NAME: UGWU EMENIKE CHRISTIAN

REG NO: 2010/172004

DEPT.: ECONOMICS/POL.SC. (C.S.S)
COURSE: ECONS302
(INTERMEDIATE MACROECONOMIC THEORY II)
LECTURER: MR. TONY ORJI.
DATE: 26/04/2013
ASSIGNMENT: THE THEORY OF INVESTMENT

General Introduction
The term investment means something different to economists than it does to most of the rest
of the world. For example, if you ask your banker about investment, she will probably start
talking about stocks and mutual funds that she would like you to purchase, or new kinds of
deposit accounts that her bank offers. To an economist, these purchases of financial assets are
not investment from a social point of view because financial assets do not represent real net
wealth for the economy as a whole. Instead, they reflect credit relationships within the economy.
Financial assets such as loans and bank accounts represent contracts to pay interest and repay
principal on borrowed money. Stocks represent partial ownership of a corporation, implying a
right to vote on the governance of the corporation and to receive dividends as determined by the
directors that the shareholders elect. In either case, the financial asset of one individual in the
economy is offset by a financial liability of another person or corporation. Thus, when we
aggregate the wealth of all members of the economy, these assets and liabilities cancel and
financial assets disappear. Thus, if you invest in a financial asset, someone else is
disinvesting at the same time, so aggregate, or social, investment does not rise. Economists
usually reserve the term investment for transactions that increase the magnitude of real aggregate
wealth in the economy.
Investment Theory:
An investment theory is a concept that is based on consideration of a number of different factors
associated with the process of investing. Ideally, the theory will involve looking closely at a wide
range of factors to determine how to go about choosing the right investments for a particular goal or
purpose. While there are approaches to investment theory that involve employing a number of other
theories as part of the process, some economists break down the task into four areas that just about
anyone can grasp.
The first key factor in investment theory has to do with the goals for the investment portfolio. By
determining how to diversify the portfolio while still balancing that diversification with the type of
individual securities, the idea is to protect the investor from downturns in one market by providing for
upswings in value with other holdings. Known as modern portfolio theory, this factor is key to
the investment process for investors who have specific goals for the income generated by the
portfolio.
Another important aspect of investment theory has to do with evaluating investments based on the
degree of risk and potential return. Here, the idea is to help the investor focus on options that carry
an acceptable amount of risk while providing the greatest amount of return. This element is the basis
for the capital asset pricing model, and can make a big difference in whether or not an investor
makes the right choices for his or her portfolio. A similar approach, known as the arbitrage
pricing theory, focuses more on assessing the degree of risk associated with a
given investment option, but still serves the purpose of helping an investor decide if the potential
return is worth the volatility associated with a given option.
A well-crafted investment theory will also consider the amount of information available about both
the investment option and the general condition of the market or markets where the option is traded.
Known as the efficient market hypothesis, this concept holds that all information that is relevant to
making the decision to hold, buy, or sell an option must be readily available to the investor in order
for the market to be truly efficient. Since knowing the past history, the current status, and the
potential future risks associated with any investments key to being able to make wise choices, the
investor should determine if this situation of an efficient market exists before deciding to get involved
with a given investment.
Essentially, an investment theory is all about making informed investment decisions. By taking into
consideration the goals and aims of the investor, it is possible to build a portfolio that will help meet
those goals. In order to wisely choose the right investments, it is important to know all there is to
know about the investment and the market in which it is traded. Developing
an investment theory that encompasses all these factors will greatly increase the chances for
success, as well as aid the investor in avoiding investment options that are not in his or her best
interest.
Theory of Investments:
If only we knew more about the determinants of investment! But, unfortunately, our knowledge
in this direction is still very meager. One might well ask, What is wrong with the theory of
investment? Or, perhaps, What is wrong with the subject matter itself! For one thing, this
variable, -- the pivot of modern macroeconomics -- has apparently lived a somewhat nomadic
life among the various chapters of economic theory. Perhaps it has not stayed long enough in any
one place. Perhaps it has been ill-treated. What is investment? Strictly speaking, investment is
the change in capital stock during a period. Consequently, unlike capital, investment is a flow
term and not a stock term. This means that while capital is measured at a point in time, while
investment can only be measured over a period of time. If we ask "what is capital right now?",
we might get an answer along the lines of $10 trillion. But if we ask "what is investment right
now?", this cannot be answered. The quantity of a flow always depends on the period in
consideration. Thus, we can answer "what is investment this month?" (and might be told it is $10
million) or "what is investment this year?" (and might be told $1 billion).
we can calculate the investment flow in a period as the difference between the capital stock at the
end of the period and the capital stock at the beginning of the period. Thus, the investment flow
at time period t can be defined as:
I
t
= K
t
- K
t-1

