Portfolio Theory as Applied to Property Management and Investment - Essay Example

Portfolio theory (property management and investment) Introduction Harry Markowitz introduced portfolio theory. Portfolio theory can also be referred to as modern portfolio theory. What the theory attempts to explain is how to maximize portfolio. When portfolio is maximized, there is an expected return that an individual will expect at the end of a given period of time (Bajaj, 2005 pg. 89 ). When an individual chooses an expected proportion of assets and risks are minimized, he or she will expect a certain return at the end of the day. Modern portfolio theory is widely used in many areas especially in the financial industry. Behavioral economics has recently been challenging the basic assumptions of the modern portfolio theory. There are people who understand modern portfolio theory as a mathematical formulation. The formulation mainly focuses on how investments can be diversified. Under this criterion, investments that are grouped together are put together and it is believe that they have a lower risk value when compared to individual assets. Before Markowitz’s work, many investors mainly kept their focus on risk assessment and security of rewards so that they could construct their portfolios. This was referred to as standard investment and this was mainly used to offer the best securities that offered the best opportunities. It was Markowitz who formalized the standard investment theory by coming up with the modern portfolio theory. He modernized it by using mathematics of diversification. He used this by advising investors to compile their portfolios and chose those with reward characteristics. What he was trying to propose was that they should not choose individual securities but portfolios. When a single-period return is treated as a variable that is random for the securities, expected values, correlations and expected values can be assigned to them. When one does this, then they are able to calculate the expected volatility and the expected return (Becker, 2005 pg. 90 ). This calculation can be done for any constructed portfolios with their securities. Expected return and volatility in this case can be treated as proxies for rewards and risks. One way or another risk and reward could optimally balance each other out. Markowitz referred this to as efficient frontiers for the various portfolios. Discussion Definition Portfolio theory is an approach that was developed by Markowitz. In his approach, he postulated that investors could predict how they can be able to predict and estimate both returns and risks. This usually measured statistically for any investment portfolio. Investors could either decide to combine assets that can be efficiently be diversified into investment portfolios. When we use statistics as a tool for measurement, we simply mean analyzing and collecting information. The reason why this is done is that conclusion has to be arrived at about any particular situation of uncertainty. This data should be presented and understood by people who do not understand what statistics is all about. Markowitz proposed that there could be returns that could be improved on. He proposed ways of assembling diversifies portfolios. He also postulated that these portfolios could do extremely well. There are different portfolio strategies and they are; the passive portfolio strategy, active portfolio strategy, patient portfolio strategy, aggressive portfolio and conservative portfolio. a) Passive portfolio strategy This is a strategy that actually involves an input that is minimally exceptional. It relied on the theory of diversification that can be able to match performance of market indices. There are assumptions that it can take. The assumption is that the market will always have the available information and this will be reflective on the prices that are paid for the securities. b) Active portfolio strategy This strategy uses information that is available. It also relies on techniques that are forecast so that an industry can have a performance that is worthy of mention. This type of portfolio is usually diversified in a broad manner (Curtis, 2004 pg. 64). c) The patient portfolio Under this type of portfolio, what investors normally do is to invest on stocks that are well-known. Most people usually buy the dividends and they can hold onto them for the longest period in time. A majority of these stocks usually represent companies that are classically growing. These companies are usually expected to have higher earnings. These earnings should always be performing very well despite the economic conditions. d) Aggressive portfolio This is where investors invest in stocks that are quite expensive. They are measured in terms of price earnings ratios. In this type of investment, there are huge risks that can be attained and there are also big rewards. Stocks are normally collected companies that are rapidly growing. These companies are all of different sizes and they are usually expected to deliver. Uses of portfolio theory The theory provides an understanding that has got context within it. It provides an understanding for rewards and systematic risks. Another use is that, it has provided a platform whereby portfolios are motivated and managed for the passive investment technique. Many financial institution use modern portfolio theory for financial