Security Analysis & Portfolio Management

FAC332

Investment Theory

[Sessions 5 to 8]

Professor Narendra Kushwaha

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SAPM | Winter Semester 2025
 Efficient Capital Markets

An efficient capital market is one in

which security prices adjust rapidly to
the arrival of new information.

It implies that the current prices of

securities reflect all information about
the security.

Professor Narendra Kushwaha

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SAPM | Winter Semester 2025
 Why Should Capital Markets Be Efficient?

• Three assumptions for an informationally efficient market:

• A large number of competing profit-maximizing participants analyze

and value securities, each independently of the others.

• New information (that was not known before and is not predictable)
regarding securities comes to the market in a random fashion.

• Buy and sell decisions of profit-maximizing investors cause security

prices to adjust rapidly to reflect the effect of new information.

These assumptions make capital market efficiency one

of the most controversial areas of investment research.

Professor Narendra Kushwaha

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 Why Should Capital Markets Be Efficient?

• The combined effect of:

• Information comes in a random, independent, unpredictable fashion,
and
• Numerous competing investors adjusting stock prices rapidly to reflect
this new information means that:
• Security price changes should be independent and random
• The security prices that prevail at any time should be an unbiased
reflection of all currently available information.
• In an efficient market, the expected returns implicit in the current
price of a stock should be consistent with the perceived risk of the
stock.

Professor Narendra Kushwaha

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 Efficient Market Hypothesis (Eugene Fama, 1970)

• Efficient Market Hypothesis (EMH)

• Changes in security prices occur randomly (stock price movements are

unpredictable and follow a random pattern, meaning that past price
movements or trends cannot reliably predict future prices).

• The current market price reflects all available information about

security, and the expected return based upon this price is consistent
with its risk.

• Divided into three sub-hypotheses depending on the information set

involved.

Professor Narendra Kushwaha

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 Weak-Form EMH

• Current prices reflect all security-market historical

information, including the historical sequence of prices, rates
of return, trading volume data, and other market-generated
information.

• This implies that past rates of return and other market data
should have no relationship with future rates of return.

• In short, prices reflect all historical information.

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 Semi strong-Form EMH

• Current security prices reflect all public information,

including market and non-market information.

• This implies that decisions made on new information after it

is public should not lead to above-average, risk-adjusted
profits from those transactions.

• In short, prices reflect all public information.

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 Strong-Form EMH

• Stock prices fully reflect all information from public and

private sources.

• This implies that no group of investors should be able to

consistently derive above-average, risk-adjusted rates of
return.

• This assumes perfect markets in which all information is

cost-free and available to everyone at the same time.

• In short, prices reflect all public and private information.

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 Behavioral Finance

• It is concerned with the analysis of various psychological

traits of individuals and how these traits affect the manner in
which they act as investors, analysts, and portfolio managers.

• Behavioral finance says standard finance models, which

assume rational behavior and profit maximization, are
incomplete, since it doesn’t consider individual behavior.

• Some investors are not fully rational.

Professor Narendra Kushwaha

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 Behavioral Finance

• The emphasis has been on identifying portfolio anomalies

that can be explained by various psychological traits.

• Richard Thaler was awarded the Nobel Prize in Financial

Economics in 2017 for his work in behavioral finance.

• Three “Tributaries”

• Psychology – focuses on individual behavior.

• Social psychology – how we behave and make decisions

in the presence of others.

• Neurofinance – functioning of the human brain.

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 Behavioral Biases

• Prospect Theory
• The propensity of investors to hold on to “losers” too long
and sell “winners” too soon.
• Investors fear losses much more than they value gains – a
tendency towards loss aversion.
• People don’t evaluate money or utility in absolute terms
but rather as gains or losses compared to a moving
reference point (which could be their past wealth,
expectations, or social comparisons).

Professor Narendra Kushwaha

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 Behavioral Biases

• Belief Perseverance

• Once people have formed an opinion (on a company or stock), they

cling to it too tightly for too long.

• They are reluctant to search for contradictory beliefs.

• Example: An investor believes that Company Y is a great long-term

investment. Initially, the company showed strong growth, and the
investor formed a positive opinion. Later, the company faces declining
earnings and management issues, signaling trouble. Despite the
negative news, the investor refuses to change their belief, thinking,
“It’s just a temporary setback.” They continue to hold or even buy
more shares, ignoring clear warning signs.

Professor Narendra Kushwaha

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 Behavioral Biases

• Anchoring
• Individuals rely too much on the first piece of
information (the “anchor”) they receive when making
decisions.
• Example:
• An investor buys Company X’s stock at Rs. 100 per share.
Later, the stock price drops to Rs. 80 due to market
conditions. Instead of evaluating whether the stock is
currently a good investment, the investor keeps focusing
on the original Rs. 100 price as a reference point (the
anchor).

