Dividend policies are crucial to a company and helps with the relationship between the shareholders and investors. Dividends are the sum of money paid to the company's shareholders out of the company's profits to reward them for their investment in the company. A company must decide on a policy which states the value they will pay out to the company's shareholders in dividends. A company spend a huge amount of time deciding on the dividends policies to help satisfy the needs of the shareholders; Setting a low dividend policy can lose investor confidence and setting a high dividend policy means it is unsustainable in the long term and the business may not be able to year on year make the high dividend payments to shareholders due to fluctuations in the market and not been able to predict certain future business events. The company needs to aim for stable dividends with stable growth.
Once the company has agreed a dividend policy and have implemented it into the business if profits are down over the year, then normally managers will still pay the agreed dividend policy. Managers will do this to send a signal to shareholders that the fall in earnings is only temporary and will be resolved soon, it also helps to maintain the company's share price. If profits are very high over the year, directors will become very cautious to payout high dividends due to uncertainty of been able maintain this high level of dividend payout in the future. Therefore company's may adopt a conservative approach, due to uncertainty over the future. Thus, set dividends at a low enough rate to ensure the company can always maintain future dividend payments, whilst maintain enough to satisfy future investment requirements and in the long term avoid shareholders from missing out on the high returns.
Constant Growth Dividend
This policy is favored by shareholders as it is agreed of growth year after year which will boost the returns for the company's shareholders. The company may have issues if they promise too much of the company's ability for growth to the shareholders. A company must know what they can deliver and keep the shareholders happy. Problems will quickly arise if a company's earnings have fallen and do not meet the level the company expected and thus cause issues with paying the increasing dividends. With the failure of success in the company's own dividend policy this will cause financial problems as the company pays out dividends which they cannot afford but satisfy the agreed arrangements in the policy. Also shareholders will lose confidence in the company as they notice the issues of paying out increasing rate of dividends, and will question the future returns of dividends. If the company is able to pay the shareholders the increasing dividends then this will benefit shareholder satisfaction along with delivering good returns and helping to maximise shareholder wealth.
Constant Payout Dividend
This policy agrees on the set amount to be paid to shareholders each year without the company having to promise growth. This policy can keep shareholders happy with payouts on shareholders investments as the shareholders will no the set amount they can expect to receive. Advantages for the company is that it is less pressured to keep growing revenue and will not put huge amounts of strain on the company's cash flows if profits are currently lower than expected.
Experian dividend payment method
Experian the global information service company in 2014 paid 37.50 cents per share, it is a constant dividend payment made to the shareholders with the promise that they are able to deliver every year a return to shareholders. Any increase in dividend payment from the previous year is due to high growth of return that the company has seen and therefore split the increased return between shares. The company however remains with a constant dividend payment as the information services industry is facing increasing risks in the future and are struggling to anticipate future growth rates and therefore uncertain if the company can pay any rises in the dividend policy if the company chose to opt for the constant growth dividend policy. Experian is one of few companies in the information services industry that actually pay dividend payments but this is due to the company been market leader and have an objective of to make returns to the company's shareholders.
Consequences of changing a policy
A policy once agreed and implemented in the business should remain consistent without changes to the policy to keep shareholders happy as it creates certainty of the amounts of payouts the shareholder will receive for their investments, also not changing the policy will help attract new investors and build up their confidence on what to expect thus improving the possibilities of investments for the future of the company. Changing a policy can create tension and uncertainty among a business, if the company has a constant growth dividend policy thus increase in dividends every year but the company is unable to fulfill the growth then changing the policy to what the company is actually able to achieve with the payments of dividends this will create negativity between the business and shareholders. Changing the policy means shareholders needs no longer fulfilled and this may cause them to see shares in the company and seek shares from elsewhere that does meet the shareholders needs. The only time that shareholders will want to see a change in policy is if the dividend payout rate is too low and not in line with the earnings of the business therefore greater amounts of dividends can actually be paid to shareholders. Changing the policy for this reason making the payout of dividends higher to reflect earnings of the business will help to generate higher returns for shareholders and help maximise shareholder wealth. Some companies do not make dividend payments every year such as Amazon due to the financial crisis and some companies with agreement from shareholders would see money spent in investment instead with the hope of returning bigger financial gains to shareholders in the future.
