@2010Modern portfolio theoryIntroductionModern portfolio theory is an investment theory which maximizes expected portfolio return relation to a specified amount of portfolio risk, or in equal manner reduces risk for a specified level of return through diligently selecting the proportions of the various range of assets. Modern portfolio theory corresponds to a formulation of the concept of diversification during investing, having the target of picking on a selection of investment assets that possess generally lower risk as compared to an individual asset. In modern portfolio theory models, the return of an asset as normally distributed function (or greatly general as an random variable that is elliptically distributed), explains a risk as return’s standard deviation, and models a portfolio as a weighted combination of assets in order that a portfolio return is the weighted combination of the returns of assets.
By putting together different types of assets whose returns may not be positively related or correlated, modern portfolio theory seeks fundamentally to decrease the total variance of the return of the portfolio. Modern portfolio theory is applied under the assumption that markets are efficient and investors are rational.
AssumptionsThe modern portfolio theory framework has many assumptions concerning markets and investors. Others are very explicit in the equations, for example the utilization of the model returns of normal distributions, whereas others are implicit which includes the neglect of transaction fee and taxes. None of the assumptions are true entirely and every one of them has some degree of modern portfolio theory (Swedroe, 2007). According to Elton and Gruber (1997), the first assumption is that returns on assets are normally jointly distributed random variables.
It is widely noticed that returns in other markets and equity are not usually normally distributed. Large variations of about three to six standard deviation from the mean occur in the market far more often than the usual distribution assumption would predict. While the model can be supported by the assumption that any return distribution that is jointly elliptical, distributions that are joint elliptical are symmetrical on the other hand return on asset empirically are not. Correlations between assets are constant and fixed forever. Correlations largely are determined by systematic relationships between the asset underlying and the subsequent change when the relationships are altered for example when an overall market crash or a country declares war on another.
In times of crisis that are financially oriented all assets tend towards becoming positively correlated since they all move down together, that is modern portfolio theory breaks down precisely during a time when investors most need protection from the risk. It is also assumed that all investors have the target to maximize economic utility that is, making much money as possible despite of any other prevailing considerations.
It is a major assumption made in the efficient market hypothesis on which modern portfolio theory depends on. All the investors are risk averse and rational. This is another assumption found in the efficient market hypothesis; on the other hand it is known economic behavior that market participants are normally not rational. It does not apply for group behavior or to those investors who accept low returns for higher risk. Some stock traders will pay for risk the same way casino gamblers pay for risk. It is also worth noting that all the investors in a particular market have access to the same information virtually at the same time.
This is also found in the efficient market hypothesis. Often real markets have information asymmetry, those who are better informed and insider trading.