CAPM
Capital asset pricing model is a tool used by investors to determine the risk associated with a potential investment and also gives an idea as to what can be the expected return on the investment. It was developed by William Sharpe along with a formula for working out the risk as who states that with an investment comes two types of risks:
1) Systematic Risk - These are risks that cannot be diversified away such as interest rates and recessions. As the market moves and changes occur which affect the market, each individual asset is affected to some degree and therefore they are sensitive to change causing a high level of risk.
2) Unsystematic (Specific) - Can be diversified through increasing the size of an investment portfolio as this risk is specific to individual stocks and effectively represents no correlation between stocks and market movements.
CAPM states that investors are compensated for taking systematic risk however not for taking specific risk as an investor can diversify this risk away. Systematic risk cannot be eliminated of course even by holding all the shares in a stock market, therefore CAPM has introduced a method of calculating that risk.
Advantages
CAPM has been a popular model for calculating risk for over 40 years now and is therefore a proven method, some advantages are: the focus is on systematic risk as investors have diversified their portfolios, in this case unsystematic risk has effectively been eliminated. Furthermore, in the opinion of most experts it is a more reliable and effective method of calculating risk than other models such as the Dividend Growth Model as CAPM takes into account a company's level of systematic risk against the stock market as a whole; this is a benefit as it allows for a company to compare itself to the market. An investor can also use CAPM for investment appraisal as compared to other rates its offers superior discount rates and this model also can be clearly link between required return and systematic risk.
Disadvantages
Despite the consistent use of the model over the years there has been some criticism for a few reasons: firstly, CAPM is based largely on assumptions and questions have been raised over the reality of the model and the results it produces. An example of this is that no market is perfect and there is no guarantee that the market has priced the assets correctly, this again makes the formula results unreliable and cannot guarantee an investor a safe investment. To add to this borrowing for investors does not come at the risk-free rate and this can mean in reality their security market line will be shallower. In terms of competition to CAPM investment appraisal offers a more long-term perception on investment return whilst CAPM is based on a a short, single-period time where it is is perceived an investment return is assumed constant over a longer time; however this has never been proven correct and is a limitation of CAPM.
In conclusion, CAPM is a well used model for calculating risk and return on investment, its success over the last few decades shows there are definitely some big advantages to it and I personally would recommend its use for investors. However as there are clearly some limitations to the model mostly its lack of reality and shortsightedness I would also advise other models should be used to offer a range of aspects and reduce the risk for investors.
Sunday, 26 October 2014
Sunday, 19 October 2014
Has Modern Portfolio Theory become obsolete? What alternatives have emerged?
Portfolio Theory
In the 1950's Markowitz developed a theory called Portfolio theory (using the MPT model) which states that when it comes to investing, the more sensible method is to have multiple investments creating a 'portfolio'. The idea being that the risk has now been spread and investments are now sounder and can increase the return on those investments. Using this theory is assuming that investors are risk averse; meaning the investor will always choose the less risky portfolio when given the option of two that give the same return. The theory looks at an assets price change in comparison to other asset price changes in the portfolio and not individually; this comparison allows for an analysis of all the portfolio and identifies which assets are riskiest. A calculation is used on the portfolio of investments to decide on the validity of investing in the portfolio which makes for a clearer and more defined analysis of risk and investment worth.
Challenges
Despite its popularity, receiving a Nobel memorial prize, there have been many in recent years who challenge the theory which begs the question 'is MPT still relevant?'. The main criticism is that MPT states that 'volatility is risk' which some do not believe to be true. For years the theory had been widely accepted, however the financial crisis threw up some interesting results concerning what would have been seen to be a placid asset in terms of its volatility; which suddenly lost all its value. Using the MPT model, these assets would have been viewed as less risky than most and would have continued to encourage investment, so long as the investment return was sufficient. Another point made by critics is that there has never been any proven correlation between risk (as volatility) and return; cannot prove that high volatility gives better results and low volatility produces lesser results. Considering that volatility is the main factor in determining whether returns will be high or not according to MPT, this is a major challenge to the theory and is now the reason that the theory is questioned so much.
Is it still relevant?
The financial crisis of recent times has been an anomaly that made many question MPT and is perhaps the answer to the question on it's own; whilst years ago MPT was accepted, new scenarios that have appeared in the last decade have proven that MPT does not always work and may now be outdated. In my opinion, for your safe, non-volatile asset to lose all its value during a crisis, is a very devastating blow to the theory and will make investors second guess their use of the theory, perhaps dubbing it behind the times. However, challenging the theory purely based upon the financial crisis is not full-proof and investors must consider that diversification, while not being completely successful, has certainly offered much protection against risk in the past and may have even helped investors make less of a loss in the financial crisis than if diversification had not been employed.