Professor Narendra Kushwaha

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 Behavioral Biases

• Confirmation bias (Overconfidence)

• Look for information that supports their prior opinions and
decisions.
• Confirmation bias can lead investors to overestimate the
potential of an investment, hold onto bad stocks too
long, or take unnecessary risks.
• Example: An investor strongly believes that Company X
will grow significantly. They actively search for positive
news about the company (e.g., new product launches and
strong revenue reports) and ignore negative signs, such as
declining market share or regulatory risks.
Professor Narendra Kushwaha
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 Behavioral Biases

• Noise Traders (non-professionals with no special

information)
• Influenced strongly by sentiment, they tend to move
together, which increases the prices and the volatility.

• Escalation Bias
• Put more money into a bad investment.
• Explains the popular practice of “averaging down” on an
investment that has declined in value.

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 Fusion Investing

• Integration of two elements of investment valuation-fundamental

value and investor sentiment

• When investor sentiment is muted, noise traders are inactive, so

fundamental valuation dominates market returns.

• When investor sentiment is strong, noise traders are very active,

and market returns are more heavily impacted by investor
sentiments.

• Analysts and investors must be cognizant of these dual effects.

• Fundamental valuation may be a dominant factor but takes

longer to assert itself – about three years.

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 Implications of Efficient Capital Markets

• Fundamental analysts believe that there is a basic intrinsic

value for the aggregate stock market, various industries, or
individual securities, and these values depend on underlying
economic factors.

• Investors should determine the intrinsic value of an

investment at a point in time and compare it to the market
price.

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 Implications of Efficient Capital Markets

• If you can do a superior job of estimating intrinsic value, you

can make superior market timing decisions and generate
above-average returns.

• Intrinsic value analysis involves:

• Aggregate market analysis

• Industry and company analysis

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 Insights from Behavioral Finance

• Recognize that market prices are a combination of

fundamental value and investor sentiment.

• Opportunities to derive abnormal rates of return by acting on

some of the deeply ingrained biases of investors.

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 Background Assumptions

• Investors want to maximize returns from the total set of

investments for a given level of risk.

• The portfolio includes all assets and liabilities.

• The relationship between the returns for assets in the

portfolio is important.

• A good portfolio is not simply a collection of individually

good investments.

Professor Narendra Kushwaha

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 Standard Deviation of a Portfolio
• Impact of a New Security in a Portfolio
• Two effects to the portfolio’s standard deviation when we add a
new security to such a portfolio:
• The asset’s own variance of returns
• The covariance between the returns of this new asset and
the returns of every other asset that is already in the portfolio
• The relative weight of these numerous covariances is substantially
greater than the asset’s unique variance; the more assets in the
portfolio, the more this is true.
• The important factor to consider when adding an investment to a
portfolio that contains a number of other investments is not the new
security’s own variance but the average covariance of this asset with
all other investments in the portfolio.

Professor Narendra Kushwaha

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 Standard Deviation of Two-Asset Portfolio

• Portfolio Standard Deviation Formula for two assets:

𝜎𝑝𝑜𝑟𝑡 = 𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝐶𝑜𝑣1,2

where:
σport = standard deviation of the portfolio
w1 = weight of Asset 1 in the portfolio
w2 = weight of Asset 2 in the portfolio
σ2 1 = variance of rates of return for Asset 1
σ2 2 = variance of rates of return for Asset 2
Cov12 = covariance between the rates of return for assets
1 and 2

Professor Narendra Kushwaha

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SAPM | Winter Semester 2025
 Impact of a New Security in a Portfolio

• Two effects to the portfolio’s standard deviation when we add a new

security to such a portfolio:

• The asset’s own variance of returns

• The covariance between the returns of this new asset and the
returns of every other asset that is already in the portfolio

• The relative weight of these numerous covariances is substantially

greater than the asset’s unique variance; the more assets in the portfolio,
the more this is true.

• The important factor to consider when adding an investment to a

portfolio that contains a number of other investments is not the new
security’s own variance but the average covariance of this asset with all
other investments in the portfolio.

