Modern Portfolio Theory Essay

4176 words - 17 pages

Modern Portfolio Theory: An OverviewIf you were to craft the perfect investment, you would probably want its attributes to include high returns coupled with little risk. The reality, of course, is that this kind of investment is next to impossible to find. Not surprisingly, people spend a lot of time developing methods and strategies that come close to the "perfect investment". But none is as popular, or as compelling, as modern portfolio theory (MPT). Here we look at the basic ideas behind MPT, the pros and cons of the theory, and how MPT affects the management of your portfolio.The Theory One of the most important and influential economic theories dealing with finance and investment, MPT was developed by Harry Markowitz and published under the title "Portfolio Selection" in the 1952 Journal of Finance. MPT says that it is not enough to look at the expected risk and return of one particular stock. By investing in more than one stock, an investor can reap the benefits of diversification - chief among them, a reduction in the riskiness of the portfolio. MPT quantifies the benefits of diversification, also known as not putting all of your eggs in one basket. For most investors, the risk they take when they buy a stock is that the return will be lower than expected. In other words, it is the deviation from the average return. Each stock has its own standard deviation from the mean, which MPT calls "risk". The risk in a portfolio of diverse individual stocks will be less than the risk inherent in holding any single one of the individual stocks (provided the risks of the various stocks are not directly related). Consider a portfolio that holds two risky stocks: one that pays off when it rains and another that pays off when it doesn't rain. A portfolio that contains both assets will always pay off, regardless of whether it rains or shines. Adding one risky asset to another can reduce the overall risk of an all-weather portfolio. In other words, Markowitz showed that investment is not just about picking stocks, but about choosing the right combination of stocks among which to distribute one's nest eggs.Two Kinds of Risk Modern portfolio theory states that the risk for individual stock returns has two components: Systematic Risk - These are market risks that cannot be diversified away. Interest rates, recessions and wars are examples of systematic risks. Unsystematic Risk - Also known as "specific risk", this risk is specific to individual stocks and can be diversified away as you increase the number of stocks in your portfolio (see Figure 1). It represents the component of a stock's return that is not correlated with general market moves. For a well-diversified portfolio, the risk - or average deviation from the mean - of each stock contributes little to portfolio risk. Instead, it is the difference - or covariance - between individual stocks' levels of risk that determines overall portfolio risk. As a result, investors benefit from holding diversified...

Find Another Essay On Modern Portfolio Theory

Why is the risk of a portfolio of shares normally lower than the average risk of the shares of the portfolio?

2154 words - 9 pages On a general level, investment managers and academic economists have long been aware of the necessity of taking returns as well as risk into account: "all your eggs should not be placed in the same basket". This is where the idea of holding a portfolio of shares comes from. Modern portfolio theory (MPT), or portfolio theory, was introduced by Harry Markowitz with his paper "Portfolio Selection" which appeared in the 1952 Journal of Finance

Questioning the Traditional Diversification Theory Essay

2542 words - 11 pages It is widely accepted that portfolio diversification is one of the most important concepts of modern finance. Based on the Efficient Frontier theory, long-term portfolio performance is not mainly determined by the quality of individual investments, but by the allocation of assets among broad security classes, aiming to target above-average returns with appropriate capital diversification. Successful investing is made immeasurably easier by

The New Science of Risk Management: Value-at-Risk

1431 words - 6 pages managed. The Quest for the “Holy Scale” Stories tell us that VaR was created to give a single number which would capture information about the risk in a portfolio, could be measured rapidly, and communicate that information to non-tech savvy senior managers. This is a lot to ask for and it's something that cannot be delivered without compromises. VaR and Standard Deviation are both related measures of a distribution of returns. The Modern

capital asset pricing model

1150 words - 5 pages /discovery/capm.html Capital Asset Pricing Model (CAPM). (N.d.). Retrieved from: http://moodle.port.ac.uk/pluginfile.php/407052/mod_resource/content/1/L10_Capital%20Asset%20pricing%20model.pdf Elton, E., Gruber, M., Brown, S., & Goetzmann,W. (2011). Modern Portfolio Theory and Investment Analysis. New York: Wiley & Sons. Eugene F. F., & Kenneth R. F. (2004). The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives

Analysis of the Limited Household Participation in the Stock Market Phenomenon

2813 words - 11 pages mentioned before during the past decade things did not change significantly, households are still passively participating in stock market and this phenomenon is receiving more and more attention in empirical and theoretical works. So in further chapters our paper will try to analyze this phenomenon in more detail. Research on portfolio theory The Modern Portfolio Theory deals with explaining the logics of effective asset allocation in one‘s