Conclusion
Overall the company must put in place the correct dividend policy which takes into account shareholders demands and capabilities of future growth in revenue/profit. The policy should not change so shareholders know what to expect. Planning of the policy is crucial before the policy is implemented in the company. A dividend policy is very important to keep shareholders happy and stop shareholders from selling shares and going elsewhere to invest.
Sunday, 30 November 2014
Wednesday, 19 November 2014
Appendix 4 - Which methods of valuing companies is best to ensure correct value is obtained?
Companies must understand what
creates value before they put in a takeover bid to acquire another company. The offer value must be agreed between both companies and therefore have a alignment on the value of the soon to be acquired company's value. Shareholders wealth of the company to be sold will have been maximized due to the selling of the company and the shareholders of the company placing the bid will have expanded the companies portfolio and with the hope of seeing long term wealth gains.
A company could have maybe looked at the following three
methods basic valuation methods to value the target company which they hope to acquire; Stock market valuation, net asset value based
valuations and income based valuations.
Stock market
valuation
Stock market valuation is the number of ordinary shares
issued multiplied by market price. Market value is correct if efficient market
hypothesis applies. The value is semi-strong based off past and present
information. However manager could have new information such as new innovative
products which would increase the value of the company. This method is useful
as it gives an idea to the purchasing company to the purchase price.
There are issues with this valuation method such as it
quotes share price and does not give true reflection on the value of all the
shares as only a small proportion of shares are traded on a day to day basis so
this method does not reflect all of the corporate value. If the company’s
shares are not quoted or on a stock exchange this valuation method is
impossible. This method will give the buyer a possible share purchase price but
will not help with to working out the company’s value (worth). This method also requires a substantial premium to
get shareholders to give up
their shares because of the above issues. Also when news breaks of a possible takeover bid, shareholders will be more reluctant to hold onto their shares and
the buying company will have to pay higher prices for the shares to obtain
them.
Net Asset
Valuation
Also known as book value, can be worked out by fixed assets
plus net current assets minus long term assets to give you the company’s net
asset value. This method uses historical costs which are both factual and
available then trends can be drawn up from previous year’s data. This method is not
accurate as the buyer will not understand if the depreciation method was the
right choice at the time and may have issues with the chosen method. The method
ignores intangible assets such as brand names and patents. Highly skilled work force is another intangible asset, if this work force left this would
devalue the company as this would account for loss of assets but this method
does not include these intangible assets. This method also does not detail any
future wealth generation ability such as any new products been released to
market. This method can be useful in liquidation.
Income based
Valuations
Looks towards the future income of a company.
Issues with this method are that it is unreliable and
inaccurate to predict value growth rates on past growth. Too reliant on
predictions and assumptions. Quality of data very poor normally just estimates.
Income based Valuations - Gordon's dividend model
Gordon's dividend growth model determines the intrinsic value of stock, based on future series of dividends that have a constant rate of growth. Provided that the dividend per share is payable in a year, the assumption of the growth of dividend at a constant rate is eternity, the model helps in solving the present value of the infinite series of all future dividends. Since the assumption is based on the constant growth rate of dividends, this formula would be applicable mostly to well established and mature companies. This model was developed by Professor Myron Gordon, hence called Gordon Growth Model.
Formula:
Where:
D = Expected dividend per share one year from now
k = Required rate of return for equity investor
G = Growth rate in dividends (in perpetuity)
The advantages of Gordon Growth Model are the Model is especially useful for companies that have a great cash inflow and the company has stability with dependable leverage patterns.The valuation can be easily performed since the inputs of data for Gordon’s Growth model are readily available for computation.
Income based Valuations - Gordon's dividend model
Gordon's dividend growth model determines the intrinsic value of stock, based on future series of dividends that have a constant rate of growth. Provided that the dividend per share is payable in a year, the assumption of the growth of dividend at a constant rate is eternity, the model helps in solving the present value of the infinite series of all future dividends. Since the assumption is based on the constant growth rate of dividends, this formula would be applicable mostly to well established and mature companies. This model was developed by Professor Myron Gordon, hence called Gordon Growth Model.
