Ramsri 21VBI038

Security Analysis and Portfolio Management

(SAPM)

Assignment No 2

Dow theory
The Dow theory is a financial theory that says the
market is in an upward trend if one of its averages
(i.e. industrials or transportation) advances above a
previous important high and is accompanied or
followed by a similar advance in the other average.

Dow Theory
['dau 'the-a-re]

A theory of financial market

activity consisting of 6 core
tenets developed by
journalist Charles H. Dow.
KEY TAKEAWAYS:

The Dow Theory is a technical framework that

predicts the market is in an upward trend if one of
its averages advances above a previous important
high, accompanied or followed by a similar advance
in the other average.

The theory is predicated on the notion that the

market discounts everything in a way consistent
with the efficient markets hypothesis.

In such a paradigm, different market indices must

confirm each other in terms of price action and
volume patterns until trends reverse

Some of the most important contributions to Dow

theory include the following:

William P. Hamilton's The Stock Market Barometer

(1922)
Robert Rhea's The Dow Theory (1932)
E. George Schaefer's How I Helped More Than
10,000 Investors to Profit in Stocks (1960)
Richard Russell's The Dow Theory Today (1961)
How the Dow Theory Works
There are six main components to the Dow theory.

1. The Market Discounts Everything

The Dow theory operates on the efficient markets
hypothesis (EMH), which states that asset prices
incorporate all available information. In other words,
this approach is the antithesis of behavioral
•
economics.

2. There Are Three Primary Kinds of Market Trends

Markets experience primary trends which last a year
or more, such as a bull or bear market. Within these
broader trends, they experience secondary trends,
often working against the primary trend, such as a
pullback within a bull market or a rally within a bear
market; these secondary trends last from three
weeks to three months. Finally, there are minor
trends lasting less than three weeks, which are
largely noise.

3. Primary Trends Have Three Phases

A primary trend will pass through three phases,
according to the Dow theory. In a bull market, these
are the accumulation phase, the public participation
(or big move) phase, and the excess phase. In a bear
market, they are called the distribution phase, the
public participation phase, and the panic (or despair)
phase.
4. Indices Must Confirm Each Other
In order for a trend to be established, Dow postulated
indices or market averages must confirm each other.
This means that the signals that occur on one index
must match or correspond with the signals on the
other. If one index, such as the Dow Jones Industrial
Average, is confirming a new primary uptrend, but
another index remains in a primary downward trend,
traders should not assume that a new trend has
begun.

5. Volume Must Confirm the Trend

Volume should increase if the price is moving in the
direction of the primary trend and decrease if it is
moving against it. Low volume signals a weakness in
the trend. For example, in a bull market, the volume
should increase as the price is rising, and fall during
secondary pullbacks. If in this example the volume
picks up during a pullback, it could be a sign that the
trend is reversing as more market participants turn
bearish.

6. Trends Persist Until a Clear Reversal Occurs

Reversals in primary trends can be confused with
secondary trends. It is difficult to determine whether
an upswing in a bear market is a reversal or a short-
lived rally to be followed by still lower lows, and the
Dow theory advocates caution, insisting that a
possible reversal be confirmed.
 Markowitz theory
In finance, the Markowitz model - put forward by Harry
Markowitz in 1952 - is a portfolio optimization model; it
assists in the selection of the most efficient portfolio by
analyzing various possible portfolios of the given
securities.

Markowitz is of the view that a smart investor just buys

and holds a well-diversified portfolio, using index funds.
Markowitz says that equity portfolios should be
diversified with different types of stocks like large-cap,
small-cap, value, growth, foreign and domestic stocks.
"Your portfolio should also be efficient

....
The hne represents The Effiaent Fronuer,
the optimal combtnat,on or risk and return

~~~-
..., • •••• • ••••••
•
u
Q)
Q.
X
w •••••••
•• • Each dot represents a portfolio Those closest to
The Efficient Fronller have the potential to produce
the greatest return with the lowest degree or nsk.

RiskNolatility
(Standard Dev1at1on)
Subject Matter of the Markowitz Theory:

Before the development of Markowitz theory,

combination of securities was made through "simple
diversification". The layman could make superior returns
on his investments by making a random diversification in
his investments.
Assumption of the Markowitz Theory:
Markowitz theory is based on the modern portfolio
theory under several assumptions.

Assumption under Markowitz Theory:

(1) The market is efficient and all investors have in their
knowledge all the facts about the stock market and so
an investor can continuously make superior returns
either by predicting past behaviour of stocks through
technical analysis or by fundamental analysis of internal
company management or by finding out the intrinsic
value of shares. Thus, all investors are in equal category.

(2) All investors before making any investments have a

common goal. This is the avoidance of risk because they
are risk averse.

(3) All investors would like to earn the maximum rate of

return that they can achieve from their investments.

(4) The investors base their decisions on the expected

rate of return of an investment. The expected rate of
return can be found out by finding out the purchase
price of a security dividend by the income per year and
by adding annual capital gains.
(5) Markowitz brought out the theory that it was a useful
insight to find out how the security returns are
correlated to each other. By combining the assets in
such a way that they give the lowest risk maximum
returns could be brought out by the investor.

( 6) From the above, it is clear that every investor

assumes that while making an investment he will
combine his investments in such a way that he gets a
maximum return and is surrounded by minimum risk.

(7) The investor assumes that greater or larger the

return that he achieves on his investments, the higher
the risk factor surrounds him. On the contrary, when
risks are low the return can also be expected to be low.

(8) The investor can reduce his risk if he adds

investment to his portfolio.

(9) An investor should be able to get higher return for

each level of risk "by determining the efficient set of

Markowitz Model
Expected
retum
Optrnal portfollo tor
g,ven uu~ty lunctJon

i~
Vanance

Those closest to The Efficient Frontier have the potential to produce

the greatest return with the lowest degree of risk.