Finance and Accounting: Mean-Variance Analysis and Portfolio Theory - Essay Example

? Finance and Accounting Mean-Variance Analysis and Portfolio Theory Executive Summary A collection of assets is constitutes a portfolio, which bearselements of risk and return. Therefore, controlling risk in investments is an important undertaking for portfolio managers. A method such as mean-variance analysis helps predict and reduce the amount of risk in an investment. Holding a mix of assets, otherwise known as portfolio diversification, is a key concept upon which successful investments in the business world gain greater practicability and predictability. The practical applications of portfolio theory abound in different segments of business and finance. This report seeks to explain the principles of diversification, and discuss some practical applications of portfolio theory in business and finance. Table of Contents Executive Summary 2 Table of Contents 3 Introduction 4 Principles of Diversification 4 Application of Portfolio Theory Mutual Funds 5 Application of Portfolio Theory Capital Allocation 7 Application of Portfolio Theory to Product Portfolio Decisions 8 Recommendations 10 Conclusion 10 References 11 Introduction Diversification is the premise that underlies portfolio theory (Markus, 2008). A portfolio is a combination of assets with a unified risk and return value expectation. Diversified portfolios ensure that loses are minimized if they occur (Hill, 2010). Mean-variance analysis helps determine the viability of an investment portfolio through the analysis of the portfolio risk. The theory relies on the use of portfolio’s variance by comparing how assets in the portfolio vary with regard to each other (Diether, 2010). Mean-variance analysis for a diversified portfolio measures the portfolio’s efficiency. The most efficient portfolio has the highest expected return for a certain standard deviation. Mean-variance analysis application in business and finance helps in making the optimum decisions about the riskiness of a portfolio. This report seeks to demonstrate the practical applications of mean-variance analysis in portfolio theory. Principles of Diversification One of the principles of diversification is the belief that the portfolio, as a whole, is more important than the individual assets (Sumnicht, 2008). Secondly, investors are risk averse, and therefore will only invest in those portfolios which they belief will be adequately commensurate to their returns. Investment should be for the long term, probably up to ten years into the future (Sumnicht, 2008). Diversification presumes that markets are efficient, and will not have any unforeseen disruptions. Finally, each risk level bears its own unique optimal allocation with regard to asset class at which the portfolio bears maximum returns. Application of Portfolio Theory Mutual Funds Mutual funds are actively managed investment options in which investors pay investment companies to invest their money in stocks and pay a return on the same. The financial analysts at the mutual fund companies make use of portfolio theory in calculating risks on their clients’ portfolios. The portfolio theory offers a robust and comprehensive model on which to calculate risk and make sound investment decisions from the results (Sumnicht, 2008). However, mutual funds offer a unique challenge to the effectiveness of the portfolio theory in that the final return faces significant distortions due to high fees, hidden costs, unpredictable taxes, and uncertain stock investments (Rutner, 2004). A major part of the modern portfolio theory is the frontier curve. The frontier curve plots risk and return (FundsMover, 2012). According to the portfolio theory, the funds that lie on the curve form the maximum yield potential for a given level of risk, measured as standard deviation. The curve flattens as the return rises. The rate of return per risk decreases, and at some point the amount of risk an investor exposes himself/herself to increases considerably for a slight increase in the return. The standard deviation indicates the volatility of the mutual fund. For instance, a fund with as constant return over a couple of years would have a zero standard deviation (FundsMover, 2012). However, a mutual fund that has had wild variations in the rates for a couple of years will have big standard deviations and hence higher risk. Therefore, volatility in the returns of a fund is the only measure of risk. In choosing the better portfolio, the investor compares investments with comparable returns over a period, and compares the standard deviations. The fund with the lowest standard deviation is the least risky and therefore the most optimal for investment. The curve above is a plot of standard deviation (risk) against return. The fund B presents greater amount of risk to the investor in comparison to fund A, even though the two have the same level of return. The fund A falls right on the efficient frontier curve, and therefore offers optimum risk-return relationship. In most investment options for mutual funds, financial analysts make us of portfolio beta, a value that gauges the risk a portfolio carries in relation to the market. For instance, for a portfolio with a beta of 1, the fund suffers the same impact as the market when the value falls or rises. A correlation exists with regard to risk and return, with portfolios with higher risks having higher returns and vice versa. Therefore, to manage risk and still have a good chance to make returns, diversification, and creation of a portfolio is necessary. For instance, a mutual fund with beta of 1, 1.5 and 0.5 portfolio theory can help determine the overall risk of the portfolio. Assuming the investor divided his investment money equally among the three, the overall risk (market beta) would be 1/3*1 + 1/3*1.5 + 1/3*0.5 = 1 Therefore, through creation of a portfolio, the investor minimizes risk on the riskier assets and improves the overall return on the less risky but less profitable assets. Application of Portfolio Theory Capital Allocation Capital allocation has traditionally relied on other models for the allocation of capital to activities within an organization. Although analysts in the field were initially hostile to the concept of portfolio theory, they eventually came to appreciate the effectiveness of the model in deciding capital allocations within certain segments within an organization (Kulik, 1998). The initial methods, such as market equilibrium perspectives were less robust in revealing the inherent risk elements in certain investments. Using modern portfolio theory, the management can have better understanding of the capital productivity and the return on capital expected on investment on certain