Traditional Portfolio Theory

Traditional portfolio theory says that, the market is inefficient and the fundamental analyst can
take advantage of this situation. It is a very fundamental and subjective in nature. The normal method
of estimating the return on an individual security is to find out the amount of dividends, price earning
ratios, the common holding period and market value of shares. The traditional theory recognizes
specific types of risk and non-risk factors, bearing upon the return such as interest rate risk, purchasing
power risk and financial risk and non-risk variables such as taxation and liquidity. The traditional
theory is based on the fact that risk can be measured on each deviation, greater variability the higher
the standard deviation and vice versa.
The traditional theory believes that the investors prefer larger to smaller returns from securities,
the ability to achieve higher depends upon the investors ability to make judgement and vice versa.
The analysis can’t be based on single analysis but a series of analysis on the company’s portfolio the
following steps need in a traditional portfolio:
1. Background information: The get the background check about the company’s
performance.
2. Investment goals: The investors has to have certain goals with respect to his investment.
3. Investment policies: The investor has to establish a suitable goal for building his portfolio
mix.
4. Security selection: Above all steps help the investor to choose an appropriate security
which would satisfy him and the security selection must be based on the P/E ratio and the
earnings and dividend payout ratio and efficient management of the company.
Modern Portfolio Theory
Modern portfolio theory is the philosophical opposite of traditional stock picking. It is the creation
of economists, who try to understand the market as a whole, rather than business analysts, who look
for what makes each investment opportunity unique. Investments are described statistically, in terms
of their expected long-term return rate and their expected short-term volatility. The volatility is equated
with “risk”, measuring how much worse than average an investment’s bad years are likely to be. The
goal is to identify your acceptable level of risk tolerance, and then to find a portfolio with the maximum
expected return for that level of risk.

What Does Modern Portfolio Theory – MPT Mean?

A theory on how risk-averse investors can construct portfolios to optimize or maximize expected
return based on a given level of market risk, emphasizing that risk is an inherent part of higher
reward.

Also called “Portfolio Theory” or “Portfolio Management Theory”

Modern portfolio theory is the philosophical opposite of traditional stock picking. It is the creation
of economists, who try to understand the market as a whole, rather than business analysts, who look
for what makes each investment opportunity unique. Investments are described statistically, in terms
of their expected long-term return rate and their expected short-term volatility. The volatility is equated
with “risk”, measuring how much worse than average an investment’s bad years are likely to be. The
goal is to identify your acceptable level of risk tolerance, and then to find a portfolio with the maximum
expected return for that level of risk.
Portfolio theory deals with the value and risk of portfolios rather than individual securities. It is
often called modern portfolio theory or Markowitz portfolio theory.
The key result in portfolio theory is that the volatility of a portfolio is less than the weighted
average of the volatilities of the securities it contains.
Modern portfolio theory is not universally accepted, despite being the standard textbook description
of portfolio risk and return. Markowitz himself thought normally distributed variance an inadequate
measure of risk. Models have been developed that use asymmetric and fat tailed distributions (post-
modern portfolio theory). There are also more radical objections, including an alternative behavioural
portfolio theory.
Modern portfolio theory (MPT) is a theory of investment which attempts to maximize portfolio
expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of
expected return, by carefully choosing the proportions of various assets. Although MPT is widely
used in practice in the financial industry and several of its creators won a Nobel memorial prize for
the theory, in recent years the basic assumptions of MPT have been widely challenged by fields such
as behavioural economics.
 MPT is a mathematical formulation of the concept of diversification in investing, with the aim of
selecting a collection of investment assets that has collectively lower risk than any individual asset.
That this is possible can be seen intuitively because different types of assets often change in value in
opposite ways. For example, as prices in the stock market tend to move independently from prices in
the bond market, a collection of both types of assets can therefore have lower overall risk than either
individually. But diversification lowers risk even if assets’ returns are not negatively correlated—
indeed, even if they are positively correlated.
More technically, MPT models an asset’s return as a normally distributed function (or more
generally as an elliptically distributed random variable), defines risk as the standard deviation of
return, and models a portfolio as a weighted combination of assets so that the return of a portfolio is
the weighted combination of the assets’ returns. By combining different assets whose returns are not
perfectly positively correlated, MPT seeks to reduce the total variance of the portfolio return. MPT
also assumes that investors are rational and markets are efficient.
MPT was developed in the 1950s through the early 1970s and was considered an important
advance in the mathematical modelling of finance. Since then, many theoretical and practical criticisms
have been levelled against it. These include the fact that financial returns do not follow a Gaussian
distribution or indeed any symmetric distribution, and that correlations between asset classes are not
fixed but can vary depending on external events (especially in crises). Further, there is growing
evidence that investors are not rational and markets are not efficient. Any theory or strategy that
suggests it is possible to outperform the market without taking extra risk contradicts Markowitz
portfolio theory, as does the evidence for the value effect or the existence of persistent arbitrage
opportunities.
The objective of this topic is to show how you can apply modern portfolio theory in real life to
create an optimized portfolio.

