Portfolio Diversification and Markowitz Theory - Essay Example

?Portfolio diversification and Markowitz theory I. Modern portfolio theory Sumnicht (2009, p. 16) asserted that modern portfolio theory continues to “valid after 5 decades” since the theory was articulated. On the other hand, contradicting Sumnicht, Swisher (2009) asserted that modern portfolio theory was never alive in the first place. However, even much earlier, the article of Fisher (1973) confirmed that the theory has been very alive and was even the core of Fisher’s (1973) contributions to the theory. As recent or late as 2005, the article of Leibowitz and Bova contributed to modern portfolio theory in the area of “allocation betas.” This confirms that modern portfolio theory continues to be the benchmark theory of many analysts. However, there is a claim from Swisher & Kasten (2005) that a post-modern portfolio theory factoring in the role emotions and subjectivities has emerged but the leading journals do not confirm the claim. Gitman & Joehnk (1996, p. 670) attribute to Harry Markowitz, a trained mathematician, the development of the first set of theories “that form the basis of modern portfolio.” Modern portfolio theory is “an approach to portfolio management that uses statistical measures to develop a portfolio plan” (Gitman & Joehnk 1996, p. 670). Other than Markovitz, “several other scholars and investment experts have contributed to the theory in the intervening years” (Gitman & Joehnk 1996, p. 670). Gitman & Joehnk (1996, p. 671) identified that some of the key concepts used by the theory “are expected returns and standard deviations of returns for both securities and portfolios and the correlations between returns.” Gitman & Joehnk (1996, p. 673) pointed out that at the theoretical level, the optimal portfolio choice is made by an investor at the point of tangency between the investor’s indifference curve and his or her efficient frontier of investment. The efficient frontiers of investments consist of a set of combination of risks and returns deemed most acceptable to the investor. The investor is assumed to accept higher risks provided returns will be higher. This is shown in Figure 1 where the Is are the indifference curves of the investor associated with the investor’s utility. Figure 1. Indifference curves, efficient frontier, and optimal portfolio. Source: Gitman & Joehnk 1996, p. 673 In figure 1, portfolio risk is measured by the sample standard deviation of the risk and is implied in Gitman & Joehnk (1996, p. 662): sp=? (ri-rmean)/(n-1) The square of the risk is known as the variance (more precisely, sample variance) and can be interpreted as a measure of the volatility of returns. Assessing 50-years of Markowitz’s portfolio theory, Rubinstein (2002, p. 1044) remarked that “Markowitz approach is now commonplace among institutional managers” and “led to the increasingly refined theories of the effects of risk on valuation.” In contrast with modern portfolio theory is the traditional portfolio approach. Traditional portfolio managers prescribe investments in well-known companies on three grounds (Gitman & Joehnk 1996, p. 670). First, there is an expectation that the companies would perform well based on her past performance. Second, well-known companies are typically secured and, thus, perceived to be stable. Finally or third, portfolio managers are inclined to recommend investment in well-known companies because it is easier to convince clients to invest on well-known companies. II. Purpose and process of portfolio diversification Investors vary with regard to their portfolio objectives (Gitman & Johnk 1996, p. 660). However, there are two fundamental orientations in a portfolio: a growth-oriented versus an income-oriented portfolio (Gitman & Joehnk 1996). “The primary goal of a growth-oriented portfolio is long-term price appreciation” (Gitman & Joehnk 1996, p. 660). In contrast, “an income-oriented portfolio stresses current dividend and interest returns” (Gitman & Joehnk 1996, p. 660). For Gitman & Joehnk, it is of fundamental importance to identify the portfolio objectives before making the decision to invest (p. 660). The ultimate goal of portfolio diversification is to acquire an efficient portfolio, “one that provides the highest return for a given level of risk or that has the lowest risk for a given level of return” (Gitman & Joehnk 1996, p. 660). “Investors benefit from a holding portfolio of investments rather than from a single investment vehicles” (Gitman & Joehnk 1996, p. 660). Gitman & Joehnk (1996, p. 660) emphasized that “without sacrificing returns, investors who hold portfolios can reduce risk, often to a level below that of any investments held in isolation.” This constitutes the fundamental ground for portfolio diversification. III. Constructing optimal and efficient portfolio for private investors As mentioned earlier, an optimal and efficient portfolio is “one that provides the highest returns for a given level of risk or that has the lowest risk for a given level of return” Gitman & Joehnk 1996, p. 660). On the matter, another important concept according to Bodiet et al. (2010, p. 151) is covariance which is defined as: . In turn, an easier interpretation of the covariance formula is achieved when the correlation coefficient is used instead (Bodie et al. 2010, p. 151): . In reducing the overall risk in one’s portfolio, it is best to combine negatively correlated asset based on the correlation coefficient (Gitman & Joehnk 1996, p. 662). However, Gitman & Joehnk (1996, p. 662) emphasized that “even if assets are not negatively correlated, the lower the positive correlation between them, the lower the resulting risk.” Further, “combining uncorrelated assets can reduce risk---not as effectively as combining uncorrelated assets, but more effectively