Any business – financial, manufacturer, distributor or service provider – follows the standard assumption in microeconomic theory of the firm states that the primary goal of a firm in a market-based economy is to maximize economic profits (Varian, 1999). However, unlike a manufacturing company the make up of a financial or investing brokerage firm such as AG Edwards, Inc. is a lot different.In this paper, I talk about how economic and investing theories affect AG Edwards. Through this I aim to demonstrate my understanding and knowledge of theories such as the random walk theory, efficient market theory, modern portfolio theory, fundamental and technical analysis, and of course the capital asset pricing model.
Risks
Risk refers to the chance that some unfavorable event will occur. An investment risk, on the other hand, is defined as the probability of earning a return less than the expected return. However, risk such as investment risk is a difficult concept to grasp; and a lot of controversy has surrounded attempts to define and measure it. As it turns out individuals who have money to invest have a harder time to decide what vehicle to invest in. The investment vehicle should at least matc
[...] However, achieving portfolio diversification is what investors pay investment brokerage houses such as AG Edwards for. Diversification in a portfolio of securities is a primary tenet of modern portfolio theory as it is at AG Edwards. The level of diversification to be adopted into a portfolio depends on the risk profile of the investor. The risk preferences of the investor are matched with the risks of the individual assets in the portfolio and with the risk of the entire portfolio itself. [...]
[...] Obviously, at AG Edwards they also don't agree with the efficient market theory of Dr. Eugene Fama. Modern Portfolio Theory The Modern Portfolio Theory or MPT proposes that rational investors should diversify their portfolio in order to optimize profit and minimize the risks. The MPT assumes that risk and reward are opposite: the more risks you take, the more reward you can obtain. If the returns are the same, investor should choose the less risky investment. More so, an individual should invest according to its own risk tolerance. [...]
[...] Capital Asset Pricing Model Aside from technical analysis and fundamental analysis, AG Edwards also uses the capital asset pricing model in evaluating stocks. The central prediction of the Capital Asset Pricing Model or CAPM is that the market portfolio of invested wealth is mean-variance efficient in the sense of Markowitz. The efficiency of the market portfolio implies that expected returns on securities are a positive linear function of their market βs (the slope in the regression of a security's return on the market's return) or beta, and market βs suffice to describe the cross-section of expected return. [...]
[...] The Random Walk Theory is used in academic circles as an argument that investment research and management are useless. If stock price movements are truly random and cannot be predicted, and there are only two possible outcomes up and down any prediction of stock price movement must be wrong half the time. If this is correct, then half of the time any prediction of stock price movement must be correct. At AG Edwards, portfolios are managed with the principle that, in one way or another, whatever is happening in the market now will affect what will happen to it tomorrow. [...]
[...] The portfolio risk will be smaller that the weighted average of the vehicles' risks because the variations in the individual vehicle's risks will be off-setting to some degree. The purpose of portfolio diversification then is to maximize the portfolio's returns while minimizing its risks. Investment brokerage houses such as AG Edwards use different methods in choosing the investment vehicles to include in their clients' portfolios. Some of these methods are discussed in the following portion of the paper. Economic Theories Random Walk Theory In 1973, Burton Malkie wrote a book called, Random Walk Down Wall Street". [...]
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