risk assessment and management. Portfolio theory helps investors when to invest their money so that they can be able to reap the benefits of investments (Botha, 2004 pg. 77). When looking for investment options, investors should seek the advice of valuers who will help them in determining when to invest their hard earned money. What they do is that they usually assume that the rated of interests remain the same over a period of time. Maturity of the investment can usually be described using the yield curve. Therefore, investors should be aware of the interest rates that exist. There is the short term interest rate and the long-term interest rate. Therefore portfolio management helps an investor in this way. The term structure of interest rates is the guiding principle during investments. When the curve of the yield is on the ascent, one would obviously conclude that they would be able to get a better return. When the yield curve is on the descent, one would be better off investing in a sequence of one year bond. The reason is that an years redemption will yield higher than a long term yield. Strengths of portfolio theory One of the strengths of modern portfolio theory is that it helps an investor to choose securities and other stocks that he or she may be interested in. There are several options that are available for him. The investor has the duty to choose stocks that will optimize returns and have lesser risks of investments. Therefore it is equally important to ensure that stocks are diversified with the relevant securities. When risks and security are negatively correlated, the net effect is that they optimize returns and lower the overall risks. Another strength of portfolio investment is that it greatly helps investors to understand how risks are reduced therefore, with very insufficient information, they can get huge returns. It acts as guidance during the investment period. The investor is usually advised not to invest in one stock but in stocks that have got portfolio, Treasury bills and bonds. The net effect of diversification is that they are able to maximize the level of returns. Portfolio theory is a theory that is indispensable for any investor. It assists them to design appropriate portfolios. It also helps financial institutions to have a certain roadmap so that they can have a certain level of investment that is extremely viable. When this happens, then the company will greatly reap the benefits of investments. Financial managers can calculate rates of equity that they expect. They use tools such as Capital Asse pricing model. They use this particular tool or model so that they can be able to evaluate budgeting of capital or even tell the value of a business (Brigham and Houston, 2009 pg. 89). They usually use certain rates that are adjusted so that equity can be returned in the long run. Weaknesses of portfolio theory One of the weaknesses of modern portfolio theory is that it is only a theoretical construct that tries to explain how capital markets carry out their functions. It is simply not a recipe or solution investment portfolios that are designed. Another limitation of the modern portfolio is that it is only used under particular circumstances. These situations could be those that one may be aware of or maybe totally unaware of. One thing for sure that we know is that modern portfolio theory is that it normally assumes a pricing that is continuous in nature. Events are normally governed by rules that are completely different. In simple terms, modern theory is simply descriptive in nature and not prescriptive. What this means is that, instead of offering solutions to problems that may arise at any point in time, it would only give an analysis that is simply descriptive. Definition of time In modern portfolio theory, time refers to the period under which an investment takes to mature. This period could either be long-term or short term. In the financial industry, the expected level or return is usually calculated and risks are usually minimized to a level that can be managed. Modern portfolio theory was developed so that it could be able to assist investors to make the right choices during investing. Definition of Risks Investors will usually be concerned with returns when they are considering any kind of security. There is also an associated risk when an investment is undertaken. Therefore, risk refers to returns that one accrues and he or she had not planned for it all. The return that been planned for is not achieved one way or another (Ghosh, 2001 pg. 83). In an environment where there is no risk at all, return would for sure be as it was expected or planned for. When uncertainty sets in, then we find that the returns would not be as it was planned for. All kinds of securities or types are usually subject to any kind of risk that may be in existence in any type of environment. There are securities that may be riskier than others. Therefore, investors should be able to get the best advice when venturing to any kind of investment. The reason is that, by doing this they will be able to identify and quantify uncertain returns and their uncertainty. A decision will then be made once a proper analysis is made. There are different types of risk investors. There are those who are referred to as risk adverse investors and those who are referred to as risk seeking investors. As the names suggest, a risk