than combining positively correlated assets” (Gitman & Joehnk 1996, p. 662). Based on the discussion implied in Gitman & Joehnk (1996, pp. 660-) which I have modified or simplified in a small way, the fundamentals steps involved in constructing an optimal and efficient portfolio are as follows. First, determine your principal objective in your portfolio: is it to maximize returns given an acceptable risk or is it to minimize risks based on a target return? Second, identify the companies, equities, or financial instruments in which you are planning, intending, or interested to invest in. On this step, one can tap the wisdom embodied in traditional portfolio theory in investments. Perhaps, the companies which have existed for decades or hundreds of years may be the best companies to put one’s money. To a certain extent, the use of conventional wisdom or traditional portfolio theory in this case may be useful because getting the returns data of too many companies are not practical. Another possible criterion for including or excluding what companies to include in the second step is that one must make sure that the companies or instruments that one is interested to invest is able to accept small investment if one can only afford a small investment. Third, get the returns data and risk data within a period of the companies you are interested to invest it. The period may be 5, 10, or a longer number of years. A longer period may reflect the possible long-term performance but a shorter period may be ones that are relevant because of changing economic situation. Convert the returns data into percentage net return per year and then get the average percentage return for the period. Use the average return for the period to get the sample standard deviation of the returns for the period which becomes a good measure of risk (the sample standard deviation of the returns for the period becomes the measure of risk). Fourth, using statistics or statistical computer programs, identify which assets are negatively, positively, or zero correlated. Fifth, compute expected returns and expected risk when assets are combined at different percentages. As mentioned earlier, if one’s portfolio strategy is to reduce risks while targeting a given return, one can combine negatively correlated assets. However, if one’s target is to get the highest returns based on an acceptable risk then one can do so. This step is labor-intensive but labor intensity can be significantly reduced if one use computer programs like Excel. Sixth, combine portfolio based on step 5. On this step, I expect that some would use intuition or even use economic forecasts and company inside information in making the right choices for investments. This is not surprising because companies or instruments that appear to be statistically similar will look dissimilar based on company inside information, forecasts, and economic reviews. Gitman & Joehnk (1996) recommends the inclusion of international diversification for two reasons. First, yield is believed to be higher overseas. And, second, risks may be lower. However, Gitman & Joehnk are unsure if individual investors should also diversify internationally. In the light of the ongoing United States crisis, however, diversification presents a good way to diversify risks. Earlier, Markowitz (1952, p. 77) pointed out that “the process of selecting a portfolio may be divided into two stages.” The “first stage starts with observation and experience and ends with beliefs about the future performance of available securities” (Markowitz 1952, p. 77). In Markowitz (1952, p. 77) second stage, the stage “starts with relevant believes about the future performances and ends with the choice of the portfolio.” It follows from our discussion that the primary benefit from portfolio diversification is that it is possible to reduce risks to a lower value or even zero given a target return. IV. Assumptions and limitations of portfolio theory It follows from our discussion that the key assumption of the modern portfolio theory is that is that future movements on the returns and risk of the asset would be consistent with the past performance of the assets. This may be a reasonable assumption to make in the absence of a set of data that would suggest otherwise. Based on this it also follows that the key limitation of the portfolio theory is it does not factor in the possible or probable impact on returns that movements in the international and macro variables suggest. For instance, there may be a general economic crisis ahead and there may war brewing on the horizon that can affect returns. There can also be disaster risks related to climate change and the like. The portfolio theory is not able to capture the changing economic tastes or even the public relations or public image problems that companies may be facing and which can affect returns. References Bodie, Z., Kane, A., & Marcus, A. (2010) Essentials of investment. 8th ed. New York: McGraw Hill. Fisher, L. (1975) ‘Using modern portfolio theory to maintain an efficiently diversified portfolio’. Financial Analyst Journal. 31 (3) pp. 73-85. Gitman, L. & Joehnk, M. (1996) Fundamentals of investing. New York: HarperCollins Publisher Inc. Leibowitz, M. and Bova, A. (2005) ‘Allocation betas’. Financial Analyst Journal. 51 (4) pp. 70-80. Markowtiz, H. (1952) ‘Portfolio selection’. The Journal of Finance. 7 (1) pp. 77-91. Rubinstein, M (2002) ‘Markowitz ‘Portfolio Selection’: A fifty-year retrospective.’ The Journal of Finance. 57 (3) pp. 1041-1045. Sumnicht, V. (2009) ‘MPT principles valid after 5 decades’. Trends in Investing. June. pp. 16-19. Swisher, P. (2009) ‘MPT was never alive’. Trends in Investing. June. pp. 16-19. Swisher, P. & Kasten, G. (2005) Post-modern portfolio theory. Journal of Financial Planning. September pp. 1-11. Read More