Gap fill: Understanding investment theories

In the latest in our exclusive series of gap fill articles helping you prepare for RDR, Jackie Lockie covers everything you need to know about the main investment theories…

Some aspects of this article may be new to you, or may feel alien, but bear with me. Not all the aspects we talk about will be used by all investment managers but the majority should have a good understanding of most aspects of this.

A history of asset pricing:

Since the 18th century, Adam Smith has been credited as one of the leading intellectuals on the origin of free markets. He advocated that free markets work and that they are the best way to gain social order and allocate resources appropriately.

Friedrich Hayek used Smith’s work as a base and gave us insights into how and why free markets work. His idea was that a pricing system was the best way to communicate information for any goods or services because there are so many people demanding these goods or services, i.e. market participants.

Since the 1950s, the work of others including Harry Markowitz, Merton Miller, William Sharpe and Eugene Fama have shaped the investment and finance world, providing much more scientific and academic research into how markets work. In 1990 Markowitz, Miller and Sharpe won the Nobel prize in economics.

Even those with a very basic level of financial knowledge appreciate that there is a relationship between risk and return. Markowitz showed how diversification reduces portfolio risk, Miller developed the parameters of the relationship between risk and return and the cost of capital and Sharpe developed the parameters of the relationship between risk and expected investment return.

Collectively, they suggest capital markets will produce returns for the various asset classes as a reward for taking on the various diversified risks associated with them. This implies we should create portfolios that are diversified across asset classes and in which each asset class is weighted so the overall portfolio return is based on the investor’s attitude to risk.

It should be noted these are not the only investment theories; however, for the basis of this discussion I shall stick to those specifically mentioned.

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