Investment Theories/concepts - Investment Friend

investment theory final edition

Investment theories and concepts provide a framework for understanding how financial markets work and how investors can make informed decisions. Here’s an overview of some key ideas:

Modern Portfolio Theory (MPT)

MPT, pioneered by Harry Markowitz, emphasizes diversification to optimize risk and return. It posits that investors should construct portfolios based on the correlation between assets, not just individual asset performance. The core principle is that by combining assets with low or negative correlations, investors can reduce portfolio volatility without sacrificing expected returns. The “efficient frontier” represents a set of portfolios that offer the highest expected return for a given level of risk, or the lowest risk for a given expected return.

Efficient Market Hypothesis (EMH)

The EMH suggests that asset prices fully reflect all available information. It comes in three forms: weak, semi-strong, and strong. Weak-form efficiency claims that past price data cannot be used to predict future prices. Semi-strong form efficiency asserts that publicly available information cannot be used to generate excess returns. Strong-form efficiency contends that even private information cannot be used to consistently outperform the market. If the EMH holds true, it becomes difficult, if not impossible, for active fund managers to consistently beat the market through stock picking or market timing.

Value Investing

Value investing, popularized by Benjamin Graham and Warren Buffett, focuses on identifying undervalued assets. Value investors seek companies whose stock prices are trading below their intrinsic value, which is estimated through fundamental analysis (e.g., analyzing financial statements, industry trends, and competitive landscape). Common metrics used in value investing include price-to-earnings (P/E) ratio, price-to-book (P/B) ratio, and dividend yield. The idea is that the market will eventually recognize the true value of these companies, leading to price appreciation.

Growth Investing

Growth investing, in contrast to value investing, targets companies with high growth potential. Growth investors are willing to pay a premium for companies expected to experience rapid revenue and earnings growth in the future. They often focus on companies in emerging industries or those with innovative products or services. While growth stocks can offer significant returns, they are also generally considered riskier than value stocks because their valuations are heavily dependent on future expectations.

Behavioral Finance

Behavioral finance challenges the assumption that investors are always rational. It incorporates psychological principles to explain why investors make irrational decisions, such as buying high and selling low. Common behavioral biases include loss aversion (the tendency to feel the pain of a loss more strongly than the pleasure of an equivalent gain), confirmation bias (seeking out information that confirms existing beliefs), and herding (following the actions of others). Understanding these biases can help investors make more rational investment decisions.

Factor Investing

Factor investing involves targeting specific attributes of stocks, known as factors, that have historically been associated with higher returns. Common factors include size (small-cap stocks tend to outperform large-cap stocks), value (as described above), momentum (stocks that have performed well recently tend to continue performing well), quality (companies with strong financials and profitability), and low volatility (stocks with lower volatility tend to outperform high-volatility stocks). Factor investing can be implemented through index funds or exchange-traded funds (ETFs) that track specific factor indexes.