Definitions and Assumptions

Before we begin to explain portfolio theory and its application, let’s begin by defining a number
of key terms. A common nomenclature is essential to correctly interpreting this series.
 Return: For many assets, this may include both capital appreciation (the price of the stock
rises) and dividends. For debt instruments, the return may include price appreciation (for
example, when interest rates fall), the periodic interest payments, or the payment of the
principal. Expected returns may be based on historical performance; however, it is important
to think critically about whether past performance is likely to continue in the future. (For
example, do you really expect to see a 50% rise in technology stocks year-over-year for
the next 10 years?)
 Risk: This is perhaps the most contentious definition. In the context of this series, risk is
the measure of variability in the expected return. We will use simple statistical tools to
quantify risk. Risk is typically based on past volatility; however, as with returns, investors
should think critically about the assumptions underlying the estimates of risk. If anything, the recent
credit crisis has shown that two assets that appeared to be unrelated (uncorrelated,) may actually move
together quite quickly under certain economic conditions.

Assumptions
The framework of MPT makes many assumptions about investors and markets. Some are
explicit in the equations, such as the use of normal distributions to model returns. Others are implicit,
such as the neglect of taxes and transaction fees. None of these assumptions are entirely true, and
each of them compromises MPT to some degree.
 Asset returns are (jointly) normally distributed random variables. In fact, it is
frequently observed that returns in equity and other markets are not normally distributed.
Large swings (3 to 6 standard deviations from the mean) occur in the market far more
frequently than the normal distribution assumption would predict. While the model can also
be justified by assuming any return distribution which is jointly elliptical, all the joint elliptical
distributions are symmetrical, whereas asset returns empirically are not.
 Correlations between assets are fixed and constant forever. Correlations depend on
systemic relationships between the underlying assets, and change when these relationships
change. Examples include one country declaring war on another, or a general market
crash. During times of financial crisis all assets tend to become positively correlated, because
they all move (down) together. In other words, MPT breaks down precisely when investors
are most in need of protection from risk.
 All investors aim to maximize economic utility (in other words, to make as much
money as possible, regardless of any other considerations). This is a key assumption
of the efficient market hypothesis, upon which MPT relies.
 All investors are rational and risk-averse. This is another assumption of the efficient
market hypothesis, but we now know from behavioural economics that market participants
are not rational. It does not allow for “herd behaviour” or investors who will accept lower
returns for higher risk. Casino gamblers clearly pay for risk, and it is possible that some
stock traders will pay for risk as well.
 All investors have access to the same information at the same time. This also
comes from the efficient market hypothesis. In fact, real markets contain information
asymmetry, insider trading, and those who are simply better informed than others.
 Investors have an accurate conception of possible returns, i.e., the probability
beliefs of investors match the true distribution of returns. A different possibility is
that investors’ expectations are biased, causing market prices to be informationally inefficient.
This possibility is studied in the field of behavioural finance, which uses psychological
assumptions to provide alternatives to the CAPM such as the overconfidence-based asset
pricing model of Kent Daniel, David Hirshleifer, and Avanidhar Subrahmanyam (2001).
  There are no taxes or transaction costs. Real financial products are subject both to taxes
and transaction costs (such as broker fees), and taking these into account will alter the
composition of the optimum portfolio. These assumptions can be relaxed with more
complicated versions of the model.
 All investors are price takers, i.e., their actions do not influence prices. In reality,
sufficiently large sales or purchases of individual assets can shift market prices for that asset
and others (via cross-elasticity of demand.) An investor may not even be able to assemble
the theoretically optimal portfolio if the market moves too much while they are buying the
required securities.
 Any investor can lend and borrow an unlimited amount at the risk-free rate of interest.
In reality, every investor has a credit limit.
 All securities can be divided into parcels of any size. In reality, fractional shares usually
cannot be bought or sold, and some assets have minimum orders sizes.
More complex versions of MPT can take into account a more sophisticated model of the world
(such as one with non-normal distributions and taxes) but all mathematical models of finance still rely on
many unrealistic premises.