Investment and Analysis - Essay Example

Topic: Investment and Analysis Modern Portfolio Theory The theory of modern portfolio implies that investor’s decision to address market risks is based on the fact that there are different combinations of investments in a portfolio. The basis of the theory is that investors should not to put all their eggs in one basket (Harder, 2010, p. 178). The portfolio theory applies statistical measures including correlation and covariance in determining the overall effect of diversification on the portfolio. Efficient Markets Theory The theory is based on the assumption that information available in the securities market such as price levels is extremely efficient in reflecting the performance of the assets in the market. The general view regarding the theory is that information spreads in the shortest time possible and gets incorporated in the prices of assets in the market (Hughes, 2005, p. 118). The theory disputes the ability of investors to use historical information in determining the fair value of securities in the market. I would like to point out that the conventional wisdom of wisdom may not necessarily break down in situations of extreme market volatility. This is because making investments is all about diversifying in the right manner using the relevant tools. In 2008 and 2009, there was the occurrence of a serious stock-market cataclysm that led to massive loss of wealth in the US. Market reports estimated that investors lost approximately $6 trillion worth of wealth. The stock-market cataclysm not only led to massive loss of wealth but also eroded investor’s faith in the conventional wisdom of diversification (Oberuc, 2004, p. 290). However, the failure of the diversification does not arise from the concept of diversification itself. This is because diversifying investments does work especially when done with the appropriate tools. In the newspaper excerpt, the writer noted that there is a tendency of assets correlating hence limiting the opportunity for investors to diversify (Markowitz, 2009, p. 117). Investors who record losses during periods of high market volatility are the ones who do not manage to establish a well rounded portfolio. A well rounded portfolio consists of assets that do not have the tendency of swinging up and down in correlation with each other. This means that investors need to diversify their assets to include those that have very the least correlations to each other. In recent times, starting from the year 2000, investors who have diversified their investments among companies that have different sizes have managed to record positive gains. This can be supported by the 2002-2003 performance of the bear market (Satchwell, 2004, p. 24). During this period, the S&P recorded a loss of 47.4 percent but small and undervalued companies produced a gain of 1.6 percent. Real investment trusts also managed to record a gain of 36.6 percent. The market has also in recent times recorded losses as a result of diversification. The latest occurrence of a bear market resulted in small, undervalued companies losing 59.6 percent and REITs losing 68.5 percent. This clearly indicates that what many investors seem to count as diversification does not count any further. This is attributed to the prevailing market dynamics that have changed the correlation between different assets in the market. Despite the mixed results, there is one better approach of utilizing the conventional wisdom of diversification (Jones, 2009, 200). This approach involves paying attention to the correlations of the different assets within a portfolio. Investors should consider diversifying their investments in assets that do not move in sync with each other in terms of market volatility. This can be demonstrated by an example that relates to the stock and bond markets. Given two assets that include Stock S and Bond A, the investor has to first to determine the correlation between the two. Let us assume that the two assets have a perfect negative correlation and are in a similar market that is highly volatile. Furthermore, we are assuming that the expected return from Stock S is 16% and Bond A is 9%. Since the two assets have a negative correlation, when stock S records returns of more than 16% then bond A will record returns below 9%. This means that the investor will be able to record returns of approximately 12.5%. The above analysis points to the conclusion that it is possible for investors to build a stable portfolio by diversifying in assets that have opposite movements in terms of market performance. The Concept of Smart Beta and It Relates with the Modern Portfolio Theory Investing in the stock market is associated with two major risks that include market risks and company risks. The two risks are associated with the formulation of two indices that are used in determining levels of returns for investments. The two indices include beta and alpha and relate to the market and company respectively (Bootle, 2011, p. 110). In such a case, smart beta is defined as an index used in determining the fair value of an investment. Smart beta enables investors capture the market beta in a simple and less expensive manner. The index is also used in delivering market returns using a better approach other than the market capitalization approach. Beta refers to the determined market risk of an asset. Basically, beta is used in determining the market volatility. It creates the foundation for the Capital Asset Pricing Method which is derived by the Modern Portfolio Theory. An accurate and effective beta determines the CAPM that will be use in valuing assets in the market. Based on this analysis, there is a close relationship between ‘smart beta’ and the modern portfolio theory in the sense that the former determines the CAPM that is used in valuing assets (Ang, 2011, p. 218). This is because ‘smart beta’ is an improved version of the market beta. Beta has had the weakness of appearing to be a very complex mathematical formula that makes it very difficult to compute market volatility. However, the weakness is corrected by the use of smart beta which is an improved version of the market beta that makes it simpler to determine market volatility. References Ang, W, 2011, The Efficient Market Theory and Evidence: Implications for Active Investment Management, New York: Now Publishers Inc. Bootle, R, 2011, The Trouble with Markets: Saving Capitalism from Itself, Chicago: Nicholas Brealey Publishing. Elton, E, 2009, Modern Portfolio Theory and Investment Analysis, New York: John Wiley & Sons. Harder, S, 2010, The Efficient Market Hypothesis and Its Application to Stock Markets, New York: GRIN Verlag. Hughes, D, 2005, Asset Management in Theory And Practice, Chicago: New Age International. Jones, C, 2009, Investments: Analysis and Management, New York: John Wiley and Sons. Markowitz, H, 2009, Portfolio Selection: Efficient Diversification of Investments, Chicago: Yale University Press. Oberuc, R, 2004, Dynamic Portfolio Theory and Management: Using Active Asset Allocation to Improve Profits and Reduce Risk, Chicago: McGraw-Hill Professional. Satchwell, C, 2004, Pattern Recognition and Trading Decisions, Chicago: McGraw-Hill Professional. Palan, S, 2007, The Efficient Market Hypothesis and Its Validity in Today's Markets, Chicago: GRIN Verlag. Read More