where K
t
is the stock of capital at the end of period t and K
t-1
is the stock of capital at the end of
period t-1 (and thus at the beginning of period t).
How is the the theory of investment different from the theory of capital? If all capital is
circulating capital, so that it is completely used up within a period, then no capital built up during
the previous period can be brought over into next period. In this special case, the theory of
capital and the theory of investment become one and the same thing.
With fixed capital, the story is different -- and more complicated as there seems to be two
decisions that must be addressed: the amount of capital and the amount of investment. These are
different decisions. One is about the desired level of capital stock. The other is about the desired
rate of investment flow. The decisions governing one will inevitably affect the other, but it is not
necessarily the case that one is reducible to the other.
There are effectively two ways of thinking about investment. At the risk of annoying some
people, we shall refer to these as the "Hayekian" and "Keynesian" perspectives. The Hayekian
perspective conceives of investment as the adjustment to equilibrium and thus the optimal
amount of investment is effectively a decision on the optimal speed of adjustment. A firm may
decide it needs a factory (the "capital stock" decision), but its decision on how fast to build it,
how much to spend each month building it, etc. -- effectively, the "investment" decision -- is a
separate consideration.
Naturally, the capital decision influences the investment decision: a firm which has $10 billion of
capital and decides that it needs $15 billion of capital, therefore requires investment of $5 billion.
But if this adjustment can be done "instantly", then there is really no actual investment decision
to speak of. We just change the capital stock automatically. The capital decision governs
everything.
However, if for some reason, instant adjustment is not possible, then the investment story begins
to matter. How do we distribute this $5 billion adjustment? Do we invest in an even flow over
time, e.g. $1 billion this week, another $1 billion next week, and so on? Or do we invest in
descending increments, e.g. invest $1 billion this week, $500 million next week, $300 million the
week after that, etc. and approach the $5 billion mark asymptotically? Or should we invest in
ascending increments, e.g. $10 million this week, $100 million next week, etc.? Delivery costs,
changing prices of suppliers, fluctuating interest rates and financing costs, and other such
considerations, make some adjustment processes more desirable than others. .
The Hayekian approach is shown heuristically in Figure 1, where we start at capital stock K
0
and
then, at t*, we suddenly change our desired capital stock from K
0
to K*. Figure 1 depicts four
alternative investment paths from K
0
towards K*. Path I represents "instant" adjustment type of
investment (i.e. all investment happens at once at t* and no more investment afterwards). Path I
represents an "even flow" adjustment path, with investment happening at a steady rate after t*
until K* is reached. Path I is the asymptotic investment path (gradually declining investment),
while path I depicts a gradually increasing investment path. All paths, except for the first
instant one, imply that "investment" flows will be happening during the periods that follow t*.
Properly speaking, then, investment theory in the Hayekian perspective is concerned with
analyzing and comparing paths such as I , I and I .

Figure 1 - Adjustment Paths towards K*

Ke y ne s i a n The o r y o f I nv e s t me nt
Interest rates and planned capital investment
The Keynesian theory of investment places emphasis on the importance of interest rates in
investment decisions. But other factors also enter into the model - not least the expected
profitability of an investment project.
Changes in interest rates should have an effect on the level of planned investment undertaken
by private sector businesses in the economy.
A fall in interest rates should decrease the cost of investment relative to the potential yield and as
result planned capital investment projects on the margin may become worthwhile. A firm will
only invest if the discounted yield exceeds the cost of the project.
The inverse relationship between investment and the rate of interest can be shown in a diagram
(see below). The relationship between the two variables is represented by the marginal efficiency
of capital investment (MEC) curve. A fall in the rate of interest from R1 to R2 causes an
expansion of planned investment.


