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Modern Portfolio Theory: An Introduction

Modern portfolio theory, or MPT, is a popular investment theory which suggests that investors can maximise returns and minimise risk by carefully selecting different types of assets in their portfolio. The theory is considered as a mathematical formulation of the concept of diversification in investing.

Modern portfolio theory was introduced in 1952 by Harry Markowitz, then a student in the University of Chicago. The theory became very popular because at that time there was no mathematical method to quantify risk and MPT offered a solution. For his contribution to the finance, Markowitz received a Nobel price in 1990.

Usually, the assets in a portfolio have certain interrelationships or correlation among them. That means, change in the value of one asset can cause a change in the value another. For example, when stock prices as a whole fall bond prices usually go up. So a portfolio consisting of both stocks and bonds in the right combination is less risky than a stocks-only portfolio. At the same time, it can give better returns than a risk-free bonds-only portfolio.This is the basic idea of MPT. Thus we can more clearly define the conclusion of MPT: a diversified portfolio, of “uncorrelated” asset classes, can provide the highest returns with the least amount of volatility.

The correlation of variables can range from -1 or perfect negative correlation through 0 or no correlation to +1or perfect positive correlation. According to MPT, an investor can reduce portfolio risk simply by holding combinations of assets which are not perfectly positively correlated. The rationale behind it is this: statistically, risk can be defined as the variance in actual returns of an asset from its expected returns. By combining different assets whose returns are not correlated, the total variance of the portfolio can be reduced.

One of the key assumptions of MPT is that markets are efficient. That means, at any time, the price of a security in the market reflects all available information about it. This is an assumption that MPT shares with another famous stock market theory Efficient-market hypothesis, or EMH. Another major assumption of MPT is that investors are perfectly rational and risk-averse, and that they do not have any “herd instinct”. This assumption is also inline with EMH.

Other major conclusions of MPT include the assumption that correlations between assets are fixed and constant, all investors have access to the same information at the same time all investors aim to make as much money as possible regardless of any other considerations, investors have an accurate conception of possible returns, and there are no taxes or transaction costs.

In order to construct a properly diversified portfolio, MPT requires three types of data: the expected return of each potential component (asset) of the portfolio, the expected volatility of each component’s return, and the expected correlation of each component with every other component. If all these data are available, an investment expert can model such a portfolio by blending those components.

Even though MPT has evolved into a major theory in finance and it is commonly used by research analysts and portfolio managers as a tool to monitor risk and return characteristics of a portfolio, some serious criticisms have also evolved to challenge the very basic assumptions of MPT, especially after the findings in the field of behavioral economics.

For example, the theories that markets are efficient and all investors are rational have been proved wrong by behavioral economists as well as the success of outstanding investors. Also other assumptions such as the correlations between asset classes are constant and all investors have access all available information are also wrong in many cases. Further, MPT does not take into account the impact of taxes and trading costs on portfolio returns.

Moreover, the reliance of MPT on past performance to project expected returns is not always reliable since as everyone knows past performance is no guarantee of future results.

Despite all these drawbacks we cannot fully ignore MPT because it was the first to introduce a mathematical framework to analyze risk and many other financial models are built on the foundation set by it. An improvised version of MPT known as Post Modern Portfolio Theory is also gaining acceptance among the proponents of the theory.

http://shareskool.com/articles/ViewArticle.inf?article=Modern+Portfolio+Theory:+An+Introduction+&article_Id=33

About the Author

Shareskool.com is an India focused investor education website. It aims to empower investors in India to make independent investment decisions through education and information.

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The financial and economic crisis that began in 2008 is the most alarming of our lifetime because of the warp-speed at which it is occurring. How could it have happened, especially after all that we’ve learned from the Great Depression? Why wasn’t it anticipated so that remedial steps could be taken to avoid or mitigate it? What can be done to reverse a slide into a full-blown depression? Why have the responses to date of the government and the economics profession been so lackluster? Richard Posner presents a concise and non-technical examination of this mother of all financial disasters and of the, as yet, stumbling efforts to cope with it. No previous acquaintance on the part of the reader with macroeconomics or the theory of finance is presupposed. This is a book for intelligent generalists that will interest specialists as well.Among the facts and causes Posner identifies are: excess savingsflowing in from Asia and the reckless lowering of interest rates by theFederal Reserve Board; the relation between executive compensation,short-term profit goals, and risky lending; the housing bubble fuelled bylow interest rates, aggressive mortgage marketing, and loose regulations; the low savings rate of American people; and the highly leveraged balance sheets of large financial institutions.Posner analyzes the two basic remedial approaches to the crisis, which correspond to the two theories of the cause of the Great Depression:the monetarist—that the Federal Reserve Board allowed the money supply to shrink, thus failing to prevent a disastrous deflation—and the Keynesian—that the depression was theproduct of a credit binge in the 1920’s, a stock-market crash, and the ensuing downward spiral in economic activity. Posner concludes that the pendulum swung too far and that our financial markets need to be more heavily regulated.Read Richard Posner’s blog, and his

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 A Focused Issue on the Marketing Process in Organizational Competence


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New – This first volume of Research in Competence-Based Management (RCBM) signals the launch of a long-awaited outlet for peer-reviewed research papers contributing to advancement of competence-based management theory. Each volume in RCBM will be focused on a key aspect of competence theory. The focus in this volume on “The Marketing Process in Organizational Competence” reflects the fundamental market orientation in competence theory’s foundational concepts and theoretical development. Papers i

 A Focused Issue on the Marketing Process in Organizational Competence


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New – This first volume of Research in Competence-Based Management (RCBM) signals the launch of a long-awaited outlet for peer-reviewed research papers contributing to advancement of competence-based management theory. Each volume in RCBM will be focused on a key aspect of competence theory. The focus in this volume on “The Marketing Process in Organizational Competence” reflects the fundamental market orientation in competence theory’s foundational concepts and theoretical development. Papers i

