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Design and assembly of modern portfolio theory
Discussion of portfolio theory
Modern portfolio theory by markowitz pdf
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2. Literature Review
This chapter will explore the theories associated with the Modern Portfolio Theory and Markowitz efficient frontier. The understanding and role of alternative investments and emotional assets in the financial world are also exemplified. The chapter will then conclude by analysing the importance of alternative investments and emotional assets to a portfolio using existing academic literature.
2.1 Introduction
In portfolio optimisation, investors should keep in mind that diversification is key to balance risk and return. Malkiel (2010), reminded investors that the best investment is a well-diversified portfolio, being re-balanced appropriately while adopting a buy-and-hold strategy. A reduction in portfolio volatility can be achieved by diversifying in several securities. However, even with a large number of assets, risk cannot be reduced to zero since portfolios are affected by macroeconomic factors which influence the market (Bodie et Al., 2004). In addition, portfolio returns can never be guaranteed as the future is unpredictable. A famous quote by a Chinese philosopher sums this up:
“To know is to know that you know nothing. That is the meaning of true knowledge.”
- Confucius.
2.2 Modern Portfolio Theory
Investors familiar with the saying “don’t put all your eggs in one basket”, can comprehend the rationale behind the modern portfolio theory, pioneered by Harry Markowitz (1952). This is one of the most significant and influential economic theories in investment and finance. The theory was further developed by William Sharpe (1966) who along with Merton Miller, the three were awarded the Nobel Prize in Financial Economics in 1990.
In simple terms, modern portfolio theory is a framework for evaluating risk...
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...rn similar to the risk-free rate. However, Krasker’s study had a lot of flaws and can be considered insignificant. The first real contribution was presented by Weil (1993), calculating wine returns between the 1977-1992 periods. The results suggest that returns from holding wine averaged 9.5% per year and compared unfavourably to stocks.
Masset, Henderson and Weisskopf (2009) made the most recent analysis on wine returns ranging data from 1996 to 2009. The data was stretched till 2009 to show that wine still is an attractive proposition in an economic downfall. Their findings suggested that over the 14-year period, wine yielded a mean rate of return (7.3%) and a low volatility (8.23%). These results showed that wine performed better than stocks. In addition, during the 2008 financial crisis, wine prices dropped by 17% while most stock indices lost half their value.
it is seen that knowledge can hurt. It is also shown that sometimes one can know
“Knowledge is power. Power to do evil...or power to do good. Power itself is not evil. So knowledge itself is not evil.” - Veronica Roth, Allegiant
Economic returns in the global market place have been influenced by trends in wine consumption. Figure 2 shows a trend of decreasing wine consumption from 2007 - 2011 in most old world countries while new world countries were increasing their consumption. This is due to the diversification of alcoholic beverages in the old world countries and the growing wine popularity in the new world
"It would be better not to know so many things than to know so many
Fama and French findings shocked the modern portfolio theory and their study was nick named "Beta is Dead". With respect to CAPM they found that stocks with high betas did not have consistently higher returns than low-beta stocks. Furthermore, Fama and French concluded that a high book value to market value was the most important variable related to predicting high stock returns on small cap stocks. These findings were published in a 1992 paper titled "The Cross-Section of Expected Stock Returns".
So to say, knowledge can either make or break a person. It can act as a benefit, for power, or loss, for ignorance. “Do not take for granted what you know. Ask yourself how you know what you know; ask yourself whom it benefits, whom it hurts and why.” (Blackboard: Knowledge is Power)
...r investments that can support the other weight and balance their portfolio and therefore alleviate some of the risk they face.
In The Matrix the character Cypher, states this when he says that he believes it better to live in the fake reality of the unknown than to identify the truth. Reality is harsh, often times knowing the truth breeds pain, but with the pain comes the freedom and joy of actually knowing what truth is. There cannot be freedom and joy if one is living in a lie. This is evident in the reality of how Neo continued and helped others understand this reality, and the man from the cave wanted to free the other man so they all could experience the good that comes with truth. The good is ultimately worth the pain. Descartes also supports that knowledge is better than ignorance as now he knows the truth and thankful to know longer be ignorant.
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...
We analyzed the market for two weeks to determine when the equity market would turn from a bearish to bullish market. Without a change in the market and a declining bond price, we decided to invest in equities according to our investment strategy, which brought us into the second phase of our portfolio. Therefore, at the beginning of February we bought shares in Sirius, Microsoft, Neon, Washington Mutual, and Nike. As assumed, the equity market continued to plummet decreasing the value of all our stocks except for our Gold Corporation stock.
According to Investopedia (Asset Allocation Definition, 2013), asset allocation is an investment strategy that aims to balance risk and reward by distributing a portfolio’s assets according to an individual’s goals, risk tolerance and investment horizon. There are three main asset classes: equities, fixed-income, cash and cash equivalents; but they all have different levels of risk and return. A prudent investor should be careful in allocating each asset class to his portfolio. Proper asset allocation is a highly debatable subject and is not designed equally for everybody, but is rather based on the desires and needs of the individual investor. This paper discusses the importance of asset allocation, the differences and the proper diversification within the portfolio.
This reveals that knowledge not known that one already had, must
Our understanding and the concept of investment in behavioural finance combines economics and psychology to analyse how and why investors make final decision. As an investor one’s decision to invest is fully influence by different type of attitudes of behavioural and psychological ( Ricciardi & Simon, 2000). Yet, in order to maximize their financial goal, investors must have a good investment planning. Furthermore , to gain a good investment planning , there must be a good decision making among investors. They have to choose the right investment plan I order to manage the resources for different type of investments not only to gain profit wise but also to avoid the risk that occur from investment.
In turn everything in the present and the future is judged through the stocks as they hold a high importance in industrialized economies showing the healthiness of said countries economy. As investing discourages consumer spending over all decreases, it lead...
The Modern portfolio theory {MPT}, "proposes how rational investors will use diversification to optimize their portfolios, and how an asset should be priced given its risk relative to the market as a whole. The basic concepts of the theory are the efficient frontier, Capital Asset Pricing Model and beta coefficient, the Capital Market Line and the Securities Market Line. MPT models the return of an asset as a random variable and a portfolio as a weighted combination of assets; the return of a portfolio is thus also a random variable and consequently has an expected value and a variance.