Essay: Modern Portfolio Theory - Investment Framework Overview.

The Foundation of Modern Portfolio Theory

Conduct a literature review on Markowitz’ Portfolio Theory (MPT) and discuss the long-term performance of portfolios constructed based on this theory/strategy; the pros and cons of MPT, the practicality of adopting this theory/strategy, etc. You are to select key research results from various journal papers and books to justify your arguments.

Modern Portfolio Theory is bought forward by the Harry Markowitz in his study portfolio selection (Wallengren and Sigurdson 2017). Being the investment based theory itis based on the notion that risk is averse and investors can construct the portfolio to optimize the or increase the anticipated rate of return based on the given level of material risks which emphasizes that risk forms the inherent portion of higher reward.

The theory is regarded as most important and influential economic theories that deals with the financial and investment related matters (Petters and Dong 2016). The MPT theory suggest that the it is possible to construct the efficient frontier of the optimal portfolios that offers the higher amount of anticipated return for the given level of risks. By making investment in greater than one stock, an investor can obtain greater benefits on the diversifications, especially in the reduction of the riskiness in the portfolio.

The foundation of modern portfolio theory was created during the year 1952 by Harry Markowitz. The vital aspects of the Markowitz model the explanation of the impact created by the theory on the diversification of the portfolio based on the number of securities inside the portfolio along with their covariance relations (Lee, Cheng and Chong 2016). Fundamentally, the theory of MPT is regarded as the investment framework relating to the selection and construction of the investment portfolios that is based on increasing the anticipated rate of return of the portfolio and at the same time reducing the investment risk.

In general, the components of risk can be measured by using numerous mathematical formulas and reducing the risks through the theory of diversification that targets to correctly choose the weighted collection of investment assets that collectively represents lower risks factors than making investment in any individual assets or single class of assets. Diversifications, as the matter of fact forms the core concept of the MPT and unswervingly remains dependent on the conventional wisdom of the “not putting all the eggs in one basket” (Gerber, Markowitz and Pujara 2015).

According to Pfiffelmann, Roger and Bourachnikova (2016) the advance liquid stocks market behave very effectively. It is vital to consider the stocks economically efficient since new information is not engrossed immediately during the long term but above average returns cannot be attained. The price of assets reacts sharply, precisely and immediately on every new price-sensitive information. Under such markets all the strategies for investment fail and no investors is able to attain any above average long term yield.

Components of Risk and Diversification

The modern portfolio theory takes into the consideration several assumptions that are not always right in the actual world (Dhrymes 2017). An example of this theory is that it presumes that returns from asset is normally distributed among the random variables. In actual world it is not often correct. In several cases there are several large swings that does not validates the theory. Another major flaw that relates to this theory is that it relates to the assumptions that all the investors has the access to the similar information which is far from true in the actual world.

An individual investor can yield higher returns and reduce their degree of risk in the portfolio at the same time (Neumann, Ebendt and Kuhns 2016). The theory is advantageous in reducing the exposure to separate assets. The theory is advantageous in defining the boundaries for anticipated loss and helping in capital allocations.    

Considering the adoption of the MPT theory reduction of risk is possible under this theory because of the historic correlations among numerous class of assets having relations to each other (Markowitz 2014). For instance, a collection of stocks and bonds that are held together may face the overall lower risks than it is held individually. Even though the class of assets returns are positively correlated the risk is reduced. By combining the different class of assets in the portfolio, the MPT theory efficiently lowers down the risks and the anticipated level of variance that is associated with the portfolio and would vary vastly during the crisis times caused by the external factors.

The two key principles of the Markowitz portfolio theory is that there are investors that hold diversified portfolio and there are only risks that matters are the beta risks. The value investors rejects both the principles (Way et al. 2017). They are not required to reject the notion of both these principles. They do not believe that astute investors should hold well-diversified portfolios and the investors reject the idea that beta constitute the measure of risk. Value investors regard diversifications as the auxiliary to the due diligence. The investors believe that stock to stock analysis is held as the wasted effort and diversifications would save the investors.

