16 Dec 2009
Part A
The portfolio theory is widely applied in the contemporary business environment. At the same time, the application of the portfolio theory is particularly important for investors since it allows selecting optimal investment portfolio and to clearly define the investment behavior. However, it should be said that the portfolio theory was not always considered to be reliable and highly effective, especially in relation to investors and their behavior. In this respect, the role of Markowitz can hardly be underestimated because he made a considerable contribution in the development of the portfolio theory and its improvement, increasing its reliability and effectiveness. In fact, while working on the portfolio theory, Markowitz defined major characteristics of the theory, which imply that the portfolio theory is concerned with investors, with economic agents who work under uncertainty, and it can be used to direct investment behavior if the investor has sufficient computer and database resources. In such a way, Markowitz attempted to make the portfolio theory particularly useful for investors as well as other economic agents working under uncertainty.
Basically, Markowitz attempted to make the portfolio theory more effective and he focused on the correlation of risks and expected returns as milestones of his theoretical developments. In such a situation, his theory naturally became concerned with investors because what he had done was the adaptation of the portfolio theory to the actual investors’ needs. In fact, Markowitz attempted to make his theory more applicable for investors who wanted to have reliable forecasts and positive outcomes of their investments. In this respect, it should be said that the portfolio theory developed by Markowitz naturally focused on investors who could use portfolios as the basis for their investments, but unlike his predecessors, Markowitz did not offer a theory which implied that investors should take risky decisions and maximize their revenues. Instead, he understood that it was necessary on the development of such a theory which could allow investors make a selection of an optimal portfolio. In such a context, the development of the entire portfolio theory becomes practically useless if investors are not concerned with this theory. Obviously, this theory can be used by other economic agents, but, above all, it is oriented on investments and, therefore, Markowitz adapted the portfolio theory for investors.
However, as it has been just mentioned above, today, the portfolio theory can applied not only by investors but also other economic agents. Although, it is worth mentioning the fact that normally other economic agents could hardly have any practical benefits from the use of the portfolio theory because they simply do not need to take decisions which investors do regularly. Nevertheless, if the market situation is uncertain, it is not only investors but other economic agents who can apply this theory because this theory is grounded on precise mathematic formulas and provides ample opportunities for the assessment of risks and potential revenues from investments as well as the assessment of the position of a company compared to its rivals. All this can be done on the basis of portfolios. Therefore, if investors normally select a company which they would like to invest, than other economic agents can clearly understand whether the company is in a risky position or probably its revenues are underestimated. Obviously, this information is very important since it can help to develop the strategic plan of the company on the ground of the analysis of its current position and prospects.
Furthermore, it is important to point out that Markowitz stood on the ground that the portfolio theory can assist investors to define investment behavior. In this respect, it should be said that Markowitz’s portfolio theory relies on a number of assumptions concerning investors’ behavior. For instance, Markowitz argues that investors will always seek the second opinion which can help them define their investment behavior and take a concrete decision concerning investments (Markowitz, 1991). In such a situation, when presented with a set of alternatives, investors will consider all expected revenues and rates of return over a specified holding period.
In fact, according to Markowitz the possibility to use the portfolio theory to direct investment behavior was very important, but, at the same time, he points out that such an application of the portfolio theory is possible on the condition that investors have sufficient computer and database resources. Basically, investors cannot use the portfolio theory effectively, if they have scarce or fragmentary information and they cannot process the available information properly to get reliable results. Obviously, the use of computer and database resources contributes to the higher reliability of the analysis of portfolios on the basis of the portfolio theory developed by Markowitz.
Part B
On analyzing the portfolio theory developed by Markowitz, it becomes obvious that risks and expected returns are key concepts for his theory. In fact, Markowitz argues that investors are interested to know the estimated risk level of all securities contained within a portfolio. As a rule, their decisions are solely based on these two variables: the levels of expected returns and the level of expected risk (Chowdhry and Howe, 1999). According to the portfolio theory, for any given risk level, investors will always rather go for portfolios with higher expected returns than for those with lower returns. Alternatively, for any given expected return level, investors are likely to prefer portfolios with less risk than those with more risk. Consequently, the correlation of risk and expected returns is crucial for investors.
Markowitz apparently understood this fact. This is why he developed the concept of the efficient frontier. The efficient frontier is actually a curve, behind which is the graphic representation of a set of portfolios that offers the highest rate of return for any given level of risk. Alternatively, the efficient frontier identifies portfolios that offer the minimum risk for any given level of return. The efficient frontier is the optimal correlation of risk and expected returns. In such a way, an investor needs to define the optimal portfolio among the variety of portfolios available to him or her.
At the same time, such a decision should be grounded on the detailed analysis of the portfolio in order to avoid the risk of error. In this respect, it is possible to speak certain drawbacks of the portfolio theory developed by Markowitz. To put it more precisely, according to Markowtiz, investors can use effectively the portfolio theory on the condition that they have sufficient computer and database resources available to them. Thus, they can process the information available to them and analyze different portfolios to select the optimal one for their investments (Garvin and Artemis, 1997). On the basis of such analysis they can define their further investment behavior. Otherwise, if investors have insufficient computer and database resources, the risk of errors increases substantially. As a result, investors will have significant difficulties with the selection of optimal portfolio.
In this respect, it is possible to speak about another drawback of the portfolio theory. In fact, Markowitz’s portfolio theory is highly dependent on mathematical calculations and it is rather rigid. On the one hand, such concern with mathematics calculations provides larger opportunities for adequate assessment of portfolios. On the other hand, such concern with mathematics deprives the analysis of portfolios of flexibility, which is very important in the contemporary business environment. What is meant here is the fact that the application of the portfolio theory makes quite difficult for investor to respond to changes which can occur rapidly and change the actual potential of the company he or she is going to invest. However, such changes increase the risk level of investments and, therefore, such risky portfolios should be rejected, even if their level of return on investments is higher compared to the optimal portfolio that meets the efficient frontier. Thus, the portfolio theory is not perfect, but still it provides investors with the opportunity to assess risks and expected returns and select the optimal portfolio.
References:
Chowdhry, B. and Howe, J. Corporate Risk Management for Multinational Corporations: Financial and Operational Hedging Policies. European Finance Review, 2, 1999.
Garvin, D. A. and Artemis M. (1997, November). A Note on Knowledge Management, Harvard Business School Case Study.
Markowitz, H.M. (1991), “Foundations of Portfolio Theory”, The Journal of Finance, Vol.46, No.2, pp.469-477
Custom essay writing service Essay-911.com. Buy essays online!
Tags: custom essay, Custom Essay Services, Portfolio
