In: Categories » Legal and finance » Market and Finances » MODERN PORTFOLIO THEORY
|
No view of contemporary analysis can be complete without at least a passing acquaintance with Modern Portfolio Theory—MPT. MPT, simply, is a scientific approach to understanding the market value of a security. While there is very little a company can do, beyond dealing with analytic fundamentals, to influence portfolio analysis using Modern Portfolio Theory, the increasing use of MPT warrants at least a minimal understanding of it. Essentially, Modern Portfolio Theory is predicated on a concept that the degree of investment risk should be measured in terms of potential reward for that risk. But it also takes as its premise the concept that the greater the range of uncertainty about a stock, the greater the risk. Portfolio diversification is not a new idea, nor is any form of spreading risk. The aim here, though, is not merely to diversify, but to do so with a balance of stocks with varying degrees of risk, and therefore varying likelihood of performance, so that the average uncertainty of the total portfolio —and therefore the average of the portfolio’s risk—is diminished in relation to potential return. For example, in a two-stock portfolio, if both stocks perform in the same way in response to the market itself, there is no real diversification. If, however, each responds differently to market forces, then you do have diversification. But not necessarily the best diversification, unless the potential performance of one effectively hedges, or acts opposite to and offsets, the potential performance of the other. Measuring potential performance, and thereby potential risk-return, is done with a series of complex mathematical functions, but the basis is still a judgment of fundamental analysis of the elements of a company’s potential. Beyond that, however, portfolio analysis becomes complex. The aim is to build an efficient portfolio, one in which the balance of potential performance of all the stocks in the portfolio is one of minimum uncertainty. Taken into account are two major elements of risk—the risk in the individual stock and the risk inherent in the market itself, keeping in mind that not all stocks react or perform in the same way in response to the market at any given moment. Using the Standard & Poor’s 500 Stock Price Index as a basis, price fluctuations—the measure of risk used—are broken down into the two risk elements (market and individual stock). The statistical technique, regression analysis, is used to measure the potential risk. A complex mathematical technique, it measures functional relationships between two or more variables, particularly where a variable (such as a price/earnings ratio) is measured against another variable (such as a market index). Put simply, the term beta is used to indicate the measure of a stock’s volatility, relative to the volatility of the market during the same period. The higher the beta, the higher the volatility; the lower the beta the more stable. A beta of one means that the stock performs exactly as the market does. The term alpha is used to indicate the measure of average rate of return, in the same period, independent of the market return. A portfolio that matches the alpha and beta of the S&P 500 should— and generally does—perform about the same as the S&P Index, and indeed many index funds (funds designed to match the Standard & Poor’s 500) have been started based on the concept. However, there is a serious question in the minds of many professional investors, particularly institutional investors, whether indexed return, rather than one that outperforms the market, is sufficient. In the several years since the theory was developed by the statistician Dr. Harry M. Markowitz, it has grown in popularity among analysts. But even its strongest advocates warn that it is a theory with a great deal yet to be developed and proven, and more significantly, that it is only one tool of many that should be used by analysts. It does not portend, in the foreseeable future, eliminating all analysts and replacing them with computers.
|
legal disclaimer
1) Our website is not responsible for the information contained by this article as well for any and all copyright infringements by authors and writers. E-articles is a free information resource. If you suspect this article for any copyright infringements, please read the Terms of service and contact us to investigate the problem.
2) The E-articles directory team is not responsible for inaccuracies, falsehoods, or any other types of misinformation this tutorial may contain and will not be liable for any loss or damage suffered by a user through the user's reliance on the information gained here. Please read the Terms of service
Useful tools and features
If you like this article (tutorial), please link to it from your web page using the information above. Linking to this page, this is the only way to help us improve our service, the same time providing your visitors with a way to improve their online experience.
related articles
Under a commodity monetary standard, a medium of exchange and unit of account is either a commodity or a claim to a commodity and the commodity is a good that would have value even if it were not used for money. Put differently, the commodity has an intrinsic value, in contrast to the paper money of an inconvertible paper standard that has value only by government fiat and is called fiat money for that reason. In the purest form of commodity money, the commodity itself may change hands. History furnishes numerous examples...
2. Identifying the Relevant Cash Flows ~ Project Cash Flow versus Accounting Income
The most important, but also the most difficult, step in capital budgeting is estimating projects’ cash flows—the investment outlays and the annual net cash flows after a project goes into operation. Many variables are involved, and many individuals and departments participate in the process. For example, the forecasts of unit sales and sales prices are normally made by the marketing group, based on their knowledge of price elasticity, advertising effects, the state of the economy, competitors’ reaction...
3. What are Bills of Exchange
Bills of exchange developed during the Middle Ages as a means of transferring funds and making payments over long distances without physically moving bulky quantities of precious metals. In the hands of thirteenth-century Italian merchants, bankers, and foreign exchange dealers, the bill of exchange evolved into a powerful financial tool, accommodating short-term credit transactions as well as facilitating foreign exchange transactions. The invention of the bill of exchange greatly facilitated foreign trade. The mechanics...
4. What is the Interest Rate
The interest rate can be regarded as the cost of money, expressed as a percentage. If the annual interest rate is 10 percent, an individual borrowing $100 for a year pays $10 interest. Decimalized currency systems substantially facilitated the calculation of interest. This is one reason countries rapidly adopted decimalized currency systems during the nineteenth century. Theoretically, interest rates adjust to a level at which the interest earned on $100 invested in financial assets (for example, corporate bonds) equals t...
Foreign exchange markets are markets in which national currencies are bought and sold with other national currencies. In a foreign exchange market U.S. dollars may purchase British pounds, German marks, French francs, Japanese yen, etc. Prices of foreign currency are expressed as exchange rates, the rate at which one currency can be converted into another currency. On 12 March 1997 it took $1.59 to purchase a British pound in foreign exchange markets, or, alternatively 0.6256 British pounds could purchase one U.S. dollar....
6. What is the Commodity Monetary Standard
Under a commodity monetary standard, a medium of exchange and unit of account is either a commodity or a claim to a commodity and the commodity is a good that would have value even if it were not used for money. Put differently, the commodity has an intrinsic value, in contrast to the paper money of an inconvertible paper standard that has value only by government fiat and is called fiat money for that reason. In the purest form of commodity money, the commodity itself may change hands. History furnishes numerous examples...
7. What is The Balance of Payments
The balance of payments for a country summarizes all the international transactions that involve either an outflow or an inflow of money. It is composed of three major elements: (1) the current account, (2) the capital account, and (3) the official reserves transactions account. The official reserves transactions account reflects the official transactions between central banks that must occur when the combined balance of the current and capital accounts is in either the deficit or surplus column. Transactions that lead to...
8. Short Introduction in Forced Savings
Forced savings refers to the use of money creation and inflation to divert resources into the production and acquisition of capital goods. A government that prints up money, as opposed to levying taxes or selling bonds, to pay for the construction of a hydroelectric generation facility is pursuing a policy of forced savings. Less-developed countries, particularly in Latin America, turned to forced savings policies in the post–World War II era as a means of financing economic development. At least some of the inflation in ...