The value investors seek to reduce the risks without restricting the upper side. The value investors select the securities whose commercial activities they understand with the history of relatively stable cash flow. The investors employ the limits of position among the other risks mitigating policies. The investors only purchase stocks when the stocks are below the fundamental or the intrinsic value (Bai, Liu and Wong 2016). The value investors tend to hold very concentrated portfolio of stocks that ranges between 15-30 stocks. The value investors believe that some diversifications together with margin of safety goes a long way in transacting with the risks.

Limitations of Modern Portfolio Theory

Value investors discards the ideas that beta represents the measure of risk. For value investors risk does not represents volatility. Volatility is referred as good but there is probability of permanent capital loss. According to Gerber, Markowitz and Pujara (2015) value stocks outperforms the growth stocks in the global markets. They outclass when the markets fall and when the stocks go up. Value investing is largely about concentrating a portfolio to a few selected and purely those stocks that are undervalued. According to the study conducted on value investors by Byers, Groth and Sakao (2015) he studied whether the value investors adds value to the stocks and beyond the simple rule that it dictates whether the investors only invest in stocks that has lower price earnings ratios. The author noticed that the values investors through value investing does adds in a way that their three stage procedure of selecting purely undervalued stocks generated significantly positive surplus returns over and above the unexperienced method of simply selecting stocks that has lower price earnings ratios (Rice 2017). The evidences suggest that value investing are favourable in risk valuations as value investors invest with the perspective of long term investment.

Passive investing on the other hand is considered as the investing strategy that keeps track of the market weighted index. The most widely known method is to simulate the performance of the externally specified index by purchasing an index fund. By keeping track of the index an investment portfolio typically obtains better diversifications, lower turnover and better management fees (Szegö 2014). With lower amount of investment, the investors under passive investment may generate higher amount of return than through the similar fund with identical investment but higher management fees or transactions costs.

Passive investing is the most common method on the equity market where the index funds tracks the index of stock market but currently it is turning out to be highly common in other types of investment that includes bonds, commodities and hedge funds. During the long run the average investors would have the average before costs performance which is equivalent to the market average (Jones 2017). As a result of this the average investors would obtain benefit more from the reducing the investment costs instead of attempting to beat the average costs.

True passive investing cannot result from the index fund whose components are altered on regular basis. The committees that undertakes the decision what stocks forms their index change their minds on regular basis. The index funds are usually managed by the committee so that it can reflect the present economy and the sectors that drive it. Stocks that does are non-performing are usually dumped and new companies that have greater momentum are added into the index holding committees (Dhrymes 2017). The passive investors under the bull market are usually found chasing the momentum for the popular index. As more investors purchase those most popular stocks and increase the price element, the index funds is increasingly composed of higher price earnings. Though it can be considered as passive but it is neither value driven nor it is conservative. The market index measures the value of the group of investments when pooled together (Nguyen et al. 2017). Similar to mutual funds it is considered as the way through which investing is diversified through the number of securities.

Value Investing vs. Passive Investing

The passive index is referred as the investing in the market namely the index funds and exchange traded funds. In simple means both are meant to diversify with lower cost alternative to administer the mutual funds (Szegö 2014). On a simple mode, the index funds is applied by purchasing the securities in the identical proportion similar to the stock market index. Evidences from the studies suggest that passive investing forms the strategy that targets to increase the returns over the long run by keeping the sum of buying and selling to the minimum. The purpose of passive investing is to avoid the fees and drive the performance that may probably occur from the regular trading.

The model of Markowitz states how investors should make an investment at the time of compiling optimal portfolios. The Markowitz portfolio theory explains that the essential aspects associated to the risk of the asset does not constitute a risk of each asset in the isolation, but represents the contribution of every assets risks of aggregate portfolio (Byers, Groth and Sakao 2015). The theory assumes that systematic risks impacts a large number of assets to each degree or another. Common conditions of economy such as inflations, interest rates, exchange rates all forms the part of the systematic risk factors. Such economic conditions possess the impact virtually on all the securities to a certain extent. The systematic risk accordingly cannot be eliminated.

The Markowitz portfolio theory states that the unsystematic risks on the other hand represents the micro level risk that particularly creates an impact on the assets or the narrow assets group. In actual concept the unsystematic risk can be lowered considerably through diversifications inside the portfolio (Gerber, Markowitz and Pujara 2015). In actual practice the returns from different assets are correlated to a certain degree and unsystematic risk cannot be entirely eliminated irrespective of the types of assets are combined in a portfolio. 

