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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 investment is 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.