The activity this paper will focus upon is something often done by professionals and laymen in the field, perhaps something most people in the industrialized world will do at least once in their lives or most probably on a regular basis. The activity has become an indispensable tool for managing fund flows in a market economy and an important way of building personal wealth. The topic in question is selecting stocks and other securities for investment.
Security selection is the subject that has received broad coverage in numerous manuals, written in diverse styles and ranging from academic discourse saturated with statistical information and graphs to handy flashy booklets designed for ordinary investors. Strategies picked by an average American investor vary widely. Some people rely exclusively on intuition, others listen to their friends and acquaintances, while some are listening to news and financial advisors to find information that will help them make a difficult choice. Modern Portfolio Theory: Goal
One of the theories that offer insight into stock selection procedures is the Modern Portfolio Theory (MPT). MPT was described by Henry Markowitz in his work “Portfolio Selection” (1952). It provides theoretical foundation for steering investors between risk and return and is based on the assumption that investors are trying to receive maximum return with minimal risk. The construction of the portfolio involves preparation of an ”efficient frontier’ of optimal portfolios offering the maximum possible expected return for a given level of risk” (”Modern Portfolio Theory”, n. . ). This means that a person wishing to minimise risk when maximising return should embark on a certain course of action. For instance, this person can concentrate on ‘growth’ stocks that offered an average annual return of 10% over the 5-year period. However, looking at their volatility, it is easy to see that their share prices also exhibited great fluctuations. The investor is risking losing a nice income due to high volatility of these stocks. What if you put in the money in expectation of a 10% return only to see stocks lose 20% of their value?
On the other hand, you do not want to keep your funds in super-safe Treasuries that offer the lowest return possible due to their virtually risk-free nature. Modern Portfolio Theory offers a way around this investor’s dilemma, providing a tool for computing portfolios of assets that give the maximum return for a given degree or risk or minimum risk for a wished return. Return is understood as the expected return on a set of securities combined in a portfolio, and risk is taken to be roughly equivalent to standard deviation. These numerical values are used by financial analysts in order to assess risk and return in mathematical computations.
MPT has important implications for asset managers. The theory claims that one has to proceed in several stages in the process of creating a portfolio: security valuation, asset allocation, portfolio optimization, and performance measurement. This implies that asset allocation should take precedence before security selection, as broader asset classes are defined in the first step, after which the portfolio is constructed based on the proportion of asset classes investors want to include in their portfolios with regard to their risk tolerance.
MPT suggests that the investor has to avoid the strategy that gives preference to stocks or bonds that have been recommended by a neighbor or colleague, afterward trying to balance the portfolio so that it includes enough investments from different asset classes. Using MPT, a clever money manager can, for instance, rebalance the weightings of the portfolio composed of Microsoft stock, Chilean Brady bonds and UK ten-year gilts, raising return and at the same time lowering risk. An example is given in Richard Slicker’s 2003 article “Practical Context Portfolio Enhancement – When is it worth it? Thus, Modern Portfolio Theory allows the investor to balance between risk and return. MPT Basics In Markowitz’s theory, risk corresponds to the standard deviation of the asset’s returns. The more these returns fluctuate over the years, the greater the risk is. It is assumed that investors are risk-averse and attempt to maximise returns while bringing the risk to a minimum. Modern Portfolio Theory recommends that you should not «base your decision on the amount of risk that carries with it» but instead «consider how that security contributes to the overall risk of your portfolio».
This will allow anybody to build a coherent strategy of investing. MPT claims that correlation between different investments in a portfolio has to be considered, with ‘correlation’ assuming the range within which these investments move in lockstep. This correlation needs to be evaluated in order to correct weightings in a portfolio so that gains on one type of security offset losses on another. For example, a rise in fuel prices will prop the stocks of oil companies, but drag down the returns on airline stocks, and vice versa.
This phenomenon is explained by the fast that «stocks of companies in these two industries often move in opposite directions» and thus have a «negative (or low) correlation» (Modern Portfolio Theory Made Easy). Therefore, an investor needs to plan the portfolio in such a way that it includes one airline stock and one oil company stock. In either case (increase or decrease in fuel price), the investor will be able to reap returns on one stock or another. A portfolio built, for instance, only of airline stocks will lose value in case of dropping fuel prices, although if you bet on a rise in price, the returns can be sizzling.
Modern Portfolio Theory was in many ways a breakthrough in investing theory. Where investors previously used intuition, Markowitz offered a coherent scholarly hypothesis that justified issues that were formerly intuitive. For example, investors felt that to concentrate on one particular type of stock would be stupid even if this stock had a good balance of risk and return. For example, without MPT one could assume that portfolio comprised entirely of telecommunication stocks would be a good idea if these stocks all offer a good combination of risk and return.
This, as intuition tells us, would be stupid, since in an economic downturn all these stocks would suffer. Markowitz only offered a scientific explanation why an investor has to attempt to locate stocks with such correlation that their fluctuations offset one another. Markowitz then arrived at the conclusion that «out of the entire universe of possible portfolios, certain ones will optimally balance risk and reward» (riskglossary. com), and named those an efficient frontier of portfolios. The investor has to pick a portfolio that lies on the efficient frontier.
Any portfolio on this line is superior to other portfolios that are not on the line because it offers a better return for a given amount of risk or a lower risk for the same level of return. The investor picks a portfolio on the frontier with consideration of his/her degree of risk tolerance. Those willing to accept a higher risk will in most cases get a higher rate of return. Conclusion Modern Portfolio Theory provides a technique widely used by financial managers in constructing their clients’ portfolios. It communicates to the investor the need to examine securities in combination and diversify one’s portfolio.
This is the ultimate upshot of the theory that has had profound impact on the way modern portfolios are built. Now the benefits of diversification are obvious to any investor. The theory, however, offers no guarantee that the investment is going to be successful. Success is going to take more than just theory and will be a combination of science, good luck and intuition. Using scholarly research does guarantee, however, that your investment will carry the highest possible return for a certain degree of risk.