Alternatives to MPT
One alternative to MPT is something called 'timing the market'. This can be seen as common sense among investors; the principle being that you hold an asset when its value is good, giving positive returns and when things start to go 'bad' for the asset you sell. This can return huge gains on an investment as the theory behind it is so obvious and simple; however a major factor in this method is investors almost need a crystal ball to ensure they can predict what will happen to the value of an asset.
Finally, something that must be considered is the idea of 'Black Swans' those assets which appear to be random and by the large majority of the market completely unpredicted. These would appear to make it impossible for the market to measure risk and therefore can any of the theories or practices be reliable enough to use as a motor for investment.
Conclusion
There is little doubt that MPT has some viable aspects and understands the role that volatility has upon the markets and investments; personally I agree that volatility is risky and must be taken into consideration by all especially since investors are risk adverse. I also think that the financial crisis was an anomaly which could not be predicted or protected against by any theory or practice. Despite this, the financial crisis has definitely proposed some challenges to MPT which any intelligent investor would consider; the main principle of volatility directly correlates to returns has never been conclusively proven and the smallest bit of doubt is enough to make risk adverse investors hesitate. These findings would suggest that MPT has become slightly outdated and there is a good case against the theory, on the other hand, its principles can still be used today and few alternatives have been presented.
In the 1950's Markowitz developed a theory called Portfolio theory (using the MPT model) which states that when it comes to investing, the more sensible method is to have multiple investments creating a 'portfolio'. The idea being that the risk has now been spread and investments are now sounder and can increase the return on those investments. Using this theory is assuming that investors are risk averse; meaning the investor will always choose the less risky portfolio when given the option of two that give the same return. The theory looks at an assets price change in comparison to other asset price changes in the portfolio and not individually; this comparison allows for an analysis of all the portfolio and identifies which assets are riskiest. A calculation is used on the portfolio of investments to decide on the validity of investing in the portfolio which makes for a clearer and more defined analysis of risk and investment worth.
Challenges
Despite its popularity, receiving a Nobel memorial prize, there have been many in recent years who challenge the theory which begs the question 'is MPT still relevant?'. The main criticism is that MPT states that 'volatility is risk' which some do not believe to be true. For years the theory had been widely accepted, however the financial crisis threw up some interesting results concerning what would have been seen to be a placid asset in terms of its volatility; which suddenly lost all its value. Using the MPT model, these assets would have been viewed as less risky than most and would have continued to encourage investment, so long as the investment return was sufficient. Another point made by critics is that there has never been any proven correlation between risk (as volatility) and return; cannot prove that high volatility gives better results and low volatility produces lesser results. Considering that volatility is the main factor in determining whether returns will be high or not according to MPT, this is a major challenge to the theory and is now the reason that the theory is questioned so much.
Is it still relevant?
The financial crisis of recent times has been an anomaly that made many question MPT and is perhaps the answer to the question on it's own; whilst years ago MPT was accepted, new scenarios that have appeared in the last decade have proven that MPT does not always work and may now be outdated. In my opinion, for your safe, non-volatile asset to lose all its value during a crisis, is a very devastating blow to the theory and will make investors second guess their use of the theory, perhaps dubbing it behind the times. However, challenging the theory purely based upon the financial crisis is not full-proof and investors must consider that diversification, while not being completely successful, has certainly offered much protection against risk in the past and may have even helped investors make less of a loss in the financial crisis than if diversification had not been employed.
Alternatives to MPT
One alternative to MPT is something called 'timing the market'. This can be seen as common sense among investors; the principle being that you hold an asset when its value is good, giving positive returns and when things start to go 'bad' for the asset you sell. This can return huge gains on an investment as the theory behind it is so obvious and simple; however a major factor in this method is investors almost need a crystal ball to ensure they can predict what will happen to the value of an asset.
Finally, something that must be considered is the idea of 'Black Swans' those assets which appear to be random and by the large majority of the market completely unpredicted. These would appear to make it impossible for the market to measure risk and therefore can any of the theories or practices be reliable enough to use as a motor for investment.
Conclusion
There is little doubt that MPT has some viable aspects and understands the role that volatility has upon the markets and investments; personally I agree that volatility is risky and must be taken into consideration by all especially since investors are risk adverse. I also think that the financial crisis was an anomaly which could not be predicted or protected against by any theory or practice. Despite this, the financial crisis has definitely proposed some challenges to MPT which any intelligent investor would consider; the main principle of volatility directly correlates to returns has never been conclusively proven and the smallest bit of doubt is enough to make risk adverse investors hesitate. These findings would suggest that MPT has become slightly outdated and there is a good case against the theory, on the other hand, its principles can still be used today and few alternatives have been presented.
Sunday, 12 October 2014
Opposition to EMH: Can the market be beaten?
With stock market prices fluctuating so frequently, especially just prior to announcements, many buyers try and 'beat' the market and predict movements in order to return abnormal yields on their investments.
