Technical Analysis

Technical Analysis is the study of past market data, primarily price and volume, to
forecast future price movements of securities. It is based on the belief that all market
fundamentals are already reflected in the stock price, and that patterns in price and
volume tend to repeat over time due to investor behavior.

Core Principles of Technical Analysis

1. Market Action Discounts Everything:
All relevant information—economic, political, or psychological—is already reflected in
the stock price.

2. Prices Move in Trends:

Securities tend to move in identifiable trends (uptrend, downtrend, or sideways), which
tend to persist until something causes the trend to change.

3. History Repeats Itself:

Technical patterns seen in charts tend to repeat because of consistent investor
psychology and market behavior.

Common Tools and Indicators in Technical Analysis

Tools Description
Price Charts Line, bar, candlestick charts showing how prices move over
time
Support & Resistance Price levels where assets repeatedly stop falling (support) or
rising (resistance)
Trend Lines Lines drawn to identify upward or downward trends
Moving Averages Average of past prices used to smooth out fluctuations
Relative Strength Index Measures the speed and change of price movements
(RSI) (momentum indicator)
MACD (Moving Tracks changes in the strength, direction, and momentum of a
Average Convergence trend
Divergence)
Volume Analysis Confirms trends based on the amount of trading activity
Chart Patterns Includes head & shoulders, double tops, flags, and triangles

Types of Charts Used

1. Line Chart: Simplest form, shows closing prices over a period.
2. Bar Chart: Displays opening, closing, high, and low prices.
3. Candlestick Chart: Similar to bar chart but more visual, highlighting bullish and
bearish periods.
Advantages of Technical Analysis
 Quick Decision-Making: Based on charts and indicators that are easy to interpret.
 No Need for Financials: Doesn’t rely on company earnings or balance sheets.
 Good for Timing: Useful for short-term trading and identifying entry/exit points.

Limitations of Technical Analysis

 Subjective Interpretation: Different analysts may interpret the same chart differently.
 Ignores Fundamentals: May overlook key news or economic factors affecting value.
 Self-Fulfilling Prophecy Risk: Popular patterns may influence trader behavior
artificially.

Use in Practice
 Traders use technical analysis for short-term gains by timing market entry and exits.
 Investors may combine it with fundamental analysis for better decision-making.

Example: Golden Cross and Death Cross

 Golden Cross: When the 50-day moving average crosses above the 200-day moving
average (bullish sign).
 Death Cross: When the 50-day MA falls below the 200-day MA (bearish sign).

Fundamental Analysis

Fundamental analysis is a method used to evaluate the intrinsic value of a security (like a
stock) by examining related economic, financial, and qualitative factors. The goal is to
determine whether a security is overvalued, undervalued, or fairly priced compared to its
true worth.

Main Objective:
To assess a company’s real value and potential for future growth by analyzing:
1. Financial health
2. Management quality
3. Industry conditions
4. Economic factors

Key Components of Fundamental Analysis

1. Quantitative Analysis (Numbers-Based)

 Financial Statements
 Income Statement (Profitability)
 Balance Sheet (Assets, liabilities, equity)
 Cash Flow Statement (Liquidity and financial health)

Financial Ratios
Ratio Purpose
Price/Earnings (P/E) Valuation – how much investors pay per $1
 of earnings
Return on Equity (ROE) Profitability relative to shareholder equity
Debt/Equity Ratio Financial leverage and stability
Current Ratio Short-term liquidity
Earnings per Share (EPS) Profit allocated to each share

2. Qualitative Analysis (Non-Numerical)

 Business Model: How the company makes money
 Management: Leadership quality and governance
 Competitive Advantage: Brand, patents, market position
 Industry Conditions: Trends and competitive landscape
 Macroeconomic Factors: Inflation, interest rates, regulations

Type Focus Area

Top-Down Economy → industry → company
Bottom-Up Company→ industry → economy

Steps in Performing Fundamental Analysis

1. Examine Macroeconomic Indicators: GDP growth, inflation, employment data
2. Study Industry Trends: Growth potential, risks, regulations
3. Analyze the Company: Financials, management, competitive edge
4. Estimate Intrinsic Value: Use valuation models like DCF (Discounted Cash Flow)
5. Make Investment Decision: Buy if undervalued, sell if overvalued