Professor Narendra Kushwaha

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 Two Characteristics of an Asset/Portfolio

Any asset or portfolio of assets can be described by two

characteristics:

A. The expected rate of return

B. The standard deviation of returns

Professor Narendra Kushwaha

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 Portfolio Standard Deviation Calculation

• Equal Risk and Return—Changing Correlations:

• The expected return of the portfolio does not change because it is

simply the weighted average of the individual expected returns

• Demonstrates the concept of diversification, whereby the risk of the

portfolio is lower than the risk of either of the assets held in the
portfolio

• Risk reduction benefit occurs to some degree any time the assets
combined in a portfolio are not perfectly positively correlated (that
is, whenever ri,j < +1)

• Diversification works because there will be investment periods when

a negative return to one asset will be offset by a positive return to the
other, thereby reducing the variability of the overall portfolio return.

Professor Narendra Kushwaha

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 Portfolio Standard Deviation Calculation

• Equal Risk and Return—Changing Correlations:

• The negative covariance term exactly offsets the individual variance

terms, leaving an overall standard deviation of the portfolio of zero

• This would be a risk-free portfolio, meaning that the average

combined return for the two securities over time would be a constant
value (that is, have no variability)

• Thus, a pair of completely negatively correlated assets provides the

maximum benefits of diversification by completely eliminating
variability from the portfolio.

Professor Narendra Kushwaha

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Professor Narendra Kushwaha
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 Portfolio Standard Deviation Calculation

• Combining Stocks with Different Returns and Risk

• Consider two assets (or portfolios) with different expected rates of

return and individual standard deviations.

• With a perfect negative correlation, the portfolio standard deviation

is not zero.

• This is because the different examples have equal weights, but the
asset standard deviations are not equal.

Professor Narendra Kushwaha

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Professor Narendra Kushwaha
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 Portfolio Standard Deviation Calculation

• Constant Correlation with Changing Weights:

• If the weights of the two assets are changed while

holding the correlation coefficient constant, a set of
combinations is derived that trace an ellipse.

• The benefits of diversification are critically dependent on

the correlation between assets.

Professor Narendra Kushwaha

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Professor Narendra Kushwaha
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 A Three-Asset Portfolio

• The results for the two-asset portfolio can be extended to a

portfolio of n assets.

• As more assets are added to the portfolio, more risk will be

reduced (everything else being the same).

• The general computing procedure is still the same, but the

amount of computation has increased rapidly.

• For the three-asset portfolio, the computation has doubled

in comparison with the two-asset portfolio.

Professor Narendra Kushwaha

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 Estimation Issues

• Results of portfolio allocation depend on accurate statistical

inputs.
• Estimates of:
• Expected returns
• Standard deviation
• Correlation coefficient
• Among an entire set of assets
• With 100 assets, 4,950 correlation estimates
• Estimation risk refers to potential errors

Professor Narendra Kushwaha

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 Estimation Issues

• With the assumption that stock returns can be explained by a

single market model, the number of correlations required
reduces to the number of assets.

• Single index market model:

Ri = ai + bi Rm + i

Where:
bi = the slope coefficient that relates the returns for security i to the returns
for the aggregate market
Rm = the returns for the aggregate stock market

Professor Narendra Kushwaha

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 Estimation Issues

• If all the securities are similarly related to the market and a bi

derived for each one, it can be shown that the correlation
coefficient between two securities i and j is given as:

 2
rij = bi b j m

 i j

where:
σ2m = variance of returns for the aggregate stock market

Professor Narendra Kushwaha

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 Textbook Appendix Problem 6 (Page 204)
• Given: E(R ) = 0.12 E(𝜎1) = 0.04
1
E(R2) = 0.16 E(𝜎2) = 0.06
Calculate the expected returns and expected standard deviations of a
two-stock portfolio having a correlation coefficient of .70 under the
following conditions.
a. w1 = 1.00
b. w1 = 0.75
c. w1 = 0.50
d. w1 = 0.25
e. w1 = 0.05
Plot the results on a risk-return graph. Without calculations, draw what
the curve would look like first if the correlation coefficient had been
0.00 and then if it had been -0.70.
Professor Narendra Kushwaha
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 The Efficient Frontier

• The efficient frontier represents that set of portfolios with

the maximum rate of return for every given level of risk or
the minimum risk for every level of return.

• Every portfolio that lies on the efficient frontier has either a

higher rate of return for the same risk level or lower risk for
an equal rate of return than some portfolio falling below the
frontier.

