Investment Theories & Frameworks

• Topic 01

  Investment Theories & Frameworks

  92 questions

A few questions from this unit, with the answer and a full explanation. The complete bank is available when you start practising.

1. Regret aversion causes investors to herd. How does this herding behaviour contribute to asset bubbles and subsequent crashes?

   • A
     Regret aversion causes individual investors to avoid unconventional positions; when everyone follows the crowd into a rising asset, prices rise beyond fundamental value (bubble); when sentiment shifts, the same herding dynamic reverses as everyone sells simultaneously, causing a sharp crash that is worse than fundamentals would justify
     Correct answer
   • B
     Herding and regret aversion are opposites: herding is driven by overconfidence; regret aversion is driven by fear; neither individually causes asset bubbles
   • C
     Regret aversion causes bubbles by making investors reluctant to sell overvalued assets; crashes occur only due to external shocks unrelated to the herding dynamic
   • D
     Regret aversion prevents herding: investors who fear future regret refuse to follow the crowd and instead take contrarian positions, stabilising prices
   Explanation

   Regret aversion creates a feedback loop: an investor who avoids a conventional investment (the hot stock, the rising asset) and then watches it rise further experiences regret ('I should have bought what everyone else was buying'). To avoid this regret in future, they join the herd in purchasing the asset. As more investors buy to avoid the regret of missing out, prices rise further, attracting more buyers. This self-reinforcing bubble inflates prices far beyond fundamental value. When confidence falters, the same dynamic runs in reverse — investors sell to avoid the regret of watching gains evaporate, and the crash is amplified by the same herd reversal. This pattern was evident in the dot-com bubble (1999-2000), the housing bubble (2006-08), and multiple other episodes.

2. What is the Carhart Four-Factor Model and what additional factor does it incorporate beyond Fama-French?

   • A
     The Carhart Four-Factor Model adds a momentum factor (UMD: Up Minus Down, or winners minus losers) to the Fama-French Three-Factor Model, capturing the tendency for stocks that have performed well over the past 3-12 months to continue outperforming in the short run
     Correct answer
   • B
     The Carhart Four-Factor Model adds a liquidity factor measuring the premium earned by illiquid stocks over liquid stocks
   • C
     The Carhart Four-Factor Model adds a quality factor (QMJ: Quality Minus Junk) measuring profitability and earnings stability
   • D
     The Carhart Four-Factor Model adds an investment factor (CMA: Conservative Minus Aggressive) measuring the return to companies with low capital expenditure over high capital expenditure
   Explanation

   Mark Carhart (1997) extended the Fama-French model by adding the momentum factor, based on the empirical finding that stocks which have outperformed over the past 3-12 months tend to continue outperforming in the following 3-12 months (the momentum anomaly). The factor is typically measured as past winners minus past losers (UMD). Momentum challenges semi-strong EMH as it is based on publicly available price data. The Carhart model is widely used to evaluate active fund manager performance by attributing returns to these four factors, leaving the unexplained component as 'alpha'.

3. A client has a concentrated portfolio of 5 UK technology shares, all highly correlated with each other. They ask whether their portfolio is well-diversified because they hold 5 different companies. What is the most accurate response in terms of MPT and risk?

   • A
     The portfolio carries significant unsystematic risk because 5 highly correlated shares in the same sector provide minimal diversification benefit; true diversification requires combining assets with low or negative correlations across different sectors, geographies, and asset classes
     Correct answer
   • B
     The portfolio is diversified against systematic risk but not unsystematic risk, which is the more important risk for a long-term investor
   • C
     The portfolio is not diversified but this is irrelevant because systematic risk cannot be diversified regardless of portfolio size
   • D
     The portfolio is well-diversified as long as each holding represents no more than 25% of the portfolio by value
   Explanation

   MPT's diversification benefit depends critically on correlation, not just the number of holdings. Five highly correlated technology shares may move almost in lockstep, providing minimal risk reduction. If correlation between all pairs is 0.9, the portfolio's effective diversification is close to holding a single technology position. Research shows that 15–20 diverse holdings (low correlations, different sectors, geographies) are needed to substantially reduce unsystematic risk. Additionally, all five UK technology shares share sector-specific risk (regulatory changes in tech, sector-wide downturns), which is not diversified. For true diversification, the client would need to include different sectors (financials, healthcare, consumer goods), different geographies, and ideally different asset classes (bonds, property).