Chapter 2: Q1B. (page 224)
Suppose investors believe that the standard deviation of the market-index portfolio has increased by 50%. What does the CAPM imply about the effect of this change on the required rate of return on Google’s investment projects?
Increase the required rate of return on Google
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Question: Don Sampson begins a meeting with his financial adviser by outlining his investment philosophy as shown below:
Statement Number | Statement |
1 | Investments should offer strong return potential but with very limited risk. I prefer to be conservative and to minimize losses, even if I miss out on substantial growth opportunities. |
2 | All nongovernmental investments should be in industry-leading and financially strong companies. |
3 | Income needs should be met entirely through interest income and cash dividends. All equity securities held should pay cash dividends. |
4 | Investment decisions should be based primarily on consensus forecasts of general economic conditions and company-specific growth. |
5 | If an investment falls below the purchase price, that security should be retained until it returns to its original cost. Conversely, I prefer to take quick profits on successful investments. |
6 | I will direct the purchase of investments, including derivative securities, periodically. These aggressive investments result from personal research and may not prove consistent with my investment policy. I have not kept records on the performance of similar past investments, but I have had some “big winners.” |
Select the statement from the table above that best illustrates each of the following behavioral finance concepts. Justify your selection.
i. Mental accounting.
ii. Overconfidence (illusion of control).
iii. Reference dependence (framing).
Growth and value can be defined in several ways. Growth usually conveys the idea of a portfolio emphasizing or including only companies believed to possess above-average future rates of per-share earnings growth. Low current yield, high price-to-book ratios, and high price-to-earnings ratios are typical characteristics of such portfolios. Value usually conveys the idea of portfolios emphasizing or including only issues currently showing low price-to-book ratios, low price-to-earnings ratios, above-average levels of dividend yield, and market prices believed to be below the issues’ intrinsic values.
a. Identify and provide reasons why, over an extended period of time, value-stock investing might outperform growth-stock investing.
b. Explain why the outcome suggested in ( a ) should not be possible in a market widely regarded as being highly efficient.
If the simple CAPM is valid, which of the situations in Problems 13 – 19 below are possible? Explain. Consider each situation independently.
When adding a risky asset to a portfolio of many risky assets, which property of the asset is more important, its standard deviation or its covariance with the other assets? Explain.
The semi-strong form of the efficient market hypothesis asserts that stock prices:
a. Fully reflect all historical price information.
b. Fully reflect all publicly available information.
c. Fully reflect all relevant information including insider information.
d. May be predictable.
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