One of the mechanisms through which investors can mitigate portfolio risks is through holding various instruments that are not well positively correlated. This implies that possession of the diversified portfolio assets can cushion an investor from individual asset risks. Diversification can also enable an investor to gain the expected return on portfolio, but with a minimum risk. Generally, assets that have high returns are usually riskier than ones with low returns (Chincarini, 2006). Modern portfolio theory also provides guidelines for choosing low risk portfolios. Therefore, modern portfolio theory is a type of diversification. This theory explains viable means of finding the best diversification strategies. The idea of diversification, as applied in this case, involves choosing a group of investment assets, which together have lower risks compared to individual asset. Nonetheless, diversification has the capacity to reduce losses even if proceeds on assets are not correlated negatively and also if they are correlated positively.
Modern portfolio theory has the assumption that investors are in most cases risk averse. This implies that when one provides investors with a choice of two portfolios, which have the same level of return, they will pick the one with less risk. Therefore, an investor can only accept increased risk if he or she expects higher returns. To this end, risk can be measured by the standard deviation and beta estimates (Sharpe, 2008). It can as well be measured using the expected return formula, but the basic risk formula is given by:
Risk = Impact x Probability
The statement implies that similar results on risk measurements can be obtained using both the standard deviation and beta estimates. This is witnessed with large standard deviation estimates and beta measurements. For instance, risk estimate for a given sub-period barely deviates from the whole period estimated measurements by at least two standard deviations. As a result, the t-statistic deviation from the whole period is insignificant and inconsistent with the estimated sub-period beta measurements. Therefore, it is evident that risk measurements using standard deviations (mean variance) and beta are inconsistent (Chincarini, 2006).
Arbitrage Pricing Model and Capital Pricing Model (CAPM) Differences
Arbitrage Pricing Model makes use of the expected return of risky assets and risk premium components from different macro-economic variables. The risky assets incorporate overprice securities. However, CAPM uses the expected market return (Chincarini, 2006). Moreover, the CAPM considers the sensitivity of assets to risks that cannot be diversified or systematic risks. The rate of return for an asset is subjected to the value of the asset on a given day. The CAPM is one of mechanisms for pricing a particular portfolio or security.
CML and SML Analysis
Capital Market Line (CML) indicates rates of return of a specific portfolio. On the other hand, Security Market Line (SML) shows a market risk’s graphical representation and its associated return at a specific time. The main difference between the two is on measurements of risk factors (Sharpe, 2008). CML uses standard deviation to measure the risk, while the SML makes use of beta coefficient. An asset that is unsystematic risk free is hypothetical, and it pays a rate that is risk free. For instance, short securities such as treasury bills can act as risk free assets. This is because they are able to pay a certain rate of interest that is fixed, and they usually have a low default risk. An asset that is risk free has a zero variance, and this makes it risk free. Besides this, an asset that is risk free is also not correlated with other assets. This is because of the zero variance that it has. Moreover, systematic risk is one that is linked with individual asset. These risks can be minimized within a portfolio through diversification (Sharpe, 2008).
This is a method used for analyzing securities using market’s activity generated statistics, such as past volume and prices. In this regard, a technical analyst uses tools and charts that help in predicting future activity, but he/she does not measure intrinsic values of securities. In this regard, technical analysis incorporates assumptions that the market is capable of discounting everything, the price movement follows certain trends, and the market history is characterized by the self-repetition (Sharpe, 2008). Moreover, technical analysis is advantageous, since it provides information on prices and market action at a glance since the movement patterns are easy to identify.
Trend line technical analysis is more appropriate for making a decision on when to buy, sell and hold the stock. In this regard, buy signal, sell signal and hold signal can be used. For instance, at the buy signal position, an investor can take the buy option. On the other hand, at the sell signal position, an investor can go for the sell option. Moreover, at the hold signal position, that is, represented by the uptrend and downtrend lines, an investor can choose the hold option.
Basic Assumptions of EMH
First, it is assumed that the available stock information is a reflection of the capital market’s total value. Second, it is always assumed that the stock is in equilibrium. Third assumption: it is not possible for an investor to beat a time for a stock market always in the EMH.
Efficient Market Hypothesis (EMH) Analysis
“Weak” form Efficient Market Hypothesis (EMH) ignores the use of technical analysis since the past data and market prices are shown in security prices. On the other hand, “Semi-strong” form ignores the use of fundamental analysis because public information is shown in the security prices. In addition, the “Strong” form disregards the use of insider information since all information is reflected in security prices (Benninga,2008). Moreover, random walk postulates that price movements do not follow some trends and movements of past prices are not used for predicting future movements of prices. However, transaction cost anomalies may reduce any advantage and limited patterns that can outperform several buy, sell and hold strategies, for instance, to be employed at the Michele's Organic Unsecurities Inc.
Pondering on the statement provided, the boss (your boss) was upset by the stock analysis and portfolio manager (you) of the company’s argument for the strong EMH since this strategy affirms that market prices are the reflections of public information as well as the private information. As a result, it is not possible to make significant returns/money through the insider trading. This implies that the strong form EMH provides inaccurate information regarding the expected earnings because this theory cannot hold in the long run. Therefore, your boss could found inconsistency and inaccuracy in your argument for the support for the strong EMH, which can barely hold. In sum, your argument would put the company at a financial risk, and your boss could not be comfortable with you since your investment arguments were not financially healthy for the business.