capital elements. The theory also helps in the management of risk for the management, and in increasing the efficiency of the investment in the asset for the benefit of the shareholders of a company. An additional benefit of the portfolio theory in the management of risk is that it does not require risk, as is the case with other analytical methods (Kulik, 1998). The portfolio theory already incorporates elements of diversification and therefore does not require additional skilled labor to help in managing the capital to ensure it delivers a more desirable return for the all involved. For actuaries working in the insurance industry, the theory was found to be usable with traditional risk analysis techniques in the analysis of portfolio risk. Actuaries can therefore aggregate numerous accounts and make use of the program to resolve the issues relating to issuance of policies and charging the premium (Kulik, 1998). For instance, different policies carry different risks, and matching returns to the insurers. For an insurer dealing in a broad range of risk insurance undertakings, diversification and portfolio theory can considerably improve the risk the insurer might carry. For instance, using principles of diversification, the insurer can chose the mix in the issuance of premium for motor and house insurance for its clients. If motor insurance carries the higher risk, and the house insurance the lower risk, the insurer can mix the two in a way that balances both incomes from premiums and the company’s exposure to risks in the policy it issues. Application of Portfolio Theory to Product Portfolio Decisions With the effectiveness of portfolio theory in financial decisions, analysts in the other sectors of business were curious to uncover other possible applications of portfolio theory. Consequently, there arose empirical studies on the application of the theory in product portfolio decisions as a planning tool (Cardozo & Smith, 1983). The study concluded that portfolio theory was highly effective in decision-making and by extension drafting action plans and making recommendations on product portfolio decisions. Therefore, business people can make use of portfolio theory to make decisions about investments in certain products (Cardozo & Smith, 1983). In addition, they can explore the options for combining the investments in proportions that offer minimum risk implications. The same concept has had prior applications in investment sectors such as real estate, and has a proven efficacy in the sector. With the use of modern portfolio theory in the product portfolio, the management will have the chance to create gauge a company’s profitability and perspective from an investor’s point of view. The theory will considerably help line manages make decisions on the products worth putting in the production line (Cardozo & Smith, 1983). Management strategic harmony with investors can help in improving the relevance of the production line to the investment segment of the company. Product portfolio theory ensures both return and the reliability of a product in generating revenues for the company is taken into consideration before product production plans get underway (Cardozo & Smith, 1983). Decisions relating to a company’s value chain require precise and effective accuracy to prove viable for the company. Inherent in every management decision is the risk implications of the decision. For instance, in an electronic manufacturing company, the product options can be overwhelming. However, through careful analysis of factors affecting each product such as competition, market and so on, the company is left with the most viable options. To help decide the best production mix, portfolio theory and careful application of diversification principles can help satisfactorily and more soundly decide the optimum product mix for the product portfolio. Recommendations The mean-variance theory has proven unreliable in the prediction of mutual fund investments because of the high fees, unpredictable taxes on returns and hidden costs. Comprehensive models are necessary to make their use in such cases more effective. In insurance industry, complexities exist in the application of portfolio theory. The full incorporation and embrace of the portfolio theory and principles of diversification can help increase the effectiveness of risk management in insurance situations. Portfolio theory is relatively new in product portfolio, and companies should make greater use of portfolio theory as it offers a comprehensive outlay of risk implications of a production chain. Conclusion Diversification of assets relies on portfolio theory, or mean-variance analysis, upon which a higher level of accuracy is determinable in the risk-return tradeoff for the portfolio. For the mean-variance analysis to deliver on its promise of minimizing risk, a number of fundamental principles come under consideration that ensure that the portfolio mitigates risk and maximizes return. Finally, the applications of portfolio theory are numerous and varied. References Cardozo, R and Smith, D 1983, Applying Financial Portfolio Theory to Product Decisions: An Empirical Study, The Journal of Marketing, Last viewed on March 4, 2012 from http://www.jstor.org/pss/1251498 Diether, K. 2010, Mean Variance Analysis, Fisher College of Business, Last viewed on March 3, 2012 form http://fisher.osu.edu/~diether_1/b822/mv_analysis_2up.pdf EconModel, 2010, Mean-Variance Analysis: Risk vs. expected return, Econmodel.com, Last viewed on March 3, 2012 from http://www.econmodel.com/classic/riskreturn.html FundsMover. 2011. Optimal Portfolio Theory and Mutual Funds. FundsMover. Last viewed on March 8, 2012 from http://fundsmover.blogspot.com/2011/05/optimal-portfolio-theory-and-mutual.html Halliwell, L, 1994, Mean-Variance Analysis and the Diversification of Risk, Casact.org, Last viewed on March 4, 2012 from http://www.casact.org/pubs/dpp/dpp95/95dpp001.pdf Kulik, J 1998, A practical Application of Modern Portfolio Theory to Capital Allocation, Casact.org, Last viewed on March 4, 2012 from http://www.casact.org/pubs/forum/99spforum/99spf137.pdf Markus, 2008, Mean-Variance Analysis and CAPM, Princeton University. Last viewed on March 3, 2012 from http://scholar.princeton.edu/markus/files/05_capm_a.pdf Monevator, 2009, Portfolio Diversification. Monevator.com, Last viewed on March 2, 2012 from http://monevator.com/2009/02/26/portfolio-diversification/ Hill, R 2010, Portfolio Theory and Financial Analyses, Ventus Publishing. Rutner, R 2004, The trouble with mutual funds, North America Press. Sumnicht, V, 2008, Practical Applications of Post-Modern Portfolio Theory, Vern Sumnicht, Last viewed on March 2. 2012 from http://www.isectors.com/pdf/Practical_App_PMPT.pdf Read More