rP os t 9-185-066 REV: FEBRUARY 20, 2007 ANDRÉ F. PEROLD Introduction to Portfolio Theory op yo Portfolio theory is concerned with the risk-reducing role played by individual assets in an investment portfolio of several assets. The benefits of diversification were first formalized in 1952 by Harry Markowitz, who later was awarded the Nobel Prize in economics for this work. Portfolio theory is today a cornerstone of modern financial theory, as well as a widely used tool for managing risk-return tradeoffs in investment portfolios. This note examines the basic building blocks of the theory. Means and Standard Deviations of Total Return Do No Figure 1 tC The return and risk of an asset are commonly …show more content…
The formula for the standard deviation (SP) of a portfolio of cash and asset B is: SP = fSB tC i.e., if we invest all our money in B(f = 1) then SP = SB; if we invest half of our money in B and half in cash, then our risk is only half as large (SP = ½SB); and so on. Both EP and SP are thus linearly related to the means and standard deviations of the assets in the portfolio. This is always true for EP but only sometimes true for SP, here because SA = 0. Graphically, these relationships are as follows: Do No Figure 3 3 This document is authorized for use only by KAIGUO ZHOU until October 2011. Copying or posting is an infringement of copyright. Permissions@hbsp.harvard.edu or 617.783.7860. Introduction to Portfolio Theory rP os t 185-066 Each point on the line in Figure 3 (say, the line through A and B) is the mean-standard deviation pair corresponding to a particular combination of A and B. For example, the point halfway between A and B gives the mean and standard deviation of a portfolio that is 50% invested in A and 50% invested in B. The lines extend beyond B and C by taking f to be larger than 1. This is possible if we can borrow at the rate of return on A (EA) and leverage our investment in B or C. Problems Would you rather hold portfolios of A and B or A and C? 2. Whichever line (A-B or A-C) you choose to be on, how will you decide where to be on the line, i.e., what fraction
Asset allocation is a portfolio management technique that is concerned with balancing between income-oriented and growth investments in a portfolio. This apportioning enables the investor to capitalize on the risk/reward trade off between the various assets in the portfolio and gain from both profits and growth. There are four basic steps to asset allocation; selecting which asset categories to include in the portfolio (stocks, bonds, real estate, money market, financial derivatives or precious metals), choosing the most suitable proportion to allot to each asset class, identify a suitable variety within the set target and then finally diversifying within each asset category.
Portfolio Standard Deviation, of a portfolio with two stocks (Stock A and Stock B) is given by following formula:
11. What is the variance of the returns on a portfolio that is invested 60 percent in stock S and 40 percent in stock T?
Efficient diversification was a term familiar with most investors. The concept of the term suggested that
By selecting securities that have little relationship with each other, an investor is able to reduce relevant risk. Ideally, one would combine their securities in a way that will reduce relevant risk, such as diversification, to optimally manage their portfolio. The decision to invest excess cash in marketable securities involves not only the amount to invest but also the type of securities to invest. To some extent, the two decisions are interdependent. Both should be based on an evaluation of expected net cash flows and the uncertainty associated with these cash flows. In future cash flow patterns are known with reasonable certainty and the yield curve is upward sloping in the sense of long-term securities yielding more than shorter-term ones, a company may wish to arrange its portfolio so that securities will mature approximately when the funds will be needed. Such a cash-flow pattern gives the firm a great deal of flexibility in maximizing the average return on the entire portfolio, for it is unlikely that significant amounts of securities will have to be sold unexpectedly.
Harry Markowitz is highly esteemed as a pioneer in theoretical justification of investor’s behavior and development of optimization model for portfolio selection process. In 1990, Markowitz received a Nobel Prize for his contributions to financial economics and corporate finance, the first time presented in his “Portfolio Selection” (1952) and more extensively in his monography “Portfolio Selection: Efficient Diversification” (1959). His seminal works form the foundation of the Modern Portfolio Theory (MPT). Markowitz’ ideas ware later substantially expanded by his Nobel Prize co-winner, William Sharpe, who is generally recognized for his Capital Asset Pricing Model (CAPM) concerning with financial asset price formation.
The aim of Portfolio Manager is to provide a brief overview of three aspects of investment:
Harry Markowitz put forward portfolio theory in 1952; portfolio theory is that using portfolio diversification to eliminate non-systematic risk; portfolio theory uses mathematical methods σanalysis the relationship between risk (variance) and expect return (mean) (Brealey, Myers and Allen,2014). Mean-variance criterion is very important for Portfolio theory. The mean is the expect return of portfolio, the formula of expect return for one asset is:
We employ the modern portfolio theory in our asset allocation strategy. We take into consideration personal risk tolerance to create clients’ portfolios.
Comparing the investments in the chart above, an investor can use the standard deviation and correlation of returns to determine the given risk of the investments, as well as which investment choice would yield a better return. With the information provided a portfolio made up of equal parts B and C will ultimately be less risky than a
ASIC. (2013, August 20). Money Smart. Retrieved January 7, 2014, from Australian Securities and Investment Commission: https://www.moneysmart.gov.au/investing/investing-basics/risk-and-return/diversification
Modern portfolio theory is an investment theory based on that investors can construct portfolio to maximize return which based on a given level of market risk, emphasizing that risk is an essential part of higher return. Modern portfolio theory is one of the most significant economic theory dealing with finance and investment, which was published by Harry Markowitz in his paper “Portfolio Selection” in 1952 by Journal of Finance (Shipway, 2009).
Diversification is worth more than a word. It works on reducing the total risk of a portfolio with different asset types. But what contributes to the success of portfolio diversification? A large size of portfolio? A variety types of asset allocation? Adding international investment? Numerous of risk factors? They are all indicators of a well-diversified portfolio. But it is hard to achieve a perfectly diversified portfolio in reality because you cannot diversify all types of risk. Following, we will discuss about the advantages and disadvantages of diversification in portfolio management under circumstances. On one hand, some mention that dynamic and numerous asset allocations in the portfolio will reduce idiosyncratic risk and some level of market risk. While some also suggest benefit exists of introducing multi-factor pricing models to cover different risk factors. On the other hand, arguments arise demonstrating adding international investment may disappoint investors because foreign markets could be correlated and moved together in a global world. Another disadvantage further defined will be the correlated asset allocations weaken the effect of diversification. At the end, conclusion will be drawn to support the useness of diversification.
The standard deviation is a measure of a portfolio’s total or stand-alone risk. The larger the standard deviation , the higher the propablity that actual realized returns will fall far below the expected return.
During 1952, Markowitz came out with a theory based on diversified investment is able to construct the risk-averse investors. He diversified investment portfolio theory and efficiency of the priory rigorous mathematical tools as a means to demonstrate risk-averse investors in a number of risky assets in construct the optimal portfolio methods (Markowitz, 1952).