Formula:
Where:
D = Expected dividend per share one year from now
k = Required rate of return for equity investor
G = Growth rate in dividends (in perpetuity)
The advantages of Gordon Growth Model are the Model is especially useful for companies that have a great cash inflow and the company has stability with dependable leverage patterns.The valuation can be easily performed since the inputs of data for Gordon’s Growth model are readily available for computation.
The disadvantages of Gordon Growth model are the Model’s simple calculations can prove to be the major disadvantage as the model takes into consideration the quantitative figures and not the qualitative ones. The future changes cannot be taken into consideration which is why this model is not much preferred.The calculations are basically on future assumptions, which can be subjected to market changes based on the economic conditions and various other factors which contribute to being one of the major disadvantage.The limitations to the model make it less favorable for market and companies which has rapid changing dividend patterns.This is why in spite of definite success with the companies that have a high cash flow in the company this model is not suitable for many other companies which are fast growing since it is not flexible enough to include the possible fluctuations in the dividend rates in the future. This model is especially not suited for companies that are in segregation but for companies that have a heavy cash in flow and out flow ratio.
Income based Valuations - Price earnings ratio
P/E ratio model is a valuation ratio of a company's current share price compared to its per-share earnings.
Calculated as:
Market Value per Share / Earnings per Share (EPS)
A high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, the P/E ratio doesn't tell us the whole story by itself. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry.
The P/E is a measure of how highly valued the company’s earnings are in the market by telling you
- what an investor is prepared to pay for every £1 of those earnings and
- how many years an investor would have to wait to get back his investment through current earnings (assuming all earnings are paid out as dividends, which would be somewhat unusual of course!).
- net income
- plus non-cash charges of depreciation and amortization
- less capital expenditures and any additional working capital that might be needed.
Income based Valuations - Discounted cash flow valuation
Is a valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital - WACC) to arrive at a present value, which is then used to evaluate the potential for investment. If the value arrived at through Discounted Cash Flow analysis is higher than the current cost of the investment, the opportunity may be a good one.
Calculated as:
There are however some disadvantages such as if the inputs - free cash flow forecasts, discount rates and perpetuity growth rates - are wrong, the fair value generated for the company won't be accurate, and it won't be useful when assessing stock prices. The model is sensitive to assumptions and not suited for short-term investing. Instead, it focuses on long-term value creation.
Conclusion
In this blog entry i have concentrated on three basic valuation methods; Stock market valuation, net asset value based valuations and income based valuations and their advantages and disadvantages for each. Dependent on the company they will use different methods to workout value, with a good company using a range of methods. A company needs to understand value and how to calculate value but this is a very difficult task especially when looking to acquire a new company as both company's need to agree on the value so which method of valuing companies is best to ensure correct value is obtained is dependent on the given business situation.Saturday, 15 November 2014
Appendix 6 - Equity vs. Debt, Which method is best to finance business growth?
The majority of businesses main goals will be to expand and grow with hope of retrieving more market share. Businesses who want to grow will need financing in place as growth can be very costly. There are two common methods which a business may want to finance the growth; Equity is one method, in the form of an investor or and the other method been debt, in the form of borrowings such as a bank loan. Below you will see the advantages and disadvantages of each method;
Equity Advantages
Choosing equity to finance the expansion for growth in a business is less risky than taking out a loan because you don't have to pay it back, and it is a good option if the business can't afford to take on debt but still wants to see expansion. Another advantage of equity is you enter into the investor's network which will add more credibility to the business. Getting investors involved in financing the growth of the business is beneficial as investors take a long-term view, and most don't expect a return on their investment immediately, Investors would rather see their funds put to good use by the business which should hopefully develop long term financial gains. With equity the business won't have to channel profits into loan repayment. There are no requirement to pay back the investment if the business fails the investor should know the risks involved before contributing funds into certain investment opportunities. Overall from choosing equity you will get the money you require to help aid in expansion and growth of the business.