Growth and Development of the Capital Asset Pricing Model

2486 words - 10 pages , 1980). Arbitrage pricing theory (APT) contends that a number of macro-economic factors determine the market returns which include without limitation inflation, industrial production, risk premiums and the slope of the term structure of interest rates (Wei, 1988).CAPM is critiqued for its difficulties in choosing a proxy for the market portfolio as a benchmark and APT is an alternative pricing theory with fewer assumptions (Bodie et al., 2014

Real Estate Volatility Tests

986 words - 4 pages more risky than the market portfolio in the Nordic countries. Fourthly, the modern portfolio theory was introduced. This theory is a tool to clearly explain how a diversified portfolio can both optimize expected return and minimize risk at the same time as the assets are not entirely positively correlated (p<1 ). Our fourth assignment will determine if CAPM is appropriate to estimate expected return of real estate stocks in Nordic markets. Then

The Transformations in My Design Process

1285 words - 5 pages In 1964 Marshall McLuhan identified a new phenomenon in Modern society. That year, McLuhan published Understanding Media, a book of essays that focus on the pervasive effects of new media on our lives. McLuhan predicted that the microchip would change how we conduct business, communicate, entertain ourselves, and how we learn. He condensed the world-shaking prophecies into the dictum ‘The Medium is the Message.’ We are just now beginning to

Economics of Corporate Strategy

2443 words - 10 pages initial propositions that laid out grounds for the Modern Portfolio Theory (MPT). Modern Portfolio Theory (MPT) pioneered by Markowitz provides mathematical justification of how diversifying investments between securities individuals can actually achieve optimum portfolio that reduces their risks. This theory is based on four components which forms basis for explaining individuals behaviour and how they can adjust their level of risks by investing in

Economics of Corporate Strategy

2443 words - 10 pages initial propositions that laid out grounds for the Modern Portfolio Theory (MPT). Modern Portfolio Theory (MPT) pioneered by Markowitz provides mathematical justification of how diversifying investments between securities individuals can actually achieve optimum portfolio that reduces their risks. This theory is based on four components which forms basis for explaining individuals behaviour and how they can adjust their level of risks by investing in

Compare how the organizational structures and communication policies of The Communications Task Force and Company K

6770 words - 27 pages Organizational StructureLevels of HierarchyCompany K in its global context has five levels of management. Company K is a large organization with over 70 area offices. It is Mr. Tanaka's dream to build the world's highest elevating systems through modern technology. In theory, an organization with rigid rules, high formalization and different levels of management, narrow span of control, high centralization, and specialized division of labor is

Similar Essays

Modern Portfolio Theory, Financial Engineering, And Their Roles In Financial Crises

1155 words - 5 pages The article “Modern Portfolio Theory, Financial Engineering, and Their Roles in Financial Crises” discusses modern portfolio theory, and the financial engineering. The author mentions roles that modern portfolio theory and financial engineering played in the financial crises. Also, the author states the issue of why elegant mathematics leads to bad polices. In this assignment, I will summarize most of the points that are discussed in the article

Dividend Growth Model, Capital Asset Pricing Model, Modern Portfolio Theory, Estimation Of Untraded Stocks

1248 words - 5 pages Portfolio Theory is an attempt to balance the risks and rewards of investment portfolios through the use of diversification to lower the risk of the entire portfolio while maintaining high returns. The use of Beta is a key concept in Modern Portfolio Theory. It uses CAPM as its basis to select investments within a portfolio; seeking to mix stocks with both positive and negative Betas to construct a portfolio with a minimal Beta for the group of stocks

Investment Policy Statement Essay

4725 words - 19 pages 2006, available at:http://www.asx.com.au/resources/newsletters/investor_update/20040914_InvestingForGrowth_IE3.htm, [Viewed on 29 April, 2006]•Hirt G. & Block S. (2006), Fundamentals of investment management, 8th ed, McGraw-Hill, New York•Managers Invest, "Capital Appreciation", available at:http://www.managersinvest.com/index/ret_equity, [viewed on 29th April 2006]•"Modern portfolio Theory", Wikipedia Encyclopaedia, available

Key Issues Relative To Portfolio Analysis And Investment

1777 words - 7 pages THEORYModern Investment Theory also known as Modern Portfolio Theory (MPT) was introduced by Harry Markowitz with his paper "Portfolio Selection," which appeared in the 1952 Journal of Finance (riskglossary.com, 2006). Prior to Markowitz's work, investors focused on assessing the risks and rewards of individual securities that offered the best opportunities for gain with the least risk and then construct a portfolio from these (riskglossary.com