LO3 Investment and Behavioural Theories
Modern portfolio theory, efficient frontier, multifactor models, EMH, CAPM, diversification, hedging, alpha, beta, risk-adjusted return and behavioural finance.
How to prepare for R02
Match the annual edition to your exam date, learn product structures and risk relationships, then practise calculation, analysis and client-application decisions.
Core concepts
Concept 1
Modern portfolio theory relates expected return, variance and correlation to efficient portfolios, while CAPM links expected return to systematic risk under restrictive assumptions.
Exam cue: State the theory's assumptions, input and claimed conclusion before judging its usefulness.
Concept 2
Efficient-market hypotheses describe differing levels of information reflected in prices; multifactor models recognise that several risk drivers may explain returns.
Exam cue: Separate total volatility from systematic beta and manager alpha.
Concept 3
Diversification reduces idiosyncratic exposure but not all market risk, hedging trades one exposure for cost and basis risk, and behavioural biases can affect individuals and markets.
Exam cue: Identify the exposure being hedged, the instrument used, hedge ratio, cost and residual basis or counterparty risk.
Risk pitfalls and guardrails
Treating an efficient frontier as a guaranteed set of future outcomes.
Guardrail: Do not mix asset and wrapper, nominal and real, price and yield, willingness and capacity, or benchmark return with investor experience.
Assuming diversification eliminates systematic risk.
Guardrail: Do not mix asset and wrapper, nominal and real, price and yield, willingness and capacity, or benchmark return with investor experience.
Explaining any past outperformance as persistent skill without benchmark, risk and cost adjustment.
Guardrail: Do not mix asset and wrapper, nominal and real, price and yield, willingness and capacity, or benchmark return with investor experience.
Memory anchors
MPT
Expected return, volatility and correlation combine to identify portfolios efficient for the assumptions used.
CAPM
CAPM relates expected excess return to market beta under a simplified equilibrium model.
EMH Levels
Weak, semi-strong and strong forms differ by the information assumed to be reflected in prices.
Beta and Alpha
Beta measures market sensitivity; alpha is return unexplained by the selected benchmark model.
Diversify, Not Immunise
Diversification can reduce asset-specific risk but cannot guarantee against market loss.
Behaviour Matters
Biases, framing, herding and loss aversion can distort decisions and market prices.
Checkpoint rule
Do the check-up only after you can summarize each concept in one sentence and identify one dangerous pitfall from memory.
Knowledge Check (after reading)
Short check-up to confirm understanding of this module.
Check-up Questions
Under modern portfolio theory, an efficient portfolio offers
A portfolio lies below the efficient frontier. What does that imply?
Answer all questions to submit.
Next step personalized recommendations
Continue learning
Move forward only after this module is stable.
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