Valuation Methods
 Discounted Cash Flow (DCF): Present value of future cash flows
 Comparative Analysis (Multiples): Compare valuation ratios (P/E, P/B) with peers
 Dividend Discount Model (DDM): For dividend-paying stocks

Advantages of Fundamental Analysis

 Long-term investment insights
 Helps understand true value
 Less susceptible to short-term market noise

Limitations
 Time-consuming and data-heavy
 Assumptions in models can be inaccurate
 Market may stay irrational longer than expected

Pioneer of Fundamental Analysis

 Benjamin Graham, 1930s also known as the "father of value investing" mentor to
Warren Buffett

Use in Practice
Investors use fundamental analysis to:
 Pick stocks for long-term investment
 Identify undervalued opportunities
 Avoid overpriced or risky companies

Mean-Variance Model (Markowitz Portfolio Theory)

The Mean-Variance Model, developed by Harry Markowitz in 1952, is the foundation of

Modern Portfolio Theory (MPT). It helps investors construct portfolios that maximize
expected return for a given level of risk, or minimize risk for a given level of expected
return.

Objective of the Model:

To choose the optimal combination of assets (a portfolio) that offers the best possible
return for the least amount of risk.

Key Concepts
1. Expected Return (Mean):
The average return an investor anticipates from a portfolio.

E(Rp) = ∑ wi●E(Ri)

where:
wi = weight of asset i
E(Ri) = expected return of asset i

2. Risk (Variance / Standard Deviation):

Measures the volatility of returns. More volatility = more risk.

σp2 = ∑ wi2(σi2) + ∑∑ wi wj·Cov(Ri, Rj)

3. Covariance & Correlation:

These describe how assets move in relation to each other, which is essential for
diversification.

Efficient Frontier
 A curve representing portfolios that have the best return for a given risk.
 Portfolios below the frontier are sub-optimal.
 Investors should choose portfolios on the frontier.

Optimal Portfolio
 The point on the efficient frontier that aligns with an investor's risk tolerance.
 The tangency point between the Capital Market Line (CML) and the efficient frontier
if a risk-free asset is included.

Example
Suppose an investor is choosing between two assets:
- Asset A: Expected return = 10%, Standard deviation = 15%
- Asset B: Expected return = 8%, Standard deviation = 10%
- Correlation = 0.2

The Mean-Variance Model will help calculate the combination of A and B that provides
the highest return for a given risk, or lowest risk for a given return.

Advantages
 Encourages diversification
 Quantifies risk and return
 Provides a systematic approach to portfolio selection

Limitations
 Assumes returns are normally distributed
 Assumes investors are rational and risk-averse
 Requires estimates of expected returns, variances, and covariances, which may not
be accurate

Historical Note:
Markowitz’s work earned him the Nobel Prize in Economics in 1990, as it revolutionized
portfolio management.

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is a financial model that describes the
relationship between risk and expected return for an individual asset or a portfolio. It
helps investors determine the appropriate required return of an asset, considering its risk
relative to the overall market.

Developed by:
 William Sharpe (1964)
 John Lintner (1965)
 Jan Mossin (1966)
(Extension of Markowitz’s Mean-Variance Model)

Core Idea:
Investors need to be compensated in two ways:
1. Time value of money → via the risk-free rate
2. Risk premium → for taking on additional risk

CAPM Formula:
E(Ri) = Rf + βi · (E(Rm) - Rf)

Where:
E(Ri): Expected return on asset i
Rf: Risk-free rate (e.g., government bond yield)
βi: Beta of asset i (sensitivity to market)
E(Rm): Expected return of the market
E(Rm) - Rf: Market risk premium

What is Beta (β)?

