Introduction
Investment decisions shape the financial landscape of businesses, individuals, and economies. Understanding the financial theory of investment helps investors allocate resources effectively and mitigate risk. This article explores the key principles of investment theory, the role of risk and return, asset pricing models, and practical applications.
Table of Contents
Foundations of Investment Theory
Investment theory rests on several core principles: risk and return, diversification, market efficiency, and valuation. These principles help investors assess opportunities and optimize portfolios.
Risk and Return
Investment decisions hinge on the trade-off between risk and return. Higher returns usually come with increased risk. This concept is quantified using expected return and standard deviation.
Formula for Expected Return:
E(R)=∑i=1npiRiE(R) = \sum_{i=1}^{n} p_i R_i
Where:
- E(R)E(R) = Expected return
- pip_i = Probability of return RiR_i
- RiR_i = Possible return outcomes
Formula for Standard Deviation:
σ=∑i=1npi(Ri−E(R))2\sigma = \sqrt{\sum_{i=1}^{n} p_i (R_i – E(R))^2}
Where:
- σ\sigma = Standard deviation
- E(R)E(R) = Expected return
- RiR_i = Possible return outcomes
- pip_i = Probability of return RiR_i
Diversification and Portfolio Theory
Diversification reduces risk by spreading investments across various assets. Harry Markowitz’s Modern Portfolio Theory (MPT) formalizes this idea.
Portfolio Return Formula:
E(Rp)=∑i=1nwiE(Ri)E(R_p) = \sum_{i=1}^{n} w_i E(R_i)
Where:
- E(Rp)E(R_p) = Expected portfolio return
- wiw_i = Weight of asset ii in the portfolio
- E(Ri)E(R_i) = Expected return of asset ii
Portfolio Risk (Two-Asset Case):
σp2=w12σ12+w22σ22+2w1w2ρ12σ1σ2\sigma_p^2 = w_1^2 \sigma_1^2 + w_2^2 \sigma_2^2 + 2w_1 w_2 \rho_{12} \sigma_1 \sigma_2
Where:
- σp2\sigma_p^2 = Portfolio variance
- ρ12\rho_{12} = Correlation coefficient between asset 1 and 2
A well-diversified portfolio minimizes unsystematic risk, leaving investors exposed only to systematic risk.
Market Efficiency Hypothesis
The Efficient Market Hypothesis (EMH), proposed by Eugene Fama, asserts that asset prices reflect all available information. It classifies markets into:
- Weak-form efficiency – Prices reflect historical data.
- Semi-strong efficiency – Prices incorporate public information.
- Strong-form efficiency – Prices reflect all public and private data.
In highly efficient markets, active investing struggles to outperform passive strategies.
Asset Pricing Models
Asset pricing models determine the fair value of investments. The most widely used models include the Capital Asset Pricing Model (CAPM), Arbitrage Pricing Theory (APT), and the Dividend Discount Model (DDM).
Capital Asset Pricing Model (CAPM)
CAPM relates an asset’s expected return to its systematic risk.
CAPM Formula:
E(Ri)=Rf+βi(E(Rm)−Rf)E(R_i) = R_f + \beta_i (E(R_m) – R_f)
Where:
- E(Ri)E(R_i) = Expected return of asset ii
- RfR_f = Risk-free rate
- βi\beta_i = Asset’s beta (systematic risk)
- E(Rm)E(R_m) = Expected market return
Higher beta values indicate greater sensitivity to market movements.
Arbitrage Pricing Theory (APT)
APT extends CAPM by incorporating multiple factors that drive asset returns.
APT Formula:
E(R)=Rf+∑j=1nλjFjE(R) = R_f + \sum_{j=1}^{n} \lambda_j F_j
Where:
- λj\lambda_j = Factor risk premium
- FjF_j = Factor sensitivity
APT provides a more flexible approach but requires identifying key macroeconomic factors.
Dividend Discount Model (DDM)
DDM values stocks based on expected future dividends.
Gordon Growth Model:
P0=D1r−gP_0 = \frac{D_1}{r – g}
Where:
- P0P_0 = Present stock price
- D1D_1 = Expected dividend next year
- rr = Required rate of return
- gg = Dividend growth rate
Practical Investment Strategies
Investors apply these theories through different strategies.
Active vs. Passive Investing
| Strategy | Description | Pros | Cons |
|---|---|---|---|
| Active Investing | Selecting stocks based on analysis | Potential for high returns | High fees, time-intensive |
| Passive Investing | Tracking an index like the S&P 500 | Low cost, consistent returns | Limited market outperformance |
Value vs. Growth Investing
Value investors seek undervalued stocks, while growth investors focus on companies with high earnings potential.
| Factor | Value Investing | Growth Investing |
|---|---|---|
| P/E Ratio | Low | High |
| Dividend Yield | High | Low or none |
| Risk Level | Moderate | High |
Conclusion
The financial theory of investment provides a structured approach to decision-making. By understanding risk-return dynamics, portfolio diversification, and asset pricing models, investors can make informed choices. Applying these principles enhances portfolio performance and ensures long-term financial growth.
