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Analysis of Modern Portfolio Theory

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The foundation of modern portfolio theory (MPT) was introduced by Harry Markowitz in 1952. Thirty-eight years later, Harry Markowitz, Merton Miller and William Sharpe were awarded Nobel Prize for what has become a broad theory for portfolio selection. Modern portfolio theory (commonly referred as mean variance analysis) established a whole new terminology which became a norm among investment managers. (Gupta, FrancisMarkowitz, Fabozzi, Frank. 2002) It has wide application in different areas of financial management such as: asset allocation through mean variance optimization, bond portfolio immunization, optimal investment trust or manager selection, international asset allocation decisions, portfolio risk management and hedging strategies.

 

The core concept of the Portfolio Theory is based on asset diversification and directly relies on the conventional wisdom which advice to avoid putting all eggs in one basket (Papers4you.com, 2006). In its simplest form MPT provides a framework to construct efficient portfolios by selection of the investment assets, considering risk appetite of the investor. MPT employs statistical measures such as correlation and co variation to quantify the effect of the diversification on the performance of portfolio. In it is essence MPT attempts to analyse how different investments are interrelated to each other. What happens if one investment goes broke? Does it mean that all other investments will go broke as well? How to minimize the negative effect of the downfall in one particular investment asset?

 

According to Markowitz (1952) investors should focus on selecting portfolios based on their overall risk-reward characteristics instead of merely compiling portfolios from securities that each individually has attractive risk-reward characteristics. In a nutshell, inventors should select portfolios not individual securities. (Risk glossary) While the theory behind MPT is quite straightforward, the implementation of efficient asset allocation can become quite complicated. The model employs a wide range of different factors such as security returns, volatilities and correlation between asset classes for constructing efficient mean variance frontier. The frontier is considered to be efficient because every point on this frontier is a portfolio that gives the greatest possible return for certain risk level. (Gupta, et al, 2002) Since asset allocation decisions are so important, majority of the financial advisors determine optimal portfolios for their clients, both institutional and private.

 

While the implementation of the mean variance analysis requires specific skill and knowledge, the main concepts are relatively easy and can be easily presented to the wide audience (Papers4you.com, 2006). Surprisingly, MPT has wide implications in everyday life as well, since all of us are somehow involved into investment decisions. Everyone has to think about securing funds for the future education or pension, investing into property or buying a new car, and allocating some money for the coming vocation. How to justify these decisions, what would be the optimal solution? Familiarity with portfolio theory allows bringing up the ideas employed by professional investors into everyday life.

 

Reference

 

Markowitz, Harry M. (1952). Portfolio selection, Journal of Finance, 7 (1), 77-91.

 

Gupta, Francis Markowitz, Harry M.Fabozzi, Frank J. (2002) The Legacy of Modern Portfolio Theory THE JOURNAL OF INVESTING

Fall 2002

 

Papers For You (2006) "P/F/427. Benefits of international diversification", Available from http://www.coursework4you.co.uk/sprtfina14.htm [19/06/2006]

 

Papers For You (2006) "C/F/37. EQUITY PORTFOLIO MANAGEMENT: CRITICAL SUCCESS FACTORS (International Diversification, Country versus Sector Allocation)", Available from http://www.coursework4you.co.uk/sprtfina14.htm [19/06/2006]

 

Risk glossary (2006) "Modern portfolio theory", Available from http://www.riskglossary.com/link/portfolio_theory.htm [19/06/2006]

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