Professor Narendra Kushwaha

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 The Efficient Frontier

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 The Efficient Frontier

• Markowitz defined the basic problem that the investor needs to

solve as:
• Select {wi} so as to:

n n n
Minimize  port =  w  +  w w   r
i =1
2
i
2
i
i =1 j =1
i j i j ij

i j

subject to the following conditions:

( )
(i) E Rport =  wi E ( Ri ) = R*
(ii)  wi = 1.0
Professor Narendra Kushwaha
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 The Efficient Frontier
• Constrained optimization: Select the investment weights that
will “optimize” the objective (minimize portfolio risk) while also
satisfying two restrictions (constraints) on the investment
process:
i. The portfolio must produce an expected return at least as
large as the return goal, R; and
ii. All of the investment weights must sum to 1.0
• The approach to forming portfolios according to this equation is
often referred to as mean-variance optimization because it
requires the investor to minimize portfolio risk for a given
expected (mean) return goal.
 Textbook Appendix Problem 7 (Page 204)
• The following are monthly percentage price changes for four market indexes:
Month DJIA S&P500 Russell Nikkei
1 0.03 0.02 0.04 0.04
2 0.07 0.06 0.10 -0.02
3 -0.02 -0.01 -0.04 0.07
4 0.01 0.03 0.03 0.02
5 0.05 0.04 0.11 0.02
6 -0.06 -0.04 -0.08 0.06
• Compute the following:
a) Average monthly rate of return for each index
b) The standard deviation for each index
c) Covariance between the rates of return for the following indexes:
• DJIA-S&P 500; S&P 500-Russell 2000; S&P 500-Nikkei; Russell 2000-
Nikkei
d) The correlation coefficients for the same four combinations
e) Using the answers from parts (a), (b), and (d), calculate the expected return
and standard deviation of a portfolio consisting of equal parts of (1) the S&P
and the Russell 2000 and (2) the S&P and the Nikkei. Discuss the two
portfolios.
Professor Narendra Kushwaha
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SAPM | Winter Semester 2025
 The Efficient Frontier

• Markowitz defined the basic problem that the investor needs to

solve as:
• Select {wi} so as to:

n n n
Minimize  port =  w  +  w w   r
i =1
2
i
2
i
i =1 j =1
i j i j ij

i j

subject to the following conditions:

( )
(i) E Rport =  wi E ( Ri ) = R*
(ii)  wi = 1.0

Professor Narendra Kushwaha

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 The Capital Market Line

• The risk-return relationship holds for every combination

of the risk-free asset with any collection of risky assets.

• This relationship holds for every combination of the

risk-free asset with any collection of risky assets.

• However, when the risky portfolio, M, is the market

portfolio containing all risky assets held anywhere in the
marketplace, this linear relationship is called the
Capital Market Line (CML).

Professor Narendra Kushwaha

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 Developing the Capital Market Line

• Covariance with a Risk-Free Asset

• Because the returns for the risk-free asset are certain, the
covariance between the risk-free asset and any risky asset
or portfolio will always be zero.
• Similarly, the correlation between any risky asset and the
risk-free asset would be zero.

Professor Narendra Kushwaha

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 Developing the Capital Market Line
• Combining a Risk-Free Asset with a Risky Portfolio
• The expected return is the weighted average of the two
returns.

( )
E Rport = wRF ( RFR ) + (1 − wRF ) E ( RM )

Standard Deviation: This is the linear proportion of the standard

deviation of the risky asset portfolio.

 port = (1 − wRF ) 
2 2
M

= (1 − wRF )  M
Professor Narendra Kushwaha
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 Developing the Capital Market Line

• The Risk–Return Combination:

• Investors who allocate their money between a riskless
security and the risky Portfolio M can expect a return equal
to the risk-free rate plus compensation for the number of risk
units (σport) they accept.

 E ( RM ) − RFR 
(
E Rport ) = RFR +  port 
M

 

Professor Narendra Kushwaha

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 Developing the Capital Market Line

• Risk-return possibilities with leverage:

• Return will increase in a linear fashion.

( )
E Rport = wRF ( RFR ) + (1 − wRF ) E ( RM )

• The standard deviation will increase in a linear fashion.

 port = ( RF ) M
1 − w 
2
2

= (1 − wRF )  M

Professor Narendra Kushwaha

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 Developing the Capital Market Line

Professor Narendra Kushwaha

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 Developing the Capital Market Line

• Risk-return possibilities with leverage:

• One can attain a higher expected return than is available at point M
• One can invest along the efficient frontier beyond point M, such as
point D
• With the risk-free asset, one can add leverage to the portfolio by
borrowing money at the risk-free rate and investing in the risky
portfolio at point M to achieve a point like E.
• Clearly, point E dominates point D.
• Similarly, one can reduce the investment risk by lending money at the
risk-free asset to reach points like C.

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 Developing the Capital Market Line

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Readings
• Textbook Chapter 5

• Pages 126 – 127

• Pages 142 – 144

• Textbook Chapter 6

• Pages 171 – 197

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Homework Questions

• Chapter 6:

• Q1 to Q10.

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