Portfolio Theory and Its Implication to Investors in the Market - Essay Example

To spread risks, most investors diversify by investing in more than one type of security or portfolio. It should be noted that investors like returns but at the same time dislikes risk and uncertainties (Sharpe, 2007). Though the financial market has significant rewards and benefits, it is very complex and very volatile, thus critical analysis is required in risk evaluation so that the expected returns can be validated. Dating back to the 1950s an American economist managed to establish the theory of portfolio choice (Markowitz, 1959).

This was a tool used by investors during this period to analyze and predict about to the expected earnings or returns. Markowitz’s theory is the currently renowned Modern Portfolio Theory (MPT). It is an investment theory that was designed to help in maximizing portfolio returns. This is done relative to the level of portfolio risks meaning that a minimum risk level correspondent to an equivalent expected return level. Though this theory has been widely applied within the financial sector, a lot of challenges have been pointed out to its basic assumptions.

However, being an improvement of the traditional investment framework, it provides an advanced system for the application of the mathematical model, especially, in finance. Portfolio theory supports asset diversification as a strategy to hedge against any possible market risks that are unique to a particular company. As a sophisticated investment decision-making tool, it helps investors to estimate, classify, as well as, control the number of possible risks that may affect the expected investment returns for the company.

The Essentials of Investments /Portfolio theory There are necessities to portfolio or investment theory. These include the quantification of risks and return relationships. The second one is the assumption that compensation should be awarded to investors due to risk assumption. Practically, portfolio theory differs from the traditional system of security analysis on the basis that it changes focus from individual investment characteristics to exploring statistical relationships exhibited within individual securities that represent the entire portfolio group (Sharpe, 2007). Through mathematical formulation, portfolio theory formulates diversification concepts in the investment with an ultimate goal of carefully selecting viable investment assets with low risks compared to the rest of the asset groups.

This is intuitively possible since assets can change their values in opposite directions. However, the diversification approach has been recognized to effectively lower risks even when there is no negative correlation in asset returns, but it is more effective in scenarios of a positive correlation. Looking at the technical dimension, portfolio theory models assume that returns on assets exhibit a normal distribution function (Sharpe, 2007). It also uses standard deviation relative to investment returns to define risks.

In addition, a portfolio is modeled based on weighted asset combinations to have what is referred to as a weighted assets return combination. Based on this view, assets whose returns are not positively correlated are combined, thus helping to reduce variations in the portfolio returns. Another assumption made with regards to portfolio theory is that market is efficient and mainly comprised of rational investors.