Shifts in the marginal efficiency of capital
Planned investment can change at each rate of interest. For example a rise in the expected rates
of return on investment projects would cause an outward shift in the marginal efficiency of
capital curve. This is shown by a shift from MEC1 to MEC2 in the diagram below.
Conversely a fall in business confidence (perhaps because of fears of a recession) would cause a
fall in expected rates of return on capital investment projects. The MEC curve shifts to the left
(MEC3) and causes a fall in planned investment at each rate of interest.

The importance of hurdle rates for investment
British firms are continuing to demand rates of return on new investments that are far too high,
undermining industry's ability to re-equip and close the productivity gap with competitor
countries according to a survey by the Confederation of British Industry. "Hurdle rates" for
major investment projects are 50 per cent higher than they need to be, while the payback periods
required are much shorter than in countries such as Germany.
The CBI survey of more than 300 firms showed that they expected to earn an internal rate of
return averaging 17 per cent and recover the cost of their investment in two to four years. But
experts said that post-tax real returns of 10 per cent were sufficient to justify most investments.
Britain's poor investment record has been a concern both for the CBI and government ministers.
Gordon Brown believes that low investment is one of the main reasons for sluggish economic
performance, and that macroeconomic stability and a tax regime less biased towards dividends
will encourage capital spending.




The "Keynesian" approach places far less emphasis on the "adjustment" nature of investment.
Instead, they have a more "behavioral" take on the investment decision. Namely, the Keynesian
approach argues that investment is simply what capitalists "do". Every period, workers consume
and capitalists "invest" as a matter of course. This leads Keynesians to underplay the capital
stock decision. This does not mean that Keynesians ignore the fact that investment is defined as a
change in capital stock. Rather, they believe that the main decision is the investment decision;
the capital stock just "follows" from the investment patterns rather than being an important thing
that needs to be "optimally" decided upon beforehand. Thus, when businesses make investment
decisions, they do not have an "optimal capital stock" in the back of their mind. They are more
concerned as to what is the optimal amount of investment for some particular period. For
Keynesians, then, optimal investment not about "optimal adjustment" but rather about "optimal
behavior".

Furthermore, when it comes to investing, there is no shortage of theories on what makes the
markets tick or what a particular market move means. The two largest factions on Wall Street are
split along theoretical lines into adherents to an efficient market theory and those who believe the
market can be beat.
Efficient Market Hypothesis
Very few people are neutral on efficient market hypothesis (EMH). You either believe in it and
adhere to passive, broad market investing strategies, or you detest it and focus on picking stocks
based on growth potential, undervalued assets and so on. The EMH states that the market price
for shares incorporates all the known information about that stock. This means that the stock is
accurately valued until a future event changes that valuation. Because the future is uncertain, an
adherent to EMH is far better off owning a wide swath of stocks and profiting from the general
rise of the market.

Opponents of EMH point to Warren Buffett and other investors who have consistently beat the
market by finding irrational prices within the overall market.

Fifty Percent Principle
The fifty percent principle predicts that, before continuing, an observed trend will undergo a
price correction of one-half to two-thirds of the change in price. This means that if a stock has
been on an upward trend and gained 20%, it will fall back 10% before continuing its rise. This is
an extreme example, as most times this rule is applied to the short-term trends that technical
analysts and traders buy and sell on.

This correction is thought to be a natural part of the trend as it's usually caused by skittish
investors taking profits early to avoid getting caught in a true reversal of the trend later on. If the
correction exceeds 50% of the change in price, it's considered a sign that the trend has failed and
the reversal has come prematurely.

Greater Fool Theory
The greater fool theory proposes that you can profit from investing as long as there is a greater
fool than yourself to buy the investment at a higher price. This means that you could make
money from an overpriced stock as long as someone else is willing to pay more to buy it from
you.

