The Modern Portfolio Theory (Advanced Corporate Finance)

Résumé du document

The Modern Portfolio Theory occupies an important position in the investment management approaches. The theory is distinctive as its application enables investors to minimize the risk involved in investing in different classes of investment by diversifying it with the help of a portfolio. The portfolio is assumed to be a combination of various assets or various types of asset classes so as to take advantage of negative association among the returns of these investments. The Modern Portfolio Theory or MPT is applied on the basis of diversification, risk analysis and risk measurement with the help of beta and CAPM. It also assists an investor to determine an efficient portfolio of assets with the help of efficient frontier line method. This paper provides a study into the fundamentals of Modern Portfolio Theory propounded by Harry Markowitz. It examines and elaborates the important elements of this theory and evaluates its application such as diversification, risk and return analysis, risk measurement, beta and CAPM etc. The paper also is an attempt to analyze the techniques of stock valuation versus technical and fundamental analysis

Extraits

[...] Mathematically, the return on an investment is measured with the help of Mean of the variable expected by the investors, whereas the risk or variability is measured by calculating Standard Deviation from the Mean. The higher the Standard Deviation from the Mean, the greater will be risk associated with an investment. Risk can be measured with the help of probability distribution such as Expected value and Normal Distribution. Expected value refers to the sum of all possible values multiplied by their respective probabilities. It is a weighted average of project expected values. Variance refers to the difference between the possible values and the expected values. [...]

[...] The risk involved in any portfolio can be evaluated with the help of total risk, covariance and the two-asset portfolio. The formula utilized to assess the risk involved in a portfolio of two investments is: σp = a2 σ2A + a)2 σ2B +2a(1 COV RB) Where a is the proportion of the total investment to asset is the proportion of total investments to asset σ2A is the variance of return on asset σ2B is the variance of return on asset B and COV RB) is the covariance of the returns on A and B. [...]

[...] The Modern Portfolio Theory (Advanced Corporate Finance) 1. Introduction The Modern Portfolio Theory occupies a very important position in the main investment management approaches. The theory is distinctive in the regard that its application enables investors to minimize the risk involved in investing in different classes of investment by diversifying it with the help of a portfolio. The portfolio is assumed to be a combination of various assets or various types of asset classes so as to take advantage of negative association among the returns of these investments. [...]

[...] The trade off between risk and return varies according the type of investor as well as the class of investment. This is due to the fact that every investment has a distinctive element of risk. Some investments involve less risk by nature as compared to the other one such as investment in bond is less risky than stock. Hence, the return on bond is always lower than that of the stock. There are generally two approaches to identifying investor characteristics with respect to risk versus risk taker and risk reluctant. [...]

[...] It is the square root of the variance total. Figure Source: Investopedia.Com Modern Portfolio Theory states that there are generally two kinds of risk: systematic and unsystematic risk. Systematic risk refers to the risk that is not diversifiable and is faced by the whole industry or market such as changes in tax rates, economic recessions, business cycle fluctuations, political instability and natural calamities. Because of the fact this risk cannot be diversified, this risk is dangerous for investors and as a result there is always a high return on the investment. [...]