship between A – C suggests that the “rational” investor will investor in C rather than A because the trade –off between Risk and reward is the same
This assumes “indifference effect is equally linear for everybody”
Yr 1 5% Yr 1 5%
Yr 2 5% Yr 2 -5%
Yr 3 5% Yr 3 15%
Average 5% Average 5%
Next Yr 5% Range- 5% to 15%
We could mix Asset A & B --- Pab
Return is sum of return from A and B
Assume 50 /50 split
50% x 5% = 2.5 % from A
50% x 5% = 2.5% from B
ERPab = 5%
Ra = 5%
Rc = 9%
ERPac =
7%
Better return than Pa less than Pc
What if 30% A and 70% C
Ra = 5%
Rc = 9%
ERPac = (0.30 * 5% ) + (0.70 * 9%)
7.8 %
Better return than Pa less than Pc
E(Rp) = ∑ wi E(Ri)
Eriskab = Risk from A + Risk from B
Ri = (%i)^2 x VARIANCE
Risk A = 0
Risk B ====== Sd = 9 *9 =81
(0.50 *0.50) * 81 = 20.25
Eriskab = 0 + 20.25 = 20.25%
XA2 VarA +(1-XA)2 VarB
ER(a) 0.4 *20% + 0.6 * 0% = 8%
ER(b) 0.4 * 0 % +0.6 * 10% =6%
Var(a)= 0.4 (20-8)^2 +0.6*(0-8)^2
= 0.4 *144 + 0.6*64
= 57.6 + 38.4
= 96
Ωa = √Vara
Ωa = √96
Ωa = 9.797
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