Question

explain any 3 three portfolio theories and show their application in modern investment environment

Answer 1

(1) Efficient Market Hypothesis

Explanation:

The efficient market hypothesis theorizes that markets are perfectly efficient and all significant/relevant information is incorporated into the market prices of securities. In this theory, neither fundamental analysis, technical analysis, or any other system can produce risk-adjusted excess returns. In other words, no investor or portfolio management system can generate alpha. This theory hypothesized that securities always trade at their fair values in the market, and therefore no investor can purchase securities at prices below their fair value. Conversely, no investor can sell securities at prices above their fair value.

Application:

Since the theory is that no investor can generate alpha through active portfolio management, it is concluded that investors are better off by investing in passive, low-cost portfolios such as index-tracking funds. Active management increases costs due to cost of research. Index-tracking funds invest in indices such as S&P 500, MSCI Emerging Markets, Russell 2000 etc.

(2) Modern Portfolio Theory

Explanation:

In Modern Portfolio Theory (MPT), any single investment's risk and return characteristics are not viewed on a standalone basis, but in the context of its effect on the entire portfolio. MPT assumes that :

• investors are risk-averse
• markets are efficient
• asset returns are normally distributed
• investors base their decisions on statistical measures such as expected returns, variance and correlation

The assumption of risk-averse investors is that investors prefer lower risk for a given level of return. Conversely, investors prefer higher return for a given level of risk.

Application:

Every possible portfolio is plotted on a graph with x-axis being the portfolio risk and y-axis being the portfolio expected return. Efficient Portfolios are those which yield the highest return for the given level of risk or conversely, the lowest portfolio risk for a given level of expected return. Then, a line is drawn to connect all the most efficient portfolios. This line is called the "efficient frontier". Investing in any portfolio that is not on this line is undesirable. This is because for any portfolio that is not on the efficient frontier, an alternative portfolio exists that has either higher return for the same risk, or lower risk for the same return.

(3) Dow Theory :

Explanation:

Dow theory theorizes that the prices of stocks do not change randomly, but move in cyclical trends. The three underlying trends are primary trends, secondary trends, and minor trends. Primary trends are long-term movements (> 1-3 years), secondary trends are medium term movements (< 1 year), and minor trends are short-term fluctuations (few days to few weeks).

Application:

Major trends reversals are identified through technical analysis. Long-term bottoms and long-term tops are identified by charts. Once the trend reversal is confirmed, long-term positions are taken or added accordingly for long-term timeframes. Medium-term trend reversals can also be identified and positions taken for medium-term timeframes.