Question

Briefly explain the following statements:

i) Fundamental Analysis and Technical Analysis and their application in securities analysis

ii) Diversification effect by using portfolio theory and CAPM

iii) The use of alpha and beta in investment selection

iv) The role of correlations, variance and covariance in portfolio theory.

Answer 1

i) Fundamental analysis involves the calculation of intrinsic value of a stock by analyzing the revenue, expenditure, growth drivers and prospects, peer analysis, and cash flows. Popular methods of valuing a stock include discounted cash flow method, relative valuation method, dividend discount method, sum of the parts method. The valuation methods help to understand whether the stock is overvalued or undervalued. The fundamental analysis helps to understand the valuation of a stock over the longer time horizon.

Technical analysis involves the stock price, trading volume and industry trading patterns. Simple moving averages, support and resistance, trend lines, and momentum-based indicators are some of the common forms of technical analysis. Both the analysis help to forecast the future stock movement. Technical analysis is usually adopted for the shorter time horizon like trading purposes.

ii) According to Harry Markowitz's Modern Portfolio Theory (MPT),

• Investors hate risk. If two assets are generating the same expected return, investors will prefer the less risky asset. An investor who expects more returns will have to take more risk. The expected trade-off between risk and return is dependent on the individual’s level of risk aversion.
• A rational investor will not invest in a portfolio if another portfolio offers a better risk-return trade-off.
• Investors will prefer portfolios with higher expected returns instead of those with lower returns.
• Investors are only interested in the expected return measured by mean and the volatility of an investment measured by standard deviation. Investors ignore any other charges.

CAPM assumes:

• Investors hate risk and want to maximize expected utility of wealth
• The capital market is not dominated by any individual investor
• Investors are only interested in a security's expected returns and variance or standard deviation
• The risk free rate is the rate at which all investors may go for unlimited borrowing or lending
• Absence of dealing charges, taxes and other imperfections
• Similar view of every security by the investors

Under CAPM, the market will compensate an investor for taking a non diversifiable or systematic risk but not a specific risk.

iii) Beta is a measure of stock volatility. Beta measures a stock movement against a benchmark (like S&P 500). Alpha is a measure of a stock's return on investment (ROI) compared to the risk adjusted expected return.

If XYZ’s stock has a ROI of 12% for the year and a beta of + 1.8. The S&P 500 was up 10% during the period.

A beta of 1.8 means volatility 80% greater than the S&P 500; therefore the stock should have had a return of 18% to compensate for the additional risk taken by owning a higher volatility investment. The stock only had a return of 12%; six percent less than the rate of return needed to compensate for the additional risk. The Alpha for this stock was -6 and implies that it was not a good investment.

iv) Covariance is a statistical measure of how one investment moves in relation to another. If two investments move up or down at the same time, then they have positive covariance. If the rise and fall of one investment is in tandem with the other, then the two investments have perfect positive covariance. If do not move in tandem, then they have negative covariance. If one inevestment rises while the other falls, then the investments have perfect negative covariance.

Covariance numbers cover a big range, and therefore the covariance is normalized into the correlation coefficient. Correlation coefficient measures the degree of correlation, ranging from negative one for a perfectly negative correlation to positive one for a perfectly positive correlation. An uncorrelated investment pair would have a correlation coefficient of zero.

The greatest negative correlations signifies the highest diversification of a portfolio.

Correlations can change over time and in different economic conditions.

Risk is defined by the standard deviation of the expected returns of an asset, which is equal to the square root of its variance.

Portfolio risks can be calculated by taking the standard deviation of the variance of actual returns of the portfolio over time.