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Portfolio Management Theories: Dow Jones & Random Walk Theory

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Portfolio Management Theories: Dow Jones & Random Walk Theory. When we think of investing, we also think of consulting an expert Portfolio Manager. Why not become your own Portfolio Manager? These theories will help you understand various Portfolio Analysis Techniques. Now Scroll down below n check more details for “Portfolio Management Theories”

Portfolio Management Theories, Various Types

Dow Jones Theory:

This theory was formulated by Charles H. Dow.

The Dow Jones Theory is probably the most popular, oldest and most famous theory regarding the behavior of stock market prices.

The Dow Theory’s purpose is to determine where the market is and where is it going.

It classifies the movements of the prices on the share market into three major categories:

  • Primary Movements,
  • Secondary Movements, and
  • Daily Fluctuations.
  1. Primary Movements: They reflect the trend of the stock market & last from one year to three years, or sometimes even more. During a Bull phase, the primary trend is that of rise in prices. During a Bear Phase, the primary trend is that of fall in prices.
  2. Secondary Movements: These movements are opposite in direction to the primary movements and are shorter in duration. These movements normally last from three weeks to three months.
  3. Daily Movements: There are irregular fluctuations which occur every day in the market. These fluctuations are without any definite trend.

Benefit of Dow – Jones Theory:

  1. Timings of Investments: Investor can choose the appropriate time for his investment / divestment Investment should be made in shares when their prices have reached the lowest level, and sell them at a time when they reached the highest peak.
  2. Identification of Trend: Using Dow-Jones theory, the correct and appropriate movement in the market Prices can be identified, and depending on the investor’s preference, decisions can be taken.

Markowitz Model of Risk-Return Optimization:

Markowitz model provides a theoretical framework for analysis of risk-return choices. The concept of efficient portfolios has been enunciated in this model. A portfolio is efficient when it yields highest return for a particular level of risk or minimizes risk for a specified level of expected return.

The Markowitz model makes the following assumptions regarding investor behavior: Investors consider each investment alternative as being represented by a probability distribution of expected returns over some holding period.

Investors maximize one period expected utility and possess utility curve, which demonstrates diminishing marginal utility of wealth.

Individuals estimate risk on the basis of variability of expected returns.

Investors base decisions solely on expected return and variance of returns only.

At a given risk level, higher returns are preferred to lower returns. Similarly for a given level of expected returns, investors prefer less risk to more risk.

Random Walk Theory:

Random walk theory gained popularity in 1973 when Burton Malkiel wrote a book “A Random Walk down Wall Street”, which is now regarded as an investment classic.

It’s a stock market theory that states that the past movement or direction of the price of a stock or overall market cannot be used to predict its future movement. It propounds that stocks take a random and unpredictable path and no connection can be established between two successive peaks (high price of stocks) and troughs (low price of stocks). The chance of a stock’s future price going up is the similar as chance of its going down. A follower of random walk believes it is impossible to outperform the market without assuming additional risk. This is because; the price trends are not the result of any underlying factors, but represent a statistical expression of past data.

Capital Asset Pricing Model:

Capital asset pricing model (CAPM) helps to work out the required rate of return required by investor in the form of equity investment. It establishes a linear relationship between the required rate of return of a security and its beta (β).

CAPM model is based on certain assumptions:

  1. Market efficiency: the capital market efficiency means that share prices reflect all available information.
  2. Risk aversion and mean variance optimization: investors are risk averse. They evaluate a security’s return and risk in terms of expected return and variance or standard deviation respectively. They prefer the highest expected return for a given level of risk. This implies that the investors are mean variance optimizers and they form efficient portfolios.
  3. Homogenous expectations: all investors have the same expectations about expected returns and risks of securities.
  4. Single time period: all investors’ decisions are based on a single time period.
  5. Risk-free rate: all investors can lend and borrow at a risk-free rate of interest.
  6. No Taxes: there exist no taxes whether personal or corporate.
  7. No Transaction cost: Transaction in securities is without any transaction cost.

These models will help you in your analysis regarding best portfolios.

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About CA Ridhi Dhoot

The writer is a Chartered Accountant & a Licentiate Company Secretary. You can reach out to her at [email protected]

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