Wait a second!
More handpicked essays just for you.
More handpicked essays just for you.
Investment and portfolio management chapter one
Design and assembly of modern portfolio theory
Portfolio management chapter 1
Don’t take our word for it - see why 10 million students trust us with their essay needs.
Recommended: Investment and portfolio management chapter one
Portfolio theory deals with the problem of constructing a collection of assets that reflect the individual needs. When a portfolio is constructed a variety of parameters can be taken into account, such as value, average, the riskiness of the asset. The financial objectives of the investor determines what types of assets to be used. In this paper a quantitative approach of choosing the portfolio will be discussed. Modern Portfolio Theory as introduced by Markowitz (1952) frames the time dimension of investing as a single period over which the parameters of the probability distribution of asset returns are both known with certainty and are unchanging. However, neither assumption hold in real life. The underlying assumption that legitimizes …show more content…
Markowitz suggested that for each asset that someone wants to include in the portfolio, the asset return and its risk should be measured and he proposed to use mean return for asset return and risk by asset’s variance of return. Apart of variance and return, Markowitz model also takes into account the covariance between all assets. For this reason, the Markowitz framework is commonly referred to as mean-variance portfolio analysis. Much of the focus has been on mathematical theories behind uncertainty set construction and reformulations resulting in optimization problems that can be solved efficiently; and, as a result, there are many formulations that can be used to build robust equity portfolios. Since 1990 there have been numerous extensions of the Markowitz’s mean-variance model. (Woo Chang Kim, 2015) Risk can be described by its two components : Systematic risk, that is common to many assets and is non-diversifiable Non-systematic risk, that is specific to individual assets. Forming a portfolio of individual assets, the non-systematic risk can be eliminated. An example of a simple portfolio is a 2 asset portfolio, where the assets can be either stocks, bonds, treasury bills and so son. The return on the portfolio with two assets is: The variance: Standard
When setting up a stock portfolio there are things one should look into. First off, one should know what is currently happening, not only in the stock market, but in the economy as well. Researching stock indexes such as “The Dow” and the “S&P 500” will give you general stock performance. The Dow Jones Industrial Average only tracks 30 large industrial firms in hopes of getting a sense of where the market is heading. The S&P 500, on the other hand, tracks 500 stocks which may give the investor a better overall picture of where the market is going. Which ever the investor may choose to use, the idea is to find out whether stock prices are going up or down. Also important to know is state of the economy. Certain stocks tend to perform better or worse depending on the state of the economy. Knowing which stocks tend to perform well at a given state will help the investor choose which type of stock is best for the given conditions.
Over the last couple of decades there has been a debate going whether or not there are behavioral aspects in finance. This means that financial markets are subject to different investors’ sentiments and that markets are not efficient, i.e. the efficient market hypothesis (EMH) does not hold. The supporters of EMH argue that all available information is included in the stock prices, which means that any long-term abnormal returns earned are a matter of chance. On the other side, the supporters of behavioral finance argues that because of over- and under-reaction by investors to information, it takes time before prices fully adjust and thus there is an opportunity to earn long-term abnormal returns.
Ross, S.A., Westerfield, R.W., Jaffe, J. and Jordan, B.D., 2008. Modern Financial Management: International Student Edition. 8th Edition. New York: McGraw-Hill Companies.
A generation ago, it was generally believed that security markets were efficient in adjusting information about individual stocks and stock market as a whole (Malkiel, (2003)). However, we cannot deny the efficient market hypothesis has several paradoxes.
The concept of beta has gained prominence due to the pioneering works of Sharpe (1963), Lintner (1965) and Mossin (1966). There are many studies that examine the behaviour and nature of beta. These studies include the impact of the length of the estimation interval, the stability of individual security beta as compared to portfolio beta, factors influencing the beta as well as the stability of beta in various market conditions.
Investment theory is based upon some simple concepts. Investors should want to maximize their return while minimizing their risk at the same time. In order to accomplish this goal investors should diversify their portfolios based upon expected returns and standard deviations of individual securities. Investment theory assumes that investors are risk averse, which means that they will choose a portfolio with a smaller standard deviation. (Alexander, Sharpe, and Bailey, 1998). It is also assumed that wealth has marginal utility, which basically means that a dollar potentially lost has more perceived value than a dollar potentially gained. An indifference curve is a term that represents a combination of risk and expected return that has an equal amount of utility to an investor. A two dimensional figure that provides us with return measurements on the vertical axis and risk measurements (std. deviation) on the horizontal axis will show indifference curves starting at a point and moving higher up the vertical axis the further along the horizontal axis it moves. Therefore a risk averse investor will choose an indifference curve that lies the furthest to the northwest because this would r...
