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.

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
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. 

1 comment:

  1. A good layout where you have made it easy for the reader to find information from the use of subheadings. The detail of the blog is good as you use visual aids to help with your explanations, and you also give detailed information about the issue of portfolio theory as well as alternatives.

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