 A Focused Issue on the Marketing Process in Organizational Competence


A Focused Issue on the Marketing Process in Organizational Competence


$29


Used – This first volume of Research in Competence-Based Management (RCBM) signals the launch of a long-awaited outlet for peer-reviewed research papers contributing to advancement of competence-based management theory. Each volume in RCBM will be focused on a key aspect of competence theory. The focus in this volume on “The Marketing Process in Organizational Competence” reflects the fundamental market orientation in competence theory’s foundational concepts and theoretical development. Papers

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 A Framework for Marketing Management


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Used – For graduate and undergraduate marketing management courses. This title is a Pearson Global Edition. The Editorial team at Pearson has worked closely with educators around the world to include content which is especially relevant to students outside the United States. Framework for Marketing Management is a concise adaptation of the gold standard marketing management textbook for professors who want authoritative coverage of current marketing management practice and theory, but the want

 A Framework for Marketing Management


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New – For graduate and undergraduate marketing management courses. This title is a Pearson Global Edition. The Editorial team at Pearson has worked closely with educators around the world to include content which is especially relevant to students outside the United States. Framework for Marketing Management is a concise adaptation of the gold standard marketing management textbook for professors who want authoritative coverage of current marketing management practice and theory, but the want

 A Framework for Marketing Management


A Framework for Marketing Management


$41.9


New – For graduate and undergraduate marketing management courses. This title is a Pearson Global Edition. The Editorial team at Pearson has worked closely with educators around the world to include content which is especially relevant to students outside the United States. Framework for Marketing Management is a concise adaptation of the gold standard marketing management textbook for professors who want authoritative coverage of current marketing management practice and theory, but the want

 A Framework for Marketing Management


A Framework for Marketing Management


$13.94


Used – For graduate and undergraduate marketing management courses. This title is a Pearson Global Edition. The Editorial team at Pearson has worked closely with educators around the world to include content which is especially relevant to students outside the United States. Framework for Marketing Management is a concise adaptation of the gold standard marketing management textbook for professors who want authoritative coverage of current marketing management practice and theory, but the want

 A Framework for Marketing Management


A Framework for Marketing Management


$72.61


New – For graduate and undergraduate marketing management courses. This title is a Pearson Global Edition. The Editorial team at Pearson has worked closely with educators around the world to include content which is especially relevant to students outside the United States. Framework for Marketing Management is a concise adaptation of the gold standard marketing management textbook for professors who want authoritative coverage of current marketing management practice and theory, but the want

 A Framework for Marketing Management


A Framework for Marketing Management


$140


Framework for Marketing Management is a concise adaptation of the gold standard marketing management textbook for professors who want authoritative coverage of current marketing management practice and theory, but the want the flexibility to add outside cases, simulations, or projects. Development of marketing strategies, market demand and environments, creating customer value, analysis of consumer markets, market segmentation, brand loyalty, the Product Life Cycle, managing mass communication, and marketing management in the global economy. This text is for companies, groups, and individuals who want to adapt their marketing strategies and management to the marketplace of the twenty-first century.

 A Framework for Marketing Management


A Framework for Marketing Management


$152.08


Framework for Marketing Management is a concise adaptation of the gold standard marketing management textbook for professors who want authoritative coverage of current marketing management practice and theory, but the want the flexibility to add outside cases, simulations, or projects.This text is for companies, groups, and individuals who want to adapt their marketing strategies and management to the marketplace of the twenty-first century.

 A Framework for Marketing Management


A Framework for Marketing Management


$151.44


Framework for Marketing Management is a concise adaptation of the gold standard marketing management textbook for professors who want authoritative coverage of current marketing management practice and theory, but who want the flexibility to add outside cases, simulations, or projects. Development of marketing strategies, market demand and environments, creating customer value, analysis of consumer markets, market segmentation, brand loyalty, the Product Life Cycle, managing mass communication, and marketing management in the global economy.This text is for companies, groups, and individuals who want to adapt their marketing strategies and management to the marketplace of the twenty-first century.

 A Framework for Marketing Management


A Framework for Marketing Management


$49.25


New – For graduate and undergraduate marketing management courses. This title is a Pearson Global Edition. The Editorial team at Pearson has worked closely with educators around the world to include content which is especially relevant to students outside the United States. Framework for Marketing Management is a concise adaptation of the gold standard marketing management textbook for professors who want authoritative coverage of current marketing management practice and theory, but the want

 A Framework for Marketing Management


A Framework for Marketing Management


$66


Used – For graduate and undergraduate marketing management courses. This title is a Pearson Global Edition. The Editorial team at Pearson has worked closely with educators around the world to include content which is especially relevant to students outside the United States. Framework for Marketing Management is a concise adaptation of the gold standard marketing management textbook for professors who want authoritative coverage of current marketing management practice and theory, but the want

 A Framework for Marketing Management


A Framework for Marketing Management


$44.66


Used – For graduate and undergraduate marketing management courses. This title is a Pearson Global Edition. The Editorial team at Pearson has worked closely with educators around the world to include content which is especially relevant to students outside the United States. Framework for Marketing Management is a concise adaptation of the gold standard marketing management textbook for professors who want authoritative coverage of current marketing management practice and theory, but the want

 A Framework for Marketing Management


A Framework for Marketing Management


$68.16


New – For graduate and undergraduate marketing management courses. This title is a Pearson Global Edition. The Editorial team at Pearson has worked closely with educators around the world to include content which is especially relevant to students outside the United States. Framework for Marketing Management is a concise adaptation of the gold standard marketing management textbook for professors who want authoritative coverage of current marketing management practice and theory, but the want

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