Modern Portfolio Theory Research Papers Example
Considered as an unstable industry despite the rewards and benefits that it can produce, the financial world still continues to grow. Because of its volatility, Omisore, Yusuf and Christopher (2012, p. 19), discuss that systems of finance require critical analysis for the appropriate assessment of risks involved especially in certain investment vehicles. This event is where the investment theories come into play.
Investment portfolio theories form the groundwork for investors or financial planners. These theories guide individuals in allocating money and other assets in an investment portfolio. This portfolio has a continuous goal that is self-governing from the daily fluctuations of the market. This scenario created a clearer vision of how investment portfolio theories have purposively helped investors or financial planners. The theory has helped individuals calculate the risks expected from an investment and the returns related to an asset (Omisore, Yusuf and Christopher, 2012).
One of the most popular portfolio theories is Harry Markowitz’ theory; that is now known as the Modern Portfolio Theory or the MPT. During the 1950s, Markowitz formed a theory of “portfolio choice” that permitted investors to analyze the risks involved with their foreseen returns. The MPT aims to maximize portfolio expected returns for a specified amount of risk in the portfolio. This fact also applies equivalently in aiming to minimize the risk for a given degree of returns by slowly selecting the extents of different assets. Though the MPT is widely used as an investment vehicle in the financial market, these past years revealed basic assumptions that greatly challenged the effectiveness of the MPT (Omisore, Yusuf and Christopher, 2012).
The Modern Portfolio Theory is an advanced version from the traditional investment systems. It is a substantial device in the mathematical facet of finance. The theory highly encourages variation to border against risks in the market as well as the risks that are exceptional to a particular company. The theory is a refined investment tool that helps an investor estimate, control and classify the expected risks and returns. It is vital to the theory that it quantifies the connection between the risks and returns and the formulated guess that investors must be regarded for upon foreseeing the associated risks of the investment.
The Portfolio theory moves away from the customary security evaluation in transitioning importance from evaluating the characteristic of separate investments to identifying the statistical connections among singular securities that compose the portfolio.
The MPT numerically frames the idea of differences in investing with the goal of choosing a group of investment benefits. The likelihood of this scenario can be seen instinctively as various kinds of assets most likely change in value in opposed directions. However, a variety in investment lessens the risk even if the returns are not negatively correlated. Technically the MPT replicates an investment return as a well distributed function that identifies risk as the standard deviation of returns. The theory also depicts a portfolio as a one-sided combination of benefits so that the returns of an investment portfolio is the combination of the assets’ returns.
In the manner of combining the different assets that of which whose returns are not exactly and positively related, the MPT aims to lessen the total variance of the investment returns. The MPT also undertakes that individual investors are lucid and that markets are effective. The fundamental concept of the MPT is that an investment portfolio’s assets must not be selected singularly. Rather, it is essential to note and concentrate on how each asset changes in the amount that is connected to how every other asset in the portfolio transforms in amount.
One of the benefits of the MPT is that it gives an identification of how to select an investment portfolio with the highest conceivable returns or the other way around. The idea of the theory is to move the investment portfolio closer to the most effective market boundary by allowing it to gain from different forces in the market instead of just a few (Rotblut, 2010). However commonly used the theory is, there are certain limitations that must be noted. According to Omisore, Yusuf and Christopher (2012, p. 26) the MPT has been highly criticized because of its simplistic predictions that are viewed as predominantly biased. According to the researchers, the theory does not model the actual market. The risks and returns defined by the theory are merely based on forecasted values. This fact only implicates that they are just findings of the future and not the actual situation of the market. The theory also does not consider the strategic, economic, personal, or other dimensions of the investment decision. The theory only tries to maximize the adjusted risk returns but does not regard the consequences. Because of the theory’s dependence on the prices of the assets, it makes it vulnerable to all the typical market failures. Also, because of its diversity in funds, the theory coerces investment managers to invest in assets without first reviewing their fundamentals or dynamics (Omisore, Yusuf and Christopher, 2012).
Despite the limitations mentioned above, it is still assessed that the elements of the modern portfolio theory are appropriate normally to any portfolio, thus making it widely accepted in the financial market. The idea of taking the risk of an investor by visualizing the amount of risk that is satisfactory for a certain return. Gruber in his essay, also supports the efficiency of the theory as he states in his 2003 essay that the diversity of the theory benefits investors. The notion as supported by Meyer, states that with a disciplined use of the theory, investors are taking full advantage of the power of maximizing returns and minimizing risks (Megent Financial, 2015).
Curtis, G. (2004). Modern Portfolio Theory and Behavioral Finance. The Journal of Wealth Management, 7(2), pp.16-22.
Gruber, M. (2003). Modern Portfolio Theory. [online] Available at: http://www1.law.nyu.edu/ncpl/pdfs/2003/Conf2003_Gruber_Final.pdf [Accessed 8 Jan. 2015].
McClure, B. (2006). Modern Portfolio Theory: Why It's Still Hip. [online] Investopedia. Available at: http://www.investopedia.com/articles/06/mpt.asp [Accessed 8 Jan. 2015].
Megent.com, (2015). Featured News. [online] Available at: http://megent.com/resources/featured-news?id=2270 [Accessed 8 Jan. 2015].
MÜLLER, H. (1989). Modern Portfolio Theory. ASTIN Bulletin, 19(3), pp.9-27.
Omisore, I. (2012). The modern portfolio theory as an investment decision tool. J. Account. Taxation, 4(2).
Rotblut, C. (2015). The Benefits of Modern Portfolio Theory. [online] Aaii.com. Available at: http://www.aaii.com/journal/article/the-benefits-of-modern-portfolio-theory.touch [Accessed 8 Jan. 2015].
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