Portfolio Management

Tutorial 3
Prepared by:
ANG WIN SUN
PONG CHONG BIN
CHIN CHEN HONG
JASHVIN KAUR
DIONG SENG LONG
Question 1

Discuss the rationale for expecting an efficient capital market. What factor would you look for to differentiate the market efficiency
for two alternative stocks?

• An efficient capital market is one in which security prices adjust rapidly to the arrival of new
information, which implies that the current prices of securities reflect all information about the security.

• One factor that would differentiate the market efficiency for two alternative stocks is the level of
information available to investors. If investors have more information about one stock than the other,
then the stock with more information will likely have a higher price. For example, Transport Minister
Anthony Loke announced that the citizen can don’t use the Roadtax sticker or license while driving on
road, we can directly the MyJPJ App when we are driving on rad..

• Second, the market efficiency is affected by the number of market participants and depth of analyst
coverage which mean the large number of independent profit maximizing participants who analyze and
value securities will affect the two alternative stocks. For example, if a lot of people start selling the
MYEG share, the MYEG share price will drop rapidly.
Question 2

What is meant by the term abnormal rate of return?

• Abnormal rate of return is the amount by which a security’s return differs from the
expected rate of return based upon the market’s rate of return and the security’s
relationship with the market.
Question 3

Assume you want to test the EMH by comparing alternative trading rules to a buy and hold policy. Discuss the
three common mistakes that can bias the results against the EMH.
• First, only use information or data that is publicly available at the time of the decision. As an example, if
you use information that is typically not available until six weeks after a period and you assume you have it
four weeks after, your investment results should be superior because you implicitly have prior information.

• Second, account for all transaction costs for the trading rule. This is important because almost all trading
rules involve more transactions than a buy-and-hold policy and if you don’t consider this, it will bias the
results against buy- and-hold.

• Third, be sure to adjust all results for the risk involved because many trading rules will tend to select high-
risk stocks that will have higher returns.
Question 4

Describe the general goal of behavioral finance.

• Behavioral finance deals with individual investor psychology and how it affects
individuals’ actions as investors, analysts, and portfolio managers. The goal of
behavioral finance is to understand how psychological decisions affect markets
and to be able to predict those effects.
• Behavioral finance looks to explain anomalies that can arise in markets due to
psychological factors.
Question 5

Why do the advocates of behavioral finance contend that the standard finance
theory is incomplete?
• The proponents of behavioral finance contend that, although standard finance
theory is acceptable in that it focuses on aggregate market behavior, it is
incomplete because it fails to account for individual behavior.
Question 6

Describe the goals of an index fund. Discuss the contention that index funds are the ultimate answer in a
world with efficient capital markets.

• The goals of an index fund is to archive a return that same as the particular
market index. These kind of fund is try to imitate the market. It focus on
some financial instrument that perform like the market so the return that will
be received by the investors will be at par with the return received from the
Market.

• The index funds is an answer in a world with efficient capital markets

because it is the fund that reflect the information of the market so the
investor will aware the fluctuation information in the market and also
efficient market adjusts the prices of shares accordingly
Question 7a
Briefly explain the concept of the efficient market hypothesis (EMH) and each of its three forms—weak, semi strong, and
strong—and briefly discuss the degree to which existing empirical evidence supports each of the three forms of the EMH.

Efficient market hypothesis (EMH) states that a market is efficient if security prices immediately and fully reflect all available
relevant information. Efficient means informationally efficient, not operationally efficient. Operational efficiency deals with
the cost of transferring funds. If the market fully reflects information, the knowledge that information would not allow anyone
to profit from it because stock prices already incorporate the information.
 
 
1. Weak form asserts that stock prices already reflect all information that can be derived by examining market trading data
such as the history of past prices and trading volume.

2. Semi-strong form says that a firm’s stock price already reflects all publicly available information about a firm’s prospects.
Examples of publicly available information are annual reports of companies and investment data.

3. Strong form of EMH holds that current market prices reflect all information, whether publicly available or privately held,
that is relevant to the firm.
Question 7b
Briefly discuss the implications of the efficient market hypothesis for investment policy as it applies to:
(i) technical analysis in the form of charting, and
(ii) fundamental analysis.

(i)
Technical analysis in the form of charting involves the search for recurrent and predictable patterns in stock prices to enhance
returns. The EMH implies that this type of technical analysis is without value. If past prices contain no useful information for
predicting future prices, there is no point in following any technical trading rule for timing the purchases and sales of
securities. According to weak-form efficiency, no investor can earn excess returns by developing trading rules based on
historical price and return information. A simple policy of buying and holding will be at least as good as any technical
procedure. Tests generally show that technical trading rules do not produce superior returns after adjusting for transactions
costs and taxes.

(ii)
Fundamental analysis uses earnings and dividend prospects of the firm, expectations of future interest rates, and risk
evaluation of the firm to determine proper stock prices. The EMH predicts that most fundamental analysis is doomed to
failure. According to semi-strong form efficiency, no investor can earn excess returns from trading rules based on any publicly
available information. Only analysts with unique insight receive superior returns. Fundamental analysis is no better than
technical analysis in enabling investors to capture above-average returns. However, the presence of many analysts contributes
to market efficiency.
Question 7(c)
Briefly explain two (2) major roles or responsibilities of portfolio managers in an efficient market environment.

1. Identify the risk/return objectives for the portfolio given the investor’s constraints.
In an efficient market, portfolio managers are responsible for tailoring the portfolio to meet the investor’s needs rather than
requirements and risk tolerance. Rational portfolio management also requires examining the investor’s constraints, such as
liquidity, time horizon, laws and regulations, taxes, and such unique preferences and circumstances as age and employment.

2. Developing a well-diversified portfolio with the selected risk level.

Although an efficient market prices securities fairly, each security still has firm-specific risk that portfolio managers can
eliminate through diversification. Therefore, rational security selection requires selecting a well-diversified portfolio that
provides the level of systematic risk that matches the investor’s risk tolerance.