Investment management: various approaches and their implications

Inaugural lecture--Department of Industrial Economics, Rand Afrikaans University, 12 August 1982Security analysis and portfolio management have changed significantly in recent years. Investment management has become more complicated and sophisticated, both from an academic and practical point of view. It has developed into a separate discipline over a relatively short period. The factors which contributed to the change and development were: (1) the development of the modern portfolio theory (particularly since the contribution made by Tobin, the full covariance model of Markowitz, and the capital-asset pricing model of Sharpe), (2) the development of capital market theory and the efficient market hypothesis, (3) the developments in the field of financial management and policy in general, and (4) the developments in stock market theory and practice. From a practical point of view, the capital markets developed into highly sophisticated markets, mainly as a result of the continuous growth of the institutional investors. It is the investor's objective to maximize the expected rate of return on a given investment, given the expected risk, or to minimize the expected risk, given the expected rate of return, for any given holding-period. This also applies to a diversified portfolio of investments. The expected rate of return refers to the real internal rate of return, after tax, as determined by the discounting of expected future cash flows, after adjusting the latter for inflation and taxation. The expected risk is defined as the dispersion in a subjective probability distribution, or more specifically, the variance and the standard deviation of that distribution, for example, the standard deviation of the expected return, where the latter is a random variable. The standard deviation is an absolute measure of risk. For it to be meaningful one should consider relative risk measures, for example, the coefficient of variation and the beta-coefficient. The value of beta measures the sensitivity of the security's excess return to that of the market portfolio. The expected total risk can be divided into systematic and unsystematic risk. The systematic risk is the market component of the total risk, and the unsystematic risk the non-market component of the total risk. The systematic risk depends on factors which affect all securities, eg changes in macro-economic variables, such as changes in the growth rate, changes in interest rates, the purchasing power risk, political events, etc. The unsystematic risk reflects factors which are unique to individual firms. The unsystematic risk can be reduced by the efficient diversification of investments. The objective of the investor, as stated, implies a continuous trade-off between risk and return. In this respect modern portfolio theories are mostly quantitative. Furthermore, modern theories treat different aspects of portfolio construction, diversification, upgrading, the influence of the market, interrelationships of securities, the risk-return trade-off etc. Lastly, modern portfolio theories include all facets pertaining to the efficient market hypothesis. In the valuation of ordinary shares, three different approaches can be indentified. They are: (1) the fundamental analysis, (2) technical analysis, and (3) the random walk hypothesis. The fundamental analysis is a three step process, beginning with a macro-economic and aggregate market analysis, followed by an industry analysis, and lastly, an analysis of the individual firm. The factors and events influencing the aggregate economy have an important effect on the future performance of industries, with the result that the economic factors must be considered before the different industries can be analysed. The underlying variables which determine intrinsic or investment value must be analysed and projected into the future. An investment based on historical data is not consistent with the efficient market hypothesis. In an efficient market a security's price will be a good estimate of its investment value. An investment based on future estimates of the relevant variables is consistent with the efficient market hypothesis. In this sense the fundamental approach is justifiable and acceptable. Even in a perfectly efficient market there is still work to be done. Fundamental analysis is essential if capital markets are to be efficient. The basic philosophy of the technicians is that it is not necessary to study the fundamentals in order to know where the price of a given security is going, because knowledge of past price movements will be indicative of future price movements. Thus the methodology of technical analysis rests upon the assumption that history tends to repeat itself. Furthermore, the technicians assume that share prices tend to move in trends which persist for long periods, and that prices adjust only partially and slowly to a new equilibrium level. To be able to derive above average results the technician must have a system to detect the beginning of price movements from one equilibrium value to the next. There are numerous technical rules, eg contrary opinion rules, the confidence index, the breadth of the market, and charting. There is little evidence showing the efficacy of technical methods. Technical analysis is inconsistent with the efficient market hypothesis and therefore unacceptable. According to the random walk hypothesis, share price changes over time are serially independent. In an efficient market price changes would adjust very rapidly to the infusion of any new information, which comes to the market in a random, independent fashion. The independence assumption gives a good description of reality. There is consistent empirical evidence of the random walk hypothesis. The random walk theory is consistent with the weak form of the efficient market hypothesis, and is therefore acceptable. The technical analysis and random walk hypothesis are irreconcilable. In the teaching of and research on investment management, the various approaches will be dealt with. More emphasis will, however, be placed on the fundamental approach and the modern portfolio theories. Furthermore, the basic training in investment management must be of an interdisciplinary nature