Fama and EMH
There has been much discussion regarding the ability to be able to predict and with this developed the Efficient Market Hypothesis partly created by Fama; this states that any new information about stocks are already reflected in the share prices and therefore those who believe they have an advantage through new knowledge will not be able to take that advantage because the prices will have changed appropriately and the market reacts completely randomly (Investopedia, 2013). Due to Fama's hypothesis he states that there is no reason to study previous movements or use investment advice from experts claiming to know how the markets will react, it is all, as Fama claims, a waste of time and an attempt to achieve the impossible.
There are three forms of effective market hypothesis: Weak form states that prices already reflect all past publicly available information, the semi-strong form backs this and goes on to say that any new information released is reflected in changes to prices. Many believe that if they have knowledge not known to the public, such as 'insider' knowledge then they will have an advantage and can use the knowledge to return greater yields, however the third form, strong, states that even insider knowledge is reflected in share prices and therefore even insider knowledge is ineffective (Boundless).
Fama also stated predicting the stock market is like taking a random walk due to the speed at which the market reacts to new information, therefore it is impossible to predict (Vulić)
Opposition to the hypo-theory
As with all theory's there is competition to EMH who believe the market prices can be predicted and abnormal gains made. Many tests have been completed in order to test the effectiveness of EMH, most popular of these is the Augmented Dickey–Fuller test but there have been many more analysing different aspects of EMH and stock markets. Technical analysis, which analyses past price actions to advise for future trades, directly opposes the idea that a market is completely random and believes that past trends can be used to predict. Neely (1997) proposed three elements of technical analysis: the first being that price movements reflect hopes, fears, greed and optimism of the stock market participants, many believe stocks are valued not at their value but what people believe their worth to be. The second and third principles both involve the idea that history and trends are very helpful, they hold the belief that history and trends do not suddenly become random and do follow a pattern as people will always react the same way (Dixon, 2005). In my opinion the emotional make-up of investors does not always remain the same and past trends will also not remain consistent throughout trading years.
Conclusion
The debate of whether or not you can predict or even 'beat' the market will always be one of issue and will split many opinions and continue to be tested. In my opinion I do not believe anyone can be sure that past trends are likely to predict current trends and as EMH states, even new information leaked is reflected in share prices especially as investors are now able to react so quickly to information.Therefore, whilst some may be able to return abnormal yields on investment, it is not due to analysis rather than anomalies and I do not believe the market can be effectively and consistently beaten.
Fama and EMH
There has been much discussion regarding the ability to be able to predict and with this developed the Efficient Market Hypothesis partly created by Fama; this states that any new information about stocks are already reflected in the share prices and therefore those who believe they have an advantage through new knowledge will not be able to take that advantage because the prices will have changed appropriately and the market reacts completely randomly (Investopedia, 2013). Due to Fama's hypothesis he states that there is no reason to study previous movements or use investment advice from experts claiming to know how the markets will react, it is all, as Fama claims, a waste of time and an attempt to achieve the impossible.
There are three forms of effective market hypothesis: Weak form states that prices already reflect all past publicly available information, the semi-strong form backs this and goes on to say that any new information released is reflected in changes to prices. Many believe that if they have knowledge not known to the public, such as 'insider' knowledge then they will have an advantage and can use the knowledge to return greater yields, however the third form, strong, states that even insider knowledge is reflected in share prices and therefore even insider knowledge is ineffective (Boundless).
Fama also stated predicting the stock market is like taking a random walk due to the speed at which the market reacts to new information, therefore it is impossible to predict (Vulić)
Opposition to the hypo-theory
As with all theory's there is competition to EMH who believe the market prices can be predicted and abnormal gains made. Many tests have been completed in order to test the effectiveness of EMH, most popular of these is the Augmented Dickey–Fuller test but there have been many more analysing different aspects of EMH and stock markets. Technical analysis, which analyses past price actions to advise for future trades, directly opposes the idea that a market is completely random and believes that past trends can be used to predict. Neely (1997) proposed three elements of technical analysis: the first being that price movements reflect hopes, fears, greed and optimism of the stock market participants, many believe stocks are valued not at their value but what people believe their worth to be. The second and third principles both involve the idea that history and trends are very helpful, they hold the belief that history and trends do not suddenly become random and do follow a pattern as people will always react the same way (Dixon, 2005). In my opinion the emotional make-up of investors does not always remain the same and past trends will also not remain consistent throughout trading years.
Conclusion
The debate of whether or not you can predict or even 'beat' the market will always be one of issue and will split many opinions and continue to be tested. In my opinion I do not believe anyone can be sure that past trends are likely to predict current trends and as EMH states, even new information leaked is reflected in share prices especially as investors are now able to react so quickly to information.Therefore, whilst some may be able to return abnormal yields on investment, it is not due to analysis rather than anomalies and I do not believe the market can be effectively and consistently beaten.
Subscribe to:
Posts (Atom)