Portfolio Theory

“The Benefits of diversification are clear. Portfolio theory has played a crucial role in explaining the relationship between risk and return where more than one investment is held. It also enables us to identify optimal and efficient portfolios.”

With Reference to this statement, describe, discuss and illustrate the principles of portfolio theory. Your essay should include coverage of the Markowitz Efficient Frontier and the Capital Market Line.

Declaration:

I confirm that this submission is my own work.

Vinita Java

Introduction:

An investor would invest in a security for the return. However that return comes with a premium, the Risk. The higher the risk an investor is willing to take the higher the returns would be expected. Expected return is higher for bearing high risks and vice versa. Risk is not only the chance of capital loss but also the volatility of return.

(http://www.fhmanning.co.uk/diversification.htm)

Diversification:

There is a very famous saying ‘Never put all your eggs in one basket’.

Though the benefits of diversification were clear from long ago, it was not clearly put forth and quantified until Markowitz.

H.M Markowitz, in 1952, explained how an investor could get more out of his investments. He suggested that investor could achieve a more efficient investment by holding a portfolio (combination) of shares rather than investing completely into one share. He said when share are held together the expected return on the portfolio would be a weighted average of the expected returns of every individual share (J Ogilvie & B Koch 2002).

The standard investment advice to all investors was to identify securities that offered best return with lowest risks and then make a portfoli...

... middle of paper ...

...com/727/capital_market_line.html

· FHManning, Diversification:

http://www.fhmanning.co.uk/diversification.htm

· Moneychimp, Risk,

http://www.moneychimp.com/articles/risk/riskintro.htm

· ICI, Diversification,

http://www.ici.org/i4s/bro_i4s_diversification.html

· Risk glossary, Market risk, MPT, Risk limits, Financial Risk Management

· Modern portfolio theory and international investments under the Uniform Prudent Investor Act,

http://findarticles.com/p/articles/mi_qa3714/is_200101/ai_n8934269

http://findarticles.com/p/articles/mi_qa3759/is_200605/ai_n16629422

· Statman, M. , How Many Stocks Make a Diversified Portfolio?, Journal of Financial and Quantitative Analysis, Vol 22, No.3, Sep 87.

· Sendi, P., Marwenn, J. and Rutten, F., 2004, ‘Portfolio Theory and Cost Effectiveness Analysis: A Further discussion’, Value in Health, 2004, Vol 7, Number 5