Measures how an asset moves relative to the market
β = 1: Moves with the market
β > 1: More volatile than the market
β < 1: Less volatile than the market
β = 0: Uncorrelated with market
β < 0: Moves opposite the market

Interpretation Example:
If:
Risk-free rate = 5%
Market return = 10%
Beta of Stock A = 1.2

Then expected return of Stock A:

E(RA) = 5% + 1.2 · (10% - 5%) = 11%

Graphical View: Security Market Line (SML)

X-axis: Beta
Y-axis: Expected Return
The SML shows expected return for any level of risk (beta)
Assets above SML = undervalued (offer higher return for risk)
Assets below SML = overvalued

Advantages
Simple and intuitive
Useful for valuing stocks
Applies to portfolio management and performance evaluation

Limitations
Assumes efficient markets
Assumes single factor (market) affects returns
Relies on accurate estimation of expected returns, beta, and risk-free rate
Assumes investors can borrow/lend at risk-free rate (unrealistic)

Application Areas
 Estimating cost of equity
 Asset valuation
 Portfolio selection and optimization
 Performance measurement (e.g., Treynor ratio)
Efficient Market Hypothesis (EMH)

The Efficient Market Hypothesis (EMH) is a financial theory that states financial markets
are “informationally efficient,” meaning that asset prices always fully reflect all available
information. As a result, it is impossible to consistently outperform the market through
stock picking or market timing.

Origin:
Proposed by Eugene Fama in 1970

Main Idea:
You cannot beat the market because:
 All new information is quickly and accurately incorporated into asset prices.
 Any advantage gained from analyzing information is already reflected in the current
price.

Types of EMH:
Form Description Implication
Weak Form Prices reflect all past Technical analysis is
trading data (prices, ineffective
volume, etc.)
Semi-Strong Form Prices reflect all publicly Fundamental analysis is
available information also ineffective
(financial statements, news,
etc.)
Strong Form Prices reflect all Even insider trading can’t
information, both public help you consistently
and private (insider) outperform the market

Example:
A company's strong earnings report is released. According to EMH, the stock price will
adjust immediately, making it impossible to "buy low" and profit from the information
afterward.

Implications for Investors:

 Active investing (trying to pick winners) is not effective in the long run.
 Passive strategies (index funds, ETFs) are more efficient and cost-effective.
 Diversification is key to managing risk rather than chasing returns.

Advantages of EMH
 Promotes rational investing
 Encourages low-cost index investing
 Emphasizes the importance of risk-adjusted returns
Criticisms & Limitations
 Market anomalies (like momentum, value effect) contradict EMH
 Bubbles and crashes suggest that prices do not always reflect fundamentals
 Behavioral finance shows that investors often act irrationally

Related Concepts:
 Random Walk Theory: Future stock prices are random and cannot be predicted.
 Behavioral Finance: Challenges EMH by showing how cognitive biases affect
investor decisions.

Two-Factor Model (Extension of CAPM – adds a second systematic risk factor)

The Two-Factor Model is an asset pricing model that explains a security’s return using
two different sources of risk (factors). It builds on the Capital Asset Pricing Model
(CAPM) by including an additional risk factor beyond market risk to better explain asset
returns.

Basic Formula:
E(Ri) = Rf + βi1(F1 - Rf) + βi2(F2 - Rf)

Where:
E(Ri): Expected return on asset i
Rf: Risk-free rate
F1, F2: Two risk factors (e.g., market return and size premium)
βi1, βi2: Sensitivities of asset i to each factor

Examples of Common Risk Factors:

Factor Description
Market Risk (F1) Overall market movements (same as CAPM beta)
Size Risk (F2) Return difference between small-cap and large-cap stocks
Interest Rate Risk Sensitivity to changes in interest rates
Inflation Risk Exposure to inflation-related changes
Industry/sector risk Specific to industries or sectors

Example: Fama-French Two-Factor Model

A popular version includes:
 Market risk premium (market return – risk-free rate)
 SMB (Small Minus Big): The return spread between small and large companies

Purpose & Benefits:

 Improves explanation of return differences among assets compared to CAPM
 Helps investors understand how different economic forces affect their portfolio
 Useful in risk management and portfolio construction
Graphical View:
 Plots returns based on two axes representing the two risk factors
 Helps to identify how much exposure a security has to each factor

Limitations:
 Choosing the “right” factors can be subjective
 More complex than single-factor models like CAPM
 Still doesn't capture all possible sources of risk (hence multi-factor models evolved)

Relation to Other Models:

 CAPM: Only one factor (market)
 Fama-French Models: Extend this to 3 or more factors (size, value, momentum)
 Arbitrage Pricing Theory (APT): Allows multiple unspecified factors

Arbitrage Pricing Theory (APT)

 Introduced by Stephen Ross in 1976

Arbitrage Pricing Theory (APT) is a multi-factor asset pricing model that describes the
expected return of a financial asset as a linear function of various macroeconomic factors.
It assumes that returns can be predicted using the sensitivity (beta) of the asset to these
factors.

