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Posted on August 29th, 2012, by

Today, the portfolio theory can play a very important role which can influence decisions taken by investors. In fact, the portfolio theory does not only concerns investors but it can also direct investors’ behaviour. Hence, the portfolio theory can be viewed as a theoretical foundation on the ground of which investors can take decisions concerning their investment policies. At the same time, it is obvious that the portfolio theory cannot fully eliminate existing risks that influence consistently the development of markets and, therefore, this theory can only facilitate the process of decision-making concerning investments since it provide a relatively efficient tool to direct investment behaviour. In this respect, it is necessary to lay emphasis on the fact that investors can potentially make an optimal selection of investment portfolio based on parameters of risk and return which are taken into consideration by the portfolio theory. In such a way, the portfolio theory can be quite effective in regard to decisions concerning investments, though it is necessary to remember about the fact that not a single theory can totally eliminate risks related to investments, but still it is possible to reduce such a risk or, at least, make the risk of investments relevant to the expected return on investments and the portfolio theory can be very helpful in this regard.

Part A

Speaking about the development of the portfolio theory and its impact, it is hardly possible to disagree with Markowitz’s statement that this theory is concerned with investors. In actuality, it is obvious that the market portfolio is of the utmost importance for investors, while the portfolio theory provides investors with an opportunity to use diversification to optimize their portfolios. In other words, the application of the portfolio theory and the use of market portfolios along with the risk assessment allow investors making effective decisions concerning their investments. In this respect, it should be said that investors are above all interested in the practical application of fundamental concepts and principles of the portfolio theory because they are responsible for their investments. Therefore, they cannot make investments which are not backed up by detailed, profound analysis of the market, the target company and assessment of existing risks which can influence the effectiveness and return on investments. In such a way, the portfolio theory is directly concerned with investors.

Although, this theory can be applied effectively in the process of the assessment of market prospects of a company and risks which exist within the market to evaluate the efficiency of the market performance of a company as well as to identify the efficiency frontier.

At the same time, the portfolio theory is concerned with agents who act under uncertainty. In actuality, the modern business environment is characterized by a high degree of uncertainty, especially in the context of economic stagnation (Bodie and Merton, 1998). In such a situation, modern business develops in the context of a relatively high uncertainty that makes the application of the portfolio theory very useful for agents working in an uncertain business environment or in markets where the uncertainty rate is very high. In actuality, the advantage of the portfolio theory is the possibility to optimize portfolio in the context of uncertainty. Obviously, such a possibility can be crucial for agents working in an uncertain business environment because the theory allows to asses adequately risks and possible benefits or return on investments. In such a way, it is optimize to find the balance between existing and potential risks, on the one hand, and possible benefits and revenues, on the other.

Furthermore, it should be said that the economic agents who act under uncertainty need clear and effective tools which allow them to evaluate the correlation between risk and expected return and the portfolio theory provides such tools. At the same time, it does not necessarily mean that the portfolio theory can help economic agents to minimize uncertainty. In fact, what the portfolio does help to do is to find the efficient frontier that allows economic agents to take a conscious decision concerning their further actions since it is up to economic agents to decide whether to take higher risks and get higher profit, in case if they decide to go beyond the efficient frontier, which can be defined with the help of the portfolio theory, or to minimize the risk and get lower returns respectively.

In such a context, it is possible to speak about the possibility of using the portfolio theory to direct investment behaviour. However, in this respect, it is necessary to take into consideration the technical and technological opportunities of investors. What is meant here is the fact that, in order to use the portfolio theory to direct investment behaviour, investors need to have sufficient computer and database resources.

In actuality, modern economy and market processes, existing risks and potential revenues can raise problems, which investors cannot solve without a detailed and precise market analysis. At the same time, the implementation of the portfolio theory implies the use of quite complicated mathematical formulas and calculations, which should take into consideration multiple factors and variables. Hence, the use of powerful computer and database resources proves to be crucial for an efficient use of the portfolio theory to direct investment behaviour.

Instead, poor computer and database resources increase the risk of error or, at least, imprecise assessment of the correlation of risk and return that can lead to disastrous effects for investors, to the extent that investments made on the basis of scarce and imprecise data can turn out to be absolutely ineffective. In other words, insufficient or poor computer and database resources can lead to the failure of investments, while effective resources can make the application of the portfolio theory highly efficient to the extent that it can be used to direct investment behaviour.

Part B

Taking into a consideration the importance of the portfolio theory concerning investments and investors’ decisions, it should be said that investors need to be able to apply efficiently the portfolio theory to optimize their portfolios and adequately assess existing risks and expected return. In fact, risk and return on investments are crucial concepts for the portfolio theory which investors should use while selecting an optimal portfolio. In this respect, it is possible to refer to Markowitz’s model in which he applies the portfolio theory to select an optimal investment portfolio. According to this model, return and risk are key concepts. In fact, in terms of Markowitz’s model, an asset’s return is a random variable, while the risk is a standard deviation or return. In such a context, a portfolio should be viewed as a weighted model of assets so that a return of a portfolio is the weighted combination of the asset’s returns (Markowitz, 1991). In other words, the portfolio theory implies that the expected return should basically be relevant to risks. In this respect, it is worth mentioning the fact that a portfolio’s return has an expected value and variance.

Furthermore, in order to define the reasonable correlation between the risk and expected return, i.e. to find the efficient frontier or Markowitz’s frontier, an investor should take the risk-free asset as a starting point of the assessment. The risk-free asset is the asset which pays a risk-free rate (Chowdhry, 1999). Basically, it is provided by an investment in short-dated Government securities. The risk-free asset has zero variance in returns and it is uncorrelated with any other asset. Consequently, when it is combined with any other asset or portfolio assets, the change in return and also in risk is linear. Every possible asset can be placed plotted in risk-return space. The collection of all such possible portfolios defines a region in this space which reveals the extent to which a portfolio is close to the efficient frontier.

According to Markowitz, the combination along the risk-return line represents portfolios for which there is the lowest risk. What is meant here is the fact that the closer the portfolio to the risk-return is the lower is the risk because the risk and returns are correlated, while deviations from the line leads either to the unreasonable growth of risk or decrease of possible return that naturally implies losses on investments or, at least, low returns. Hence, the investor needs to define the efficient frontier mathematically to define whether investments he/she is going to make meet the efficient frontier or not. In this respect, it should be said that mathematically the efficient frontier is the intersection of the Set of portfolios with minimum variances and the Set of portfolios with maximum returns. In such a way, an investor can make a decision on investments and define the optimal portfolio.

On the other hand, it is necessary to remember that, in spite of a relatively high efficiency of the portfolio theory, it still has certain limitations. In this respect, it is important to lay emphasis on significant restrictions in its assumptions since relies on statistical model of asset returns that is apparently make it very difficult the use of explanatory model. In such a situation, the qualitative analysis and assessment can be quite difficult to do on the basis of the portfolio theory, though quantitative analysis can be quite efficient and precise.


Thus, taking into account all above mentioned, it is possible to conclude that the development of the portfolio theory contributed consistently to the improvement of the process of decision-making for investors because this theory helps to assess possible risks and expected returns on investments and to find the optimal portfolio, which, to a significant extent, can secure investments. In spite of seeming complexity, the portfolio can be applied efficiently on the condition of the use of sufficient computer and database resources.

Hence, even though the portfolio theory has certain restrictions in its assumptions, such as the use of statistical model of asset returns, it is still efficient and can be applied in the modern business environment.

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