Equity Disadvantages
Although there are some very good advantages for taking up equity to fund business growth there is also however some major disadvantages from choosing this method, such as equity may require returns that could be more that the rate you pay for a bank loan thus making it more expensive option. It is up to shareholders when they would like to see returns. Another disadvantage is when an investor invests within a company they require a certain amount of ownership and with a percentage of profits. A business will not want to give up this kind of control. Equity funded businesses can make decision process longer as and major decisions should be consulted with investors to make sure it abides by their interests and if does not this may cause disagreements thus making decision making process much longer. Also finding the right investor for the company can take a lot of time and effort if the business is performing poor and looks less attractive on the financial statements this will put investors off from investing within the business making the process very long to raise the capital the business needs for expansion.
Debt advantages
The advantages of using debt to finance growth of a business are the bank which the company retrieves the bank loan from has no say in the way the business should be run and does not take any ownership of the business. The relationship between the bank and the business will end once all the repayments of the loan have been made. The business will pay interest on the loan but this is tax deductible. Depending on the plans for growth the loans can be agreed to be short term or long term. The business is not required to hold meetings with shareholders and does not have to seek votes before taking certain actions which makes the decision making process quick and can quickly react to the market needs.
Debt Disadvantages
Some good advantages given in the above paragraph but debt funding of business growth has major disadvantages; such as the money borrowed must be paid back within a fixed amount of time. Also relying too much on debt when the business has cash flow troubles, can put the company at risk of unable to pay back the borrowed money. Carrying too much debt will be reflected on the company's financial statements and will put off potential investors and they will consider the company to be "high risk", which will limit the business ability to raise capital by equity financing, if the business also wishes to use this method as well. Debt financing will leave the business vulnerable during hard times if sales fall. Choosing debt to fund business growth can actually make it very difficult for the business to grow because of the high costs of repaying the borrowed money. If the borrowed money is not repaid within the agreed time, assets can be held as collateral to the lender and the owner of the business is often required to personally guarantee repayment of borrowings.
Conclusion
From the above arguments for both advantages and disadvantages for equity financing and debt financing of business growth i don't believe that one method is better at raising capital than the other. Often in businesses they will use both equity and debt financing to meet the business needs when expanding. The two forms of financing together can work very well to reduce the downsides of each method. The right method or how much financing you seek from each method when using both will depend on the type of business, market the business operates in, cash flow, profits and the amount of money the business wises to seek to help grow the business. I would advise a business who seeks growth to use both equity financing and debt financing to reduce the drawbacks of each method and neither way is better than the other at getting access to more capital.
Equity Advantages
Choosing equity to finance the expansion for growth in a business is less risky than taking out a loan because you don't have to pay it back, and it is a good option if the business can't afford to take on debt but still wants to see expansion. Another advantage of equity is you enter into the investor's network which will add more credibility to the business. Getting investors involved in financing the growth of the business is beneficial as investors take a long-term view, and most don't expect a return on their investment immediately, Investors would rather see their funds put to good use by the business which should hopefully develop long term financial gains. With equity the business won't have to channel profits into loan repayment. There are no requirement to pay back the investment if the business fails the investor should know the risks involved before contributing funds into certain investment opportunities. Overall from choosing equity you will get the money you require to help aid in expansion and growth of the business.
Equity Disadvantages
Although there are some very good advantages for taking up equity to fund business growth there is also however some major disadvantages from choosing this method, such as equity may require returns that could be more that the rate you pay for a bank loan thus making it more expensive option. It is up to shareholders when they would like to see returns. Another disadvantage is when an investor invests within a company they require a certain amount of ownership and with a percentage of profits. A business will not want to give up this kind of control. Equity funded businesses can make decision process longer as and major decisions should be consulted with investors to make sure it abides by their interests and if does not this may cause disagreements thus making decision making process much longer. Also finding the right investor for the company can take a lot of time and effort if the business is performing poor and looks less attractive on the financial statements this will put investors off from investing within the business making the process very long to raise the capital the business needs for expansion.
Debt advantages
The advantages of using debt to finance growth of a business are the bank which the company retrieves the bank loan from has no say in the way the business should be run and does not take any ownership of the business. The relationship between the bank and the business will end once all the repayments of the loan have been made. The business will pay interest on the loan but this is tax deductible. Depending on the plans for growth the loans can be agreed to be short term or long term. The business is not required to hold meetings with shareholders and does not have to seek votes before taking certain actions which makes the decision making process quick and can quickly react to the market needs.