averse investor is one who will prefer stocks that would certainly have the lowest risk level while a risk seeking investor will go for stocks or securities that will have maximum level of returns with a given level of risk. Types of risks Uncertainty return This is a kind of return in which shares that is ordinary in nature and could be particularly vulnerable. A good example is when a company does not pay its shareholders any dividend at the end of a financial year. A portion of the profit may be attributed to the shareholders of the company that may be enlisted. When situations such as, a company not making any profits at the end of the day, then the company may not pay any payments at all. Default risk Default risks are usually achieved when all kinds of interests including fixed ones, are usually subject to default. When a company is not performing as it is expected, then it may not be able to pay any interest on any fixed security. Interest rate risk When we have all kinds of fixed interest securities, inclusive of gilts, being vulnerable to some level of risks, then they can be defined as risk that is an interest rate risk (Jansen, 2007 pg .67). In general terms, interest rates can have a significant impact on returns that investors may be expecting. Stocks that are purchased and have maturity dates that are longer, then we find that when inflation takes place, then the stocks may plummet meaning that they would be sold at a cheaper price. Inflation risk All sorts or types of non-indexed securities that are fixed are subject to the risk of inflation. This normally happens when actual interest rates normally reflect an expected inflation. How to measure risk Risks can be measured by having some expected degree of risk and then they are compared to expected returns. When this happens, then it would be valid to make decisions that are sound and viable. When one gets a maximum return, then it demonstrates that he or she has avoided any sort of risk. It also well established that not all types of securities have a similar degree of risk. These scenarios help investors to make sound decisions. How to avoid risk Risk aversion is one of the tactics that most financial institutions employ so that they can be able to remain as profitable as possible. One of the ways to manage assets with reduced risks is by having securities that have many asset portfolios. The expected return is that the multi asset portfolios will have great returns (Ireland and Hitt, 2011 pg. 68). When they are weighted together, we find that they will have expected returns and lower risks. This is what is what is referred to as diversification of assets. Difference between share price and property valuation Share price is the language that is used in many stock exchanges in many parts of the world. It refers to the price of a share. These shares are usually for companies that are enlisted in the stock exchange and they become stocks for the company. On the other hand, property valuation refers to assets that cannot be defined and are not tangible at all. It is a creation of the human intellect, thus differentiating itself from stocks. Stocks are tangible but valuation is not tangible. Time value of money and diversification are usually applied in property investment. A good example is when the property returns goes towards normality. Properties can be combined into portfolios so that their probability can shoot or rise. When we have the market conditions and portfolio size, they both play an important part in determining if and when it would be possible the returns would be as expected. Conclusion Modern portfolio theory has greatly helped investors and individuals at large in making some sound investment decisions. When portfolio is maximized, there is an expected return that an individual will expect at the end of a given period of time. When an individual chooses an expected proportion of assets and risks are minimized, he or she will expect a certain return at the end of the day (Ireland and Hitt, 2011 89). Modern portfolio theory is widely used in many areas especially in the financial industry. Behavioral economics has recently been challenging the basic assumptions of the modern portfolio theory but modern theory is applicable in many financial institutions. When the risks are lowered, we find that the company will remain as profitable as possible and have investor confidence in the long run. Works Cited Bajaj, K K. E-Commerce. New York: Tata McGraw-Hill Education, 2005.Print Becker, G S. Economic theory. New Jersey: Aldine Transaction, 2007.Print Botha, J. E-Commerce. Juta: Juta and Company Ltd, 2004.Print Brigham, E F and J F Houston. Fundamentals of Financial Management. Stamford: Cengage Learning, 2009.Print Curtis, G. "Modern portfolio theory and behavorial finance." Financial annalysis Journal (2004): 16-22.Print Douglas, L G. Yield curve analysis:fundamental of risk and return. New York: New York Institute of Finance, 1988.Print Ghosh, B N. Economic theories:past and present. Texas: Wisdom House, 2001.Print Hill, C and G Jones. Strategic Management Theory: An Integrated Approach. Stamford: Cengage Learning, 2009.Print Ireland, D R and M A Hitt. Understanding Business Strategy: Concepts and Cases. Stamford: Cengage Learning, 2011.Print Jansen, W. New business models for the knowledge economy. Farnham: Gower Publishing, Ltd, 2007.Print Read More