Eventually you run out of fools as the market for any investment overheats. Investing according
to the greater fool theory means ignoring valuations, earning reports and all the other data.
Ignoring data is as risky as paying too much attention to it; so people ascribing to the greater fool
theory could be left holding the short end of the stick after a market correction.
Odd Lot Theory
The odd lot theory uses the sale of odd lots small blocks of stocks held by individual investors
as an indicator of when to buy into a stock. Investors following the odd lot theory buy in when
small investors sell out. The main assumption is that small investors are usually wrong.

The odd lot theory is contrarian strategy based off a very simple form of technical analysis
measuring odd lot sales. How successful an investor or trader following the theory is depends
heavily on whether or not he checks the fundamentals of companies that the theory points toward
or simply buys blindly. Small investors aren't going to be right or wrong all the time, so it's
important to distinguish odd lot sales that are occurring from a low-risk tolerance from odd lot
sales that are due to bigger problems. Individual investors are more mobile than the big funds
and thus can react to severe news faster, so odd lot sales can actually be a precursor to a wider
sell-off in a failing stock instead of just a mistake on the part of small time investors.

Prospect Theory (Loss-Aversion Theory)
Prospect theory states that people's perceptions of gain and loss are skewed. That is, people are
more afraid of a loss than they are encouraged by a gain. If a person is given a choice of two
different prospects, they will pick the one that they think has less of chance of ending in a loss,
rather than the one that offers the most gains. For example, if you offer a person two
investments, one that has returned 5% each year and one that has returned 12%, lost 2.5%, and
returned 6% in the same years, the person will pick the 5% investment because he puts an
irrational amount of importance on the single loss, while ignoring the gains that are of a greater
magnitude. In the above example, both alternatives produce the net total return after three years.

Prospect theory is important for financial professionals and investors. Although the risk/reward
trade-off gives a clear picture of the amount of risk an investor has to take on to achieve the
desired returns, prospect theory tells us that very few people understand emotionally what they
realize intellectually. For financial professionals, the challenge is in suiting a portfolio to the
client's risk profile, rather than reward desires. For the investor, the challenge is to overcome the
disappointing predictions of prospect theory and become brave enough to get the returns you
want.


Rational Expectations Theory
Rational expectations theory states that the players in an economy will act in a way that
conforms to what can logically be expected in the future. That is, a person will invest, spend, etc.
according to what he or she rationally believes will happen in the future. By doing so, that person
creates a self-fulfilling prophecy that helps bring about the future event.

Although this theory has become quite important to economics, its utility is doubtful. For
example, an investor thinks a stock is going to go up, and by buying it, this act actually causes
the stock to go up. This same transaction can be framed outside of rational expectations theory.
An investor notices that a stock is undervalued, buys it, and watches as other investors notice the
same thing, thus pushing the price up to its proper market value. This highlights the main
problem with rational expectations theory: it can be changed to explain everything, but it tells us
nothing.

Short Interest Theory
Short interest theory posits that a high short interest is the precursor to a rise in the stock's price
and, at first glance, appears to be unfounded. Common sense suggests that a stock with a high
short interest that is, a stock that many investors are short selling is due for a correction. The
reasoning goes that all those traders, thousands of professionals and individuals scrutinizing
every scrap of market data, surely can't be wrong. They may be right to an extent, but the stock
price may actually rise by virtue of being heavily shorted. Short sellers have to eventually cover
their positions by buying the stock they've shorted. Consequently, the buying pressure created by
the short sellers covering their positions will push the share price upwards.

CONCLUSION.
We have covered a pretty wide range of theories, from technical trading theories like short
interest and odd lot theory to economic theories like rational expectations and prospect theory.
Every theory is an attempt to impose some type of consistency or some type of frame to the
millions of buy and sell decisions that make the market swell and ebb on a daily basis. While it is
useful to know these theories, it is also important to remember that there is no unified theory that
can explain the financial world. During certain time periods, one theory seems to hold sway only
to be toppled the next instant. In the financial world, change is the only true constant. (Break
down and examine the potential consequences of economic/financial scenarios.

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