Debt Disadvantages
Some good advantages given in the above paragraph but debt funding of business growth has major disadvantages; such as the money borrowed must be paid back within a fixed amount of time. Also relying too much on debt when the business has cash flow troubles, can put the company at risk of unable to pay back the borrowed money. Carrying too much debt will be reflected on the company's financial statements and will put off potential investors and they will consider the company to be "high risk", which will limit the business ability to raise capital by equity financing, if the business also wishes to use this method as well. Debt financing will leave the business vulnerable during hard times if sales fall. Choosing debt to fund business growth can actually make it very difficult for the business to grow because of the high costs of repaying the borrowed money. If the borrowed money is not repaid within the agreed time, assets can be held as collateral to the lender and the owner of the business is often required to personally guarantee repayment of borrowings.
Conclusion
From the above arguments for both advantages and disadvantages for equity financing and debt financing of business growth i don't believe that one method is better at raising capital than the other. Often in businesses they will use both equity and debt financing to meet the business needs when expanding. The two forms of financing together can work very well to reduce the downsides of each method. The right method or how much financing you seek from each method when using both will depend on the type of business, market the business operates in, cash flow, profits and the amount of money the business wises to seek to help grow the business. I would advise a business who seeks growth to use both equity financing and debt financing to reduce the drawbacks of each method and neither way is better than the other at getting access to more capital.
Sunday, 9 November 2014
Appendix 3 - Is Modern Portfolio theory still relevant in today's markets?
In my previous blog post titled 'Capital Asset Pricing Model (CAPM)' I talked about the financial characteristics of this process with the model been able to workout the relationship between the risk and expected return on a given investment. One way a investor can reduce risk is use Modern Portfolio Theory.
What is Modern Portfolio Theory?
Modern Portfolio Theory is a theory that states investors should create an investment portfolio to spread the risk over a range of assets. The theory was developed in the 1950's which was developed by Harry Markowitz in his paper 'Portfolio Selection'. The theory is like the saying 'Don't put all your eggs in one basket'. If the investor just invests all his capital into the one investment opportunity and the investment is risky and the investment does not work this loses the investor all their capital. With Modern Portfolio Theory the investor will invest in several investment opportunities this constructing the investor a 'portfolio' to optimize expected return on a given level of market risk. The investor has also spread the risk across all the investors investments as they have not placed all their capital into the one investment. When using the theory you assume that the investor is risk averse meaning that they are reluctant to take risks. The theory is considered one of the most important and influential economic theories dealing with finance and investment.
Two Kinds of Risk
Modern portfolio theory states that the risk for individual stock returns has two components:
Systematic Risk - These are market risks that cannot be diversified away. Interest rates, recessions and wars are examples of systematic risks.
Unsystematic Risk - This risk is specific to individual stocks and can be diversified away as you increase the number of stocks in your portfolio (see below diagram). It represents the component of a stock's return that is not correlated with general market moves.
For a well-diversified portfolio, the average deviation from the mean of each stock contributes little to portfolio risk. Instead, it is the difference between individual stock's levels of risk that determines overall portfolio risk. As a result, investors benefit from holding diversified portfolios instead of individual stocks. Understanding and knowing the risks is important as to be able to mitigate them when choosing securities, helping the investor to choose the optimal portfolio.
The efficient frontier is then used to identify the combination of securities which will produce the best outcome. Below diagram is an illustration of the efficient frontier curve. The diagram shows when less risk is taken, the lower the expected return and in contrast the higher the risk taken, the higher the expected return would be. The dots nearest to the curve show the optimal combinations of securities,these are the securities that will interest investors the most, whereas the dots furthest away represent portfolios which will either offer the same returns with more risk or less return for the same risk thus interesting investors less as the portfolios are more risky or offer less returns.
Issues with Modern Portfolio Theory
The theory requires investors to rethink notions of risks. The theory can sometimes demand that the investor take on a perceived risky investment in order to reduce overall risk. Sometimes investors will not want to do this especially if they are not familiar with the benefits of sophisticated portfolio management techniques.
Another issue with modern portfolio theory is that it uses past information to help predict future trends, which is not an accurate method as it can not predict future events. For investors who have seen their portfolios successful this could just be down to luck rather than strategies, because otherwise they would all be consistently successful and the drawbacks wouldn't be so apparent.