APT is based on the idea that if two assets have the same exposure to certain risk factors,
they should offer the same expected return. If not, arbitrage opportunities arise—hence
the name.

APT Formula:

E(Ri) = Rf + βi1F1 + βi2F2 + … + βinFn

Where:
E(Ri): Expected return of asset i
Rf: Risk-free rate
Fn: Risk premium of factor n
βin: Sensitivity of asset i to factor n

Key Features:
Feature Description
Multi-factor Considers more than one source of systematic risk
No specific factor list Factors are not predefined, unlike CAPM
Linear relationship Assumes returns are linearly related to factor sensitivities
Arbitrage-based If mispricing occurs, arbitrage forces will correct it
|
Common APT Risk Factors (can vary depending on the study):
Factor Description
Inflation Higher inflation may reduce real returns
Interest rates Affects borrowing/lending and discount rates
GDP growth Indicates economic performance and firm profitability
Oil prices Affects energy-dependent sectors
Market indices General market performance

APT vs CAPM
Aspect CAPM APT
Factors Single (market) Multiple (user-defined)
Assumptions Strong (market equilibrium) Fewer (relies on no arbitrage)
Flexibility Less flexible More flexible and realistic
Use of Arbitrage Not explicitly considered Central to the theory

Advantages of APT
 More realistic than single-factor models
 Greater flexibility (choose relevant factors)
 Useful for diversified portfolios

Limitations
 Identifying factors and estimating their risk premiums can be complex
 Model instability – factors and their influence may change over time
 Assumes no arbitrage, which may not always hold in practice

Practical Use:
 Used by portfolio managers and analysts to:
 Identify macro risks affecting portfolios
 Build multi-factor models
 Detect mispriced securities

Passive vs Active Investment Strategies

Investors generally choose between passive and active strategies when managing
portfolios. These approaches differ in terms of objectives, management style, costs, and
risk/return expectations.

Passive Investment Strategy

A passive investment strategy aims to replicate market performance by tracking a market

index (like the S&P 500 or ZSE All Share Index), rather than trying to beat it.
Key Characteristics:
 Buy-and-hold approach
 Fewer transactions (low turnover)
 Minimal research or forecasting
 Relies on efficient market hypothesis (EMH)

Examples:
 Index funds
 Exchange-Traded Funds (ETFs)
 Smart beta strategies (rules-based, but passive in execution)

Advantages:
 Lower fees (management and transaction)
 More tax efficient
 Consistent with long-term growth goals
 Lower risk of underperforming the market

Disadvantages:
 Limited flexibility
 Doesn’t respond to market trends or opportunities
 May include poor-performing stocks in the index

Active Investment Strategy

An active investment strategy involves a fund manager or investor actively selecting

securities to outperform a benchmark index.

Key Characteristics:
 Frequent buying and selling
 Based on research, market timing, and forecasting
 Requires skilled managers and analysis

Examples:
 Actively managed mutual funds
 Hedge funds
 Tactical asset allocation

Advantages:
 Potential to outperform the market
 Can adjust quickly to market changes
 Custom strategies tailored to investor goals

Disadvantages:
 Higher fees and costs
 Greater risk of underperformance
 Requires more time and expertise

Comparison Table:
Feature Passive Strategy Active Strategy
Goal Match market returns Beat the market
Cost Low High
Turnover Low High
Flexibility Limited High
Risk Market risk only Market + Manager risk
Manager involvement Minimal High
Performance consistency Stable, tracks market Variable, can outperform or lag

Which One to Choose?

