Part A. Portfolio theory
1. Brief introduction of portfolio theory
In 1952, Markowitz proposed the portfolio theory. This theory has already been proven practically to be effective in developed securities market and is also widely used in portfolio selection and asset allocation, which was described by Markowitz (1991)‘my work on portfolio theory considers how an optimizing investor would behave.’ Simply put, a portfolio means using a variety of financial products—stocks, bonds, funds and others consists of an investment portfolio. The basic idea of this theory is that, the risk of the portfolio is associated with the relationship between assets’ returns of the portfolio, under a set conditions; there is a group that makes the minimize proportion of investment portfolio risk—the portfolio risk increased with the growing number of portfolio assets, but it will not increasing to infinity, there is an optimal point of risk. Bill Gate, who is a risk averse, wants to reach the optimal investment portfolio exactly. Therefore understanding the portfolio theory is really useful for Bill Gate to place his wealth legitimately.
2. Underlying information
According to traditional portfolio theory, ‘No eggs will survive out all in force’, which means the more the number of portfolio assets, the greater the risk diversification (Mary, 2005). By the way, the risk mentioned here is the unsystematic risk that is particular to a given share, while there is a non-diversification risk, which is also known as systematic risk, it refers the possibility of some factors will bring about financial loss to all securities in the market, such as inflation, money policy, and war. Moreover, the deeper meaning of diversification is to reduce the fluctuation in ...
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By focusing on only one risk, for example peer risk, it leaves the company up for even more risk in its assets and pension obligations. Figure 1 illustrates that these risks do indeed rely on one another. When investors try to only minimize one of the risks (small circles) stockholders leave themselves open / exposed to the other two scopes of risk: Beta and Matching (ALM).
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This assignment is concerned with your understanding of the key issues relative to portfolio analysis and investment. In completing this assignment you are to limit your scope to the US stock markets only. Use the Cybrary, the Internet, and course resources to write a 2-page essay which you will use with new clients of your financial planning business which addresses the following issues and/or practices:
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There is a sense of complexity today that has led many to believe the individual investor has little chance of competing with professional brokers and investment firms. However, Malkiel states this is a major misconception as he explains in his book “A Random Walk Down Wall Street”. What does a random walk mean? The random walk means in terms of the stock market that, “short term changes in stock prices cannot be predicted”. So how does a rational investor determine which stocks to purchase to maximize returns? Chapter 1 begins by defining and determining the difference in investing and speculating. Investing defined by Malkiel is the method of “purchasing assets to gain profit in the form of reasonably predictable income or appreciation over the long term”. Speculating in a sense is predicting, but without sufficient data to support any kind of conclusion. What is investing? Investing in its simplest form is the expectation to receive greater value in the future than you have today by saving income rather than spending. For example a savings account will earn a particular interest rate as will a corporate bond. Investment returns therefore depend on the allocation of funds and future events. Traditionally there have been two approaches used by the investment community to determine asset valuation: “the firm-foundation theory” and the “castle in the air theory”. The firm foundation theory argues that each investment instrument has something called intrinsic value, which can be determined analyzing securities present conditions and future growth. The basis of this theory is to buy securities when they are temporarily undervalued and sell them when they are temporarily overvalued in comparison to there intrinsic value One of the main variables used in this theory is dividend income. A stocks intrinsic value is said to be “equal to the present value of all its future dividends”. This is done using a method called discounting. Another variable to consider is the growth rate of the dividends. The greater the growth rate the more valuable the stock. However it is difficult to determine how long growth rates will last. Other factors are risk and interest rates, which will be discussed later. Warren Buffet, the great investor of our time, used this technique in making his fortune.
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The Modern portfolio theory {MPT}, "proposes how rational investors will use diversification to optimize their portfolios, and how an asset should be priced given its risk relative to the market as a whole. The basic concepts of the theory are the efficient frontier, Capital Asset Pricing Model and beta coefficient, the Capital Market Line and the Securities Market Line. MPT models the return of an asset as a random variable and a portfolio as a weighted combination of assets; the return of a portfolio is thus also a random variable and consequently has an expected value and a variance.