This article focuses on investment concepts such as modern portfolio theory and post modern portfolio theory. Modern Portfolio Theory (MPT) provides an opportunity for investors to utilize diversification in order to maximize the potential of their portfolio, and assumes that the investor is adverse to risk. Post modern portfolio theory guides the path toward an enriched science of investment that assimilates DRO and behavioral finance with other forms of novelty that results in more positive outcomes. There is a discussion of why people should invest as well as an introduction of the capital asset pricing model.
Keywords 401 (k); Investment; Modern Portfolio Theory; Mutual Funds; Portfolio Management; Post-Modern Portfolio Theory; Retirement Plan; Stock Market
Finance: Investment Concepts
It has been suggested that most Americans do not know how to save or prepare for their future. As a result, many financial investment companies have approached employers as well as individuals in an attempt to educate the masses on the benefits of investing. Some of the tips that have been provided by organizations, such as the American Association of Individual Investors, include:
- Build and advance a cash reserve that can cover short-term dangers and liquidity requirements.
- Develop an overall investment strategy even if it cannot be implemented immediately.
- Select mutual funds that fit into the overall investment strategy, then consider what the minimum initial investments are.
- Choose a balanced fund for those who invest less aggressively and choose a wider-based index fund for those who invest more aggressively. Build the portfolio after this initial investment has been completed.
- Review the rate and level of commitment in relation to each of the stock market segments as a means to decide whether or not to increase the amount of funds given to the initial investment.
- Do not agonize over small deviations from the original allocation plan. Stay the course! (p. 1-2).
Modern Portfolio Theory
Financial counselors may inquire about whether or not an organization has some type of retirement plan, such as a 401 (k) plan, in place for their employees or they may go directly to the employee for supplemental retirement opportunities. One popular approach that has emerged is the modern portfolio theory. Modern Portfolio Theory sounds like it is an academic and analytical concept; however, "it is the accepted approach to investment and portfolio management today" (American Association of Individual Investors, n.d.). The relationship between risk and return tend to form the foundation for investment theory. However, a third dimension, modern portfolio theory, can be added to the equation in order to create a framework that can assess investment opportunities that exist for the sole purpose of making money (Dunn, 2006).
Modern Portfolio Theory (MPT) provides an opportunity for investors to utilize diversification in order to maximize the potential of their portfolio, and assumes that the investor is adverse to risk. Therefore, the investor will only take a risk if he/she has determined that the risk will provide them with a higher expected return. In essence, the investor has to be willing to take on more risk in order to be compensated with higher returns.
Parts of the Modern Portfolio Theory Approach
The concept can be used by both individuals and corporations, and can be used in determining how one can optimize his/her portfolio as well as what the price should be for a risky asset. According to the Association of Individual Investors, there are two parts of this approach and they are:
- First part — focus on the concept that the best combination of assets should be developed by focusing on how the various components perform relative to each other.
- Second part — focus on the belief that the natural outcome of many people searching for under priced securities in the markets should be an "efficient market" in which it is difficult to add value by finding under priced securities, especially since it is expensive to do so (par. 4 and 5).
MPT was introduced by Harry Markowitz, an economist and college professor, when he wrote an article entitled "Portfolio Selection" in 1952. He eventually became a Nobel Prize recipient for his work in the field. Prior to his work, most investors only focused on the best way to assess risks and receive rewards on individual securities when determining what to include in the portfolio. Investors were advised to develop a portfolio based on the selection of those securities that would offer them the best opportunity to gain. Markowitz took this practice and formulized it by creating a mathematical formula of diversification. "The process for establishing optimal (or efficient) portfolio generally uses historical measures for returns, risk (standard deviation) and correlation coefficients" (Money Online, n.d., para. 6). He suggested that investors focus on selecting portfolios that fit their risk-reward characteristics (Markowitz, 1959).
Capital Asset Pricing Model (CAPM)
In order to select investments for a portfolio, modern portfolio theory will use the capital asset pricing model (Wise Geek, n.d.). The capital asset pricing model (CAPM) is utilized to calculate a theoretical price for a potential investment, and has a linear correlation between the returns of the shares and what the stock market earnings as time passes. The model analyzes the risk and return rates that can be expected for individual capital to market returns. It can be used to:
- Institute the preferred equilibrium market price of a company's assets.
- Institute the price that a company’s equity is expected to cost, taking into consideration the risk components involved in a business’s investments.
There will always be some type of risk associated with an investment portfolio. The degree of risk can fluctuate between industries as well as between companies. A portfolio's risk is divided into two categories — systematic and unsystematic risk. Systematic risk refers to investments that are naturally riskier than others, and unsystematic risk refers to when the amount of risk can be minimized through diversification of the investments.
The CAPM operates on a set of assumptions such as:
- Investors are risk adverse individuals who maximize the expected utility of their end of period wealth, which implies that the model is a one period model.
- Investors have homogenous expectations about asset returns, which indicate that all of the investors perceive themselves to have the same opportunity sets.
- Asset returns are distributed by the normal distribution.
- A risk free asset exists and investors may borrow or lend unlimited amounts of this asset at a constant rate, which is the risk free rate.
- There are definite numbers of assets and their quantities are fixed within the one period model.
- All assets are perfectly divisible and priced in a perfectly competitive market.
- Asset markets are frictionless and information is costless and simultaneously available to all investors.
- There are no market imperfections such as taxes, regulations, or restrictions on short selling (Value Based Management.net, n.d., p. 7).
In addition, the...
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