Using finance theory to maximize reward-to-risk ratio

Wealth management

There are many situations which require an investor to make a choice about the fund or combination of funds that are most suitable for their investment needs. This may depend on individual financial circumstances, the age of the investor and their tolerance for risk. 

A common choice facing many individuals is either the selection of superannuation funds when they start a new job or the selection of a broad category of funds (growth, balanced or conservative) for superannuation purposes. Alternatively, an individual may be looking to speculate in stocks or currencies (including cryptocurrencies or bitcoins), in order to generate higher returns.

Finance theory suggests that the individual should be looking to maximize their reward-to-risk ratio (or Sharpe ratio). An honours topic could look at past returns (after allowing for expenses) achieved by professional fund managers and give advice on which funds can enable an investor to do that. To do that, students need to use econometric techniques that test models they have seen in undergraduate studies such as the CAPMFama French Model and APT

Similar models can be used to evaluate other investments (currencies, bit-coins, real estate investments) that an investor may be considering. All results are subject to the limitations of these models and there may be scope to use more recent models (that allow for liquidity risk and investor psychology).

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