 Passive: Best for long-term investors who prefer low-cost, low-effort investing.
 Active: Suitable for those seeking higher returns, have risk tolerance, and access to
expert managers.

Elton-Gruber model

The Elton-Gruber model is a financial model primarily related to portfolio theory. It was
developed by Edwin J. Elton and Martin J. Gruber, two prominent finance academics
known for their work in investment analysis and portfolio management.

Purpose

The model aims to simplify and optimize portfolio selection by identifying an efficient
frontier using mean-variance analysis, building on Harry Markowitz's Modern Portfolio
Theory (MPT).

Key Concepts:
Risk-Return Tradeoff:
Investors seek to maximize return for a given level of risk or minimize risk for a given
return.

Efficient Frontier:
The model helps in identifying portfolios that lie on the efficient frontier, offering the best
possible returns for a given level of risk.

Simplified Portfolio Selection:

Unlike Markowitz’s model, which requires a large number of inputs (covariances,
variances, expected returns), Elton and Gruber proposed simplified models using factor
analysis or index models to reduce the computational burden.

Single-Index Model:
One of their key contributions was the use of the Single-Index Model, where the return of
a stock is related to the return of a market index (like the S&P 500), reducing the
complexity of estimating covariances.
Formula (Single-Index Model):
Applications

 Investment portfolio optimization

 Mutual fund analysis
 Risk management
 Asset pricing

Markowitz Model

The Markowitz Model, also known as the Modern Portfolio Theory (MPT), was
introduced by Harry Markowitz in 1952. It provides a mathematical framework for
constructing a portfolio of assets such that the expected return is maximized for a given
level of risk, or equivalently, risk is minimized for a given level of expected return.
Efficient Frontier: A curve that represents the set of optimal portfolios offering the
highest expected return for a defined level of risk.

Diversification: Reducing risk by investing in a variety of assets. The model shows how
combining assets with low or negative correlations can reduce overall portfolio risk.

Assumptions:

 Investors are rational and risk-averse.

 Markets are efficient.
 Returns are normally distributed.
 Investors make decisions based on expected return and variance (mean-variance
optimization).

The model is used by portfolio managers to:

 Determine optimal asset allocation.

 Construct the efficient frontier.
 Select portfolios based on the investor's risk tolerance.

Lagrangian Multipliers

Lagrangian Multipliers (also called Lagrange Multipliers) are a strategy in multivariable

calculus used to find the local maxima and minima of a function subject to one or more
constraints.
Programming

Ah, perfect! You're stepping into portfolio optimization, which is a great application of
linear and quadratic programming—very relevant in finance and investment analysis.

Here's a breakdown of how linear and quadratic programming are used in portfolio
optimization, along with a Python example using libraries like cvxpy and numpy.

Goal: Allocate capital among assets to maximize return and/or minimize risk.

Inputs:

 Expected returns for each asset (vector)

 Covariance matrix of returns (risk)
 Constraints (e.g., weights sum to 1, no short-selling, sector limits)

Optimization Types

 Objective is linear (e.g., maximize return).

 Constraints are linear (e.g., budget, weight limits).
 Ignores risk (volatility/covariance).
 Objective includes quadratic terms (e.g., minimize portfolio variance using
covariance matrix).
 Classic Mean-Variance Optimization (Markowitz model).

Using Solver

Portfolio optimisation using Excel Solver is a popular method to find the best asset
allocation that maximizes returns for a given level of risk or minimizes risk for a given
level of return. Below is a step-by-step guide you can follow to perform Mean-Variance
Portfolio Optimization using Excel Solver.

Step-by-Step: Portfolio Optimisation Using Excel Solver

Set Up the Data

Prepare your spreadsheet with historical return data for each asset (e.g., monthly returns).

Date Asset A Asset B Asset C

Jan 2.5% 1.8% 3.2%
Feb 1.3% 2.1% 2.8%
3. Define Decision Variables

Set up a column for weights (portfolio allocation per asset), say in cells D2:D4.

Make sure:

1. Sum of weights = 1 (i.e., 100% of capital is allocated)

2. Each weight ≥ 0 (if short selling is not allowed)