The economic rationality assumption has given an important connation for the market efficiency, as it has been the base to carry out the construction of the modern knowledge in standard finance. Resulting in the development of the most important insights in finance, such as arbitrage pricing theory of Miller and Modigliani, the Markowitz portfolio optimization, the capital asset pricing theory of Sharp, Lintner and Sharp and the option-pricing model of Black, Scholes and Merton (Pompian, 2006 and Lo, 2005). At this stage, these advances provide a sophisticated mathematical approach to explain what happen in real life. As a result, of these advances, individuals who trade stocks and bonds use these theories under the assumption that the assets they are investing in have similar value to the prices they are paying. This way, according to the market efficiency, current prices reflect all relevant information so trading stocks in an attempt to exceed the benchmark or to produce returns above average will not be possible without taking risk above the average since with arbitrage would make go back prices to their real or fundamental value (Malkiel, 2003).
The MDA model also showed potential to ease some problems in the selection of securities for a portfolio, but further investigation was recommended.
To maximize optimum performance of our investment portfolio, we placed a certain percentage of equity in different sectors of the stock market.
Capital Asset Pricing Model (CAPM) is an ex ante concept, which is built on the portfolio theory established by Markowitz (Bhatnagar and Ramlogan 2012). It enhances the understanding of elements of asset prices, specifically the linear relationship between risk and expected return (Perold 2004). The direct correlation between risk and return is well defined by the security market line (SML), where market risk of an asset is associated with the return and risk of the market along with the risk free rate to estimate expected return on an asset (Watson and Head 1998 cited in Laubscher 2002).
The CAPM first began in 1952 by Harry Markowitz and his paper rigorously described the aspect of portfolio risks. A portfolio risk is when a stockholder or an investor invests in so many assets so that the rate of a risky turnover is spread amongst the assets to reduce the percentage of loss returned on the assets. For example, Mr. A buys 10 different assets from different companies so that if asset A from Alek corporations fail, Mr. A can still get returns from the 9 other assets, hence his risk and loss has been shared amongst his invested assets.
The key purpose for managing risk is to evaluate the risk and improve the performances of consolidated value of a firm to achieve profitability. Currently the benchmark tool for measuring the risk is VAR (Value at Risk). VAR evaluate the maximum loss a value of a portfolio has for a given interval on a pre-determined period of time. It is commonly used in brokerage houses, investment banks and institutions to measure a risk on their portfolios.
Chapter 11 closes our discussion with several insights into the efficient market theory. There have been many attempts to discredit the random walk theory, but none of the theories hold against empirical evidence. Any pattern that is noticed by investors will disappear as investors try to exploit it and the valuation methods of growth rate are far too difficult to predict. As we said before the random walk concludes that no patterns exist in the market, pricing is accurate and all information available is already incorporated into the stock price. Therefore the market is efficient. Even if errors do occur in short-run pricing, they will correct themselves in the long run. The random walk suggest that short-term prices cannot be predicted and to buy stocks for the long run. Malkiel concludes the best way to consistently be profitable is to buy and hold a broad based market index fund. As the market rises so will the investors returns since historically the market continues to rise as a whole.
The CAPM is one of the most influential theories in finance, and it is widely used in applications (e.g. estimating the cost of the capital for firms) . Meanwhile, the CAPM is probably the most tested model. The beauty of the CAPM comes from its parsimony and elegance in establishing a linear relationship between risk and return. The CAPM indicates that if an investor wants to obtain a higher expected rate of return, he has to bear additional risk. It is derived on the basis of the mean-variance approach, which is first proposed by Markowitz (1959). The mean-variance approach claims that mean is a proxy of the asset’s return and variance stands for the risk which the asset bears. If two assets have the same return, the investor will choose to invest in the asset with lower degree of risk. If two assets have the same degree of risk, the investor will choose to buy the asset with higher return.
Risk in this model is identified with the standard deviation of portfolio return. Rationality is modeled by supposing that an investor choosing between several portfolios with identical expected returns will prefer that portfolio which minimizes risk." (Wikipedia, 2005) Figure 1 and Figure 2 are examples on how this theory can be illustrated on a graph.