Modern Portfolio Theory assumes that is is possible to select certain stock whose individual performance is independent of other investments in the given portfolio. But market experts have shown that there is no such tool as in times of market stress independent investments do in fact as though they are related.It is logical to borrow to hold a risk-free asset and increase your portfolio returns, but finding a truly risk-free asset is another matter.
Government-backed bonds are presumed to be risk free but in reality they are not. They are free of default risk, but expectations of higher inflation and interest rate changes can both affect their value.
Many people ask how many stocks are required to be purchased for diversification, Mutual funds can contain a vast amount of stocks. Investment guru William J. Bernstein says that even 100 stocks is not enough to diversify away unsystematic risk. By contrast, Edwin J. Elton and Martin J. Gruber, in their book "Modern Portfolio Theory And Investment Analysis" (1981), conclude that you would come very close to achieving optimal diversity after adding the twentieth stock.
Alternative to Modern Portfolio Theory
One alternative to Modern Portfolio Theory is 'timing the market'. This is the principle that you hold on to an asset when the value is good and been able to deliver good returns and when the value of the asset starts to go bad and decreases by a certain margin then you sell the asset to not suffer any further loss in value. This alternative method can also deliver huge capital gains for the investor but it is very hard to predict future trends and how certain markets act therefore investors will want pay very close attention to the market of the asset to make sure they sell at the correct time.
What is Modern Portfolio Theory?
Modern Portfolio Theory is a theory that states investors should create an investment portfolio to spread the risk over a range of assets. The theory was developed in the 1950's which was developed by Harry Markowitz in his paper 'Portfolio Selection'. The theory is like the saying 'Don't put all your eggs in one basket'. If the investor just invests all his capital into the one investment opportunity and the investment is risky and the investment does not work this loses the investor all their capital. With Modern Portfolio Theory the investor will invest in several investment opportunities this constructing the investor a 'portfolio' to optimize expected return on a given level of market risk. The investor has also spread the risk across all the investors investments as they have not placed all their capital into the one investment. When using the theory you assume that the investor is risk averse meaning that they are reluctant to take risks. The theory is considered one of the most important and influential economic theories dealing with finance and investment.
Two Kinds of Risk
Modern portfolio theory states that the risk for individual stock returns has two components:
Systematic Risk - These are market risks that cannot be diversified away. Interest rates, recessions and wars are examples of systematic risks.
Unsystematic Risk - This risk is specific to individual stocks and can be diversified away as you increase the number of stocks in your portfolio (see below diagram). It represents the component of a stock's return that is not correlated with general market moves.
For a well-diversified portfolio, the average deviation from the mean of each stock contributes little to portfolio risk. Instead, it is the difference between individual stock's levels of risk that determines overall portfolio risk. As a result, investors benefit from holding diversified portfolios instead of individual stocks. Understanding and knowing the risks is important as to be able to mitigate them when choosing securities, helping the investor to choose the optimal portfolio.
The efficient frontier is then used to identify the combination of securities which will produce the best outcome. Below diagram is an illustration of the efficient frontier curve. The diagram shows when less risk is taken, the lower the expected return and in contrast the higher the risk taken, the higher the expected return would be. The dots nearest to the curve show the optimal combinations of securities,these are the securities that will interest investors the most, whereas the dots furthest away represent portfolios which will either offer the same returns with more risk or less return for the same risk thus interesting investors less as the portfolios are more risky or offer less returns.
Issues with Modern Portfolio Theory
The theory requires investors to rethink notions of risks. The theory can sometimes demand that the investor take on a perceived risky investment in order to reduce overall risk. Sometimes investors will not want to do this especially if they are not familiar with the benefits of sophisticated portfolio management techniques.
Another issue with modern portfolio theory is that it uses past information to help predict future trends, which is not an accurate method as it can not predict future events. For investors who have seen their portfolios successful this could just be down to luck rather than strategies, because otherwise they would all be consistently successful and the drawbacks wouldn't be so apparent.
Modern Portfolio Theory assumes that is is possible to select certain stock whose individual performance is independent of other investments in the given portfolio. But market experts have shown that there is no such tool as in times of market stress independent investments do in fact as though they are related.It is logical to borrow to hold a risk-free asset and increase your portfolio returns, but finding a truly risk-free asset is another matter.