The Markowitz theory states that the risk and return are the part of the assets. The basic principle governing the theory is that investment with greater risk possess the potential of providing greater return. As a common rule, investors would usually keep the risky security given the anticipated return is sufficiently greater enough to reward them for supposing the risk (Bai, Liu and Wong 2016). Risk constitute the chance of that the original return of the investment would be different than the anticipated sum which is in practice measured through standard deviation. The greater standard deviation translates into the greater risks and requisite greater potential return.

Passive Investing and the Market Index

Given the investors are willing to undertake greater risk then they are anticipated to earn greater risk premium (Jones 2017). The greater risk and return trade-off signifies the possibility of greater return but does not guarantees the same. The Markowitz portfolio theory makes an attempt to assess the interrelation between the different forms of investment. It makes the use of the statistical measures namely the correlation to quantify the effect of diversifications on the performance of portfolio.

Conclusion:

The Markowitz portfolio theory has created itself as the gospel of the contemporary financial theory and practice. The theory summarizes that present market is hard to beat and those that finds success in doing so are able to diversify their portfolio effectively by undertaking above average investment risks. An important consideration while adopting the MPT theory is that it is simply a tool and theoretical conclusions have worked as the springboard for development in the area of portfolio theory. Overall, under the MPT the component of risk can be measured through numerous mathematical formulations and the same can be reduced through diversifications

Reference List:

Bai, Z., Liu, H. and Wong, W.K., 2016. Making Markowitz's portfolio optimization theory practically useful.

Byers, S.S., Groth, J.C. and Sakao, T., 2015. Using portfolio theory to improve resource efficiency of invested capital. Journal of Cleaner Production, 98, pp.156-165.

Dhrymes, P.J., 2017. Portfolio Theory: Origins, Markowitz and CAPM Based Selection. In Portfolio Construction, Measurement, and Efficiency (pp. 39-48). Springer, Cham.

Gerber, S., Markowitz, H. and Pujara, P., 2015. Enhancing Multi-Asset Portfolio Construction Under Modern Portfolio Theory with a Robust Co-Movement Measure.

Gerber, S., Markowitz, H. and Pujara, P., 2015. Enhancing Multi-Asset Portfolio Construction Under Modern Portfolio Theory with a Robust Co-Movement Measure.

Jones, C.K., 2017. Modern Portfolio Theory, Digital Portfolio Theory and Intertemporal Portfolio Choice.

Lee, H.S., Cheng, F.F. and Chong, S.C., 2016. Markowitz portfolio theory and capital asset pricing model for Kuala Lumpur stock exchange: A case revisited. International Journal of Economics and Financial Issues, 6(3S).

Markowitz, H., 2014. Mean–variance approximations to expected utility. European Journal of Operational Research, 234(2), pp.346-355.

Neumann, T., Ebendt, R. and Kuhns, G., 2016. From finance to ITS: traffic data fusion based on Markowitz'portfolio theory. Journal of Advanced Transportation, 50(2), pp.145-164.

Nguyen, T., Stalin, O., Diagne, A., Aukea, L., Rootzen, P.H. and Herbertsson, A., 2017. The Capital asset pricing model and the Arbitrage pricing theory.       

Petters, A.O. and Dong, X., 2016. Markowitz Portfolio Theory. In An Introduction to Mathematical Finance with Applications(pp. 83-150). Springer, New York, NY.

Pfiffelmann, M., Roger, T. and Bourachnikova, O., 2016. When behavioral portfolio theory meets Markowitz theory. Economic Modelling, 53, pp.419-435.

Rice, B., 2017. The Upside of the Downside of Modern Portfolio Theory.

Szegö, G.P., 2014. Portfolio theory: with application to bank asset management. Academic Press.

Wallengren, E. and Sigurdson, R.S., 2017. Markowitz portfolio theory.

Way, R., Lafond, F., Farmer, J.D., Lillo, F. and Panchenko, V., 2017. Wright meets Markowitz: How standard portfolio theory changes when assets are technologies following experience curves