The modern portfolio theory was introduced by Harry Markowitz with the publication of his paper "Portfolio Selection" in the Journal of Finance in 1959 and is called Markowitz portfolio theory (MPT). It is now the major guidance for portfolio allocation decisions for mutual funds, pension funds, and nearly any entity seeking to maximize investment portfolio returns and minimize risks. By exploring how risk-averse investors can construct optimal portfolios through consideration of the trade-off between market risk and expected returns, Markowitz presents the benefits of diversification. Out of a variety of risky investments, an investor can compile an effective portfolio of investments, each of which will offer the maximum possible expected return for a given level of risk. Investors are therefore supposed keep one of the optimal portfolios on the effective level and the rest to adjust to the market risk. The latter is reached through the leverage or de-leverage of that portfolio with positions in a risk-free investment such as government bonds.
[...] Again, exactly how much more one should put into stocks in view of this consideration is a tough question. (Jones, 2002). Campbell and Vicera's (1999) calculations address this hedging demand as well as market-timing demand, and figure 5 also illustrates the strength of the hedging demand for stocks. Campbell and Vicera's investors want to hold almost 30 percent of their wealth in stocks even if the expected return of stocks is no greater than that of bonds. Absent the hedging motive, of course, the optimal allocation to stocks would be zero with no expected return premium. [...]
[...] The chances get better, active managers believe, as the number of stocks in the portfolio grows; ten is better than one, and a hundred is better than ten. An index fund, by definition, affords this kind of diversification if the index it mirrors is also diversified, as they usually are. The traditional stock mutual fund, with upward of a hundred stocks constantly in motion, also offers diversification. We have all heard this mantra of diversification for so long, we have become intellectually numb to its inevitable consequence: mediocre results. [...]
[...] Longman. Chapter Bodie, Z., Kane, A. and A. Marcus, Essentials of Investents 6e, McGraw- Hill Chapter Campbell, John Y. and Luis M. Vicera "Consumption and portfolio decisions when expected returns are time varying," Quarterly Journal of Economics, forthcoming Merton Robert C "Lifetime portfolio selection under uncertainty: The continuous time case," Review of Economics and Statistics, Vol No August, pp. 247- Samuelson, Paul A "Lifetime portfolio selection by dynamic stochastic programming," Review of Economics and Statistics, Vol No August, pp. 239-246. [...]
[...] Hedging demands address whether your overall allocation to stocks, or to specific portfolios, should be higher or lower as a result of return predictability, in order to protect you against reinvestment risk. A long-term bond is the simplest example. Suppose you want to minimize the risk of your portfolio ten years out. If you invest in apparently safe short-term risk-free assets like Treasury bills or a money-market fund, your ten-year return is in fact quite risky, since interest rates can fluctuate. [...]
[...] Rational investor thinking Active portfolio managers constantly buy and sell a great number of common stocks. Their job is to try to keep their clients satisfied, and that means consistently outperforming the market so that on any given day, if a client applies the obvious measuring stick—“How is my portfolio doing compared to the market overall?”—the answer is positive and the client leaves her money in the fund. To keep on top, active managers try to predict what will happen with stocks in the coming six months and continually churn the portfolio, hoping to take advantage of their predictions. [...]
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