Government-backed bonds are presumed to be risk free but in reality they are not. They are free of default risk, but expectations of higher inflation and interest rate changes can both affect their value.
Many people ask how many stocks are required to be purchased for diversification, Mutual funds can contain a vast amount of stocks. Investment guru William J. Bernstein says that even 100 stocks is not enough to diversify away unsystematic risk. By contrast, Edwin J. Elton and Martin J. Gruber, in their book "Modern Portfolio Theory And Investment Analysis" (1981), conclude that you would come very close to achieving optimal diversity after adding the twentieth stock.
Alternative to Modern Portfolio Theory
One alternative to Modern Portfolio Theory is 'timing the market'. This is the principle that you hold on to an asset when the value is good and been able to deliver good returns and when the value of the asset starts to go bad and decreases by a certain margin then you sell the asset to not suffer any further loss in value. This alternative method can also deliver huge capital gains for the investor but it is very hard to predict future trends and how certain markets act therefore investors will want pay very close attention to the market of the asset to make sure they sell at the correct time.
Is Modern Portfolio Theory still relevant in today's markets?
The financial crisis of 2007-2008 has made many question Modern Portfolio Theory. Many years ago Modern Portfolio Theory was very much accepted but of recent times new scenarios had appeared which have proven that Modern Portfolio Theory does not always work and the theory is very much outdated.
I personally believe that the theory has been harshly criticized during the financial crisis, assets which lost all there value during the crisis would have had a negative affect against Modern Portfolio theory making investors question the theory. I would counter argue against the criticism saying that diversifying the investors portfolio offered much more protection against investors assets than holding on to single investments during the financial crisis, all though many investors would have lost value on the majority of the assets during the hard times of the financial crisis the investor may have had bad news with one asset but be compensated, by some extent of a another asset not suffering as badly during the financial crisis.
Conclusion
The financial crisis of 2007-2008 has made many question Modern Portfolio Theory. Many years ago Modern Portfolio Theory was very much accepted but of recent times new scenarios had appeared which have proven that Modern Portfolio Theory does not always work and the theory is very much outdated.
I personally believe that the theory has been harshly criticized during the financial crisis, assets which lost all there value during the crisis would have had a negative affect against Modern Portfolio theory making investors question the theory. I would counter argue against the criticism saying that diversifying the investors portfolio offered much more protection against investors assets than holding on to single investments during the financial crisis, all though many investors would have lost value on the majority of the assets during the hard times of the financial crisis the investor may have had bad news with one asset but be compensated, by some extent of a another asset not suffering as badly during the financial crisis.
Conclusion
Modern Portfolio Theory imply's the market is hard to beat and that the investors who beat the market are those who take above-average risk. But the risk taking investors are punished when markets turn down not performing well. We need to remember that Modern Portfolio Theory is simply that it is just a theory. A portfolio's success will rest on the investor's skills and the time they spend on the portfolio making the correct decisions and careful monitoring. Some people believe that an investor should look to pick out-of-favor investments and wait for that market to start to perform well and turn in the investors favor than just on market averages alone.
The theory was heavily criticized during the financial crisis but i believe that the theory would have helped a number of investors as they have diversified their portfolio meaning that assets in certain markets would have obviously reduced to having no value but some of the assets held may have not been heavily hit. The theory however is based off past information which is not good to predict future trends. I back the main principle of this theory and by not investing all the investors capital in the one asset but instead investing in many assets creating a 'portfolio' the investor has then spread the risk of losing all their capital and be able to see certain returns from different assets in different markets, so long as the investor has chosen the correct asset to invest.
The theory was heavily criticized during the financial crisis but i believe that the theory would have helped a number of investors as they have diversified their portfolio meaning that assets in certain markets would have obviously reduced to having no value but some of the assets held may have not been heavily hit. The theory however is based off past information which is not good to predict future trends. I back the main principle of this theory and by not investing all the investors capital in the one asset but instead investing in many assets creating a 'portfolio' the investor has then spread the risk of losing all their capital and be able to see certain returns from different assets in different markets, so long as the investor has chosen the correct asset to invest.
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