The Relevance of Mean-Variance Analysis for Practitioners Investing in the Equity - Coursework Example

Running head: Mean Variance analysis Name: University: Course: Tutor: Date of Submission: Introduction Thau ,(2001,pp.12-26) states that investors include retail and institutions or firms that want to buy or sell their securities and for this reason hold cash and security accounts with intermediaries. Equity: Equity is the financing part of an organization or firm. A firm can choose to be a sole proprietor, a partnership or a corporation. A corporation involves a larger number of owners than the other two who have separate legal entities from their businesses. Equity markets developed from the need of entities to expand. This could be to bigger premises, or even to larger geographical regions, expanding the range of products or even for re-branding. A firm or an entity that wants to expand can get their financing from borrowing, sell shares to an individual who then becomes an owner in the firm, or seek equity from the public investors. This involves the firm going public (Markowitz, Todd & Sharpe, 2000, pp.75-80). In doing this, the company raises the needed funds for various projects. The equity market thus involves investors wanting a stake in various companies and selling off those they are currently holding which are either not performing well in the economy or they have lost interest in. Bonds: Thau defines a bond a basically a loan or an IOU. In normally circumstances when a an investor purchases a bond, then it is quiet clear from the financial perspective that the investor is actually investing the money to a larger directly for future use and this can be through a corporation or even the government (Thau ,2001,pp.12-26). Such big institutions raise their capital by issuing bonds for periods as short as few days to as long as 40 years. The bond has a distinguishing characteristic of the borrower(the issuer) entering into a legal agreement to compensate the investor (the bond holder) through periodic interest payments in the form of coupons, and repay the original sum (principal) in full on a said date, known as the bonds maturity date. The bonds are brought to the market by an investment bank, known as the underwriter. The investment bank acts as an intermediary between the issuer and the investor. Both parties then hire lawyers to draw up legal agreements that define their relationship, and their terms and conditions (Edwin, Martin, Stephen, & William, 2009, pp.45-60). The legal document drawn up is referred to as the indenture, which is legally binding on the issuer for the entire period the bond is outstanding. It is the indenture that stipulates dates when coupons should be paid, and also the date of repayment of the principal. Bonds issues by the government are known as Treasury bonds; those issued by corporations are known as corporate bonds; those issued by local and state governments and are usually exempt from federal taxes are referred to as municipals or “munis” for short. Individuals may purchase bonds from various sources like from banks, firms that specialize in debt instruments, discount brokers or from full service brokerage firms. US Treasuries may also be bought directly from the Federal Reserve Bank. Of particular interest to investors and bond traders are factors like calculation of prices, accrued interest, yields and durations. The bonds market usually play a significant role in instrument this is because it compares and contrasts various bond prices with specific attention being given to how the different instruments are actually quoted(Frank ,2009,pp.45-60). In addition it shows the accrued interest payable by the buyer in relation to a particular traded bond price, the required borrower settlement periods, the bond cost and here it help the borrow to determine which bond he or she will invest in it since it shows if the bond is quoted on a yield basis or not. Moreover, the bond market in details indicates the rules for adjusting coupon rates as well as how bond yields are quoted and how an investor can actually y calculate his or her return. Mean variance analysis: Mean variance analysis quantifies the notions of risk and expected returns by applying concepts from statistics. Financial the mean variance analysis attempts to account for investor risk as well as expected return this has been over the years proven mathematically. In financial terms it helps an investor find a portfolio for given investment which can yield maximum return at minimum amount of risk(Frank ,2009,pp.45-60). The analysis has become a basis for guiding portfolio advice, and it emphasizes on diversification to eliminate exposure to risks in the market that are do not come with any rewards. It was developed by Harry W Markowitz in the 1950s, and is the theory that explains on how to combine risky assets so as to minimize the variance of the return, which is the risk, at any desired mean return. In finance such combinations are usually referred to as Locus of optimal mean-variance sometimes called efficient frontier which in normal circumstances is a point where all rational investors desire to be positioned as result of profit maximization(Frank ,2009,pp.45-60). Mean-variance main ideas The main ideas of the mean variance theory include: an investor should take on risk in proportion to the risk premium and in inverse proportion with variance and risk aversion; diversification pays; investors hold a mixture of two portfolios, one riskless, and the market portfolio; the market does not reward investors for taking security specific risk; and that the market rewards investors for taking a share of economic-wide risk. Assumptions The theory holds some assumptions that include: single period model, price taking with no transaction costs or taxes; and preferences depend on the mean and the variance of payoffs, which means that at a given mean, the lower variance is preferred and at a given variance, a higher mean is preferred. The assumptions of no taxes or transaction costs are known collectively as the assumption of ‘perfect capital markets(Frank ,2009,pp.45-60).’ It directs investors to maintain the same asset allocation regardless of age or investment horizon, which comes at odds with traditional financial planners give their clients and also is at odds with the asset allocation patterns present in life-cycle funds. For long there has been the assumption of constant investment opportunities but recent studies show that investment opportunity changes are quantitatively important. Long term investors usually receive large amounts of incomes and they therefore can support their standard of living. Traditionally, mean-variance analysis treats cash like the riskless asset while considering bonds to be as risky as stock (Frank ,2009,pp.45-60). The idea being that real interest rates are constant, while they are not. Thus in the circumstances, cash is only safe for a short term investor, if the short term inflation risk is small. Thus reinvesting constantly in short term bonds will preserve the investor’s initial wealth. Relevance of mean variance analysis to investors The mean variance which actually is calculated from a combination of assets portfolio helps an investor in determining the expected return of that particular investment portfolio. Mean variance also takes into account Covariance calculation which from financial perspective is important in portfolio theory because they tell us whether risks cancel or compound when assets are combined in portfolios. Covariance is has been over the years perceived to be a significant determinant of portfolio variance especially in circumstances where the number of securities is large and their weights are too small. It is also important to calculate covariance in a case of portfolios with two assets which have 2 variance terms and 1 covariance term this helps an investor in determining an assets investment opportunity set as shown the graph below Investment opportunity set: GRAPH: An investor with many risky assets it will be very much important to use the covariance as way of determining a good investment portfolio. As a shown from the graph, an investor with many risk assets then feasible investment set for such an individual will be a curve as well as the area to the right of the curve (Frank ,2009,pp.45-60). In financial terms the curve is usually called the efficient frontier where most investors desire to reach since it is here that many investors make profits at minimum risk. At this point it is always necessary that a rational investor choose a portfolio on the efficient frontier, known as the mean variance efficient portfolios rather than purchasing more bonds. Acquiring more bonds in the market by an investor exposes the investor to more risks and losses as far as the bond market as well as other financial asset market is concerned since this action pushes the efficient frontier curve towards the northwest corner of the graph putting the investor to more risks. The mean variance analysis model is simple and easy to interpret, such as the investors are assumed to maximize a preference functional defined over the mean and variance of their portfolios. This mean variance therefore is important to investors who have large investment portfolios but have little financial knowledge hence it helps them to follow the simple formulas and explanations offered by this analysis (Stephen ,2007,pp.23-30). However, the return and risk issues measures used in the model are based on expected values that are derived from mathematical calculations. This means they are mathematical statements about the future (Brown, 2008,pp.45-60). This therefore implies that it always a necessity in practice for investors to substitute predictions which have been based on historical measurements of asset return and volatility when calculating expected return as way of ascertaining which portfolio is more profitable as well as has little risk associated with it. These expected values usually fail to take into account new circumstances that were not present during the formulation of historical data. The risk measures are probabilistic in nature and not structural, thus they cannot tell when the risks will occur. While the analysis is enlightening, it is still incomplete as in practice, coupons and principal payments of long term bonds are fixed in nominal terms. It means that additional factors do affect the bonds, like inflation. The investors need to know that the Treasury bonds are safe investments only when inflation risk is low. The mean variance analysis theory does not put into account environmental, strategic, personal, or social dimensions of investment decisions. It helps investors to maximize risk adjusted returns and does not consider other inclinations such as preferences and social settings of investors (Lusardi,2008,pp.60-70). Conclusion In the light of emerging research and knowledge of the markets, the mean-variance theory offers basic steps an investor requires to know while forming their portfolios. This includes having knowledge on the risks involved and minimizing them while aiming for portfolios that will result to good returns. This is emphasized in the analysis and diversification is encouraged. However, in the modern markets where the markets are constantly changing, the assumptions held by the analysis cannot hold. Financial analysts have developed the analysis and come up with models that put into consideration factors like inflation and other changes in the markets. These should be combined by the investor for them to achieve highly low risk and high return portfolios. REFERENCES: Thau, A (2001).The bond book: everything investors need to know about treasuries, municipals, GNMAs, corporate, zeros, bond funds, money market funds, and more.2ed. Publisher: McGraw-Hill Professional,pp.12-26 Brown, J., P (2008).Bond markets: structures and yield calculations Publisher: Lessons Professional Publishing,pp.45-60 Lusardi, A (2008).Overcoming the saving slump: how to increase the effectiveness of financial education and saving programs. Publisher: University of Chicago Press, pp.60-70 Markowitz, H., Todd, P., G & Sharpe, W (2000).Mean-variance analysis in portfolio choice and capital markets.Chicago: John Wiley and Sons, pp.75-81, vol 66\\ Stephen , A, . G(2007).The international equity commitment Chicago:Wiley-Blackwell,pp.23- 30 Frank J,. F (2009). Institutional Investment Management: Equity and Bond Portfolio Strategies and Applications. United States: Wiley and Sons, p..45-60,Vol .77 Edwin, J., Martin, G., Stephen, B & William, N (2009). Modern Portfolio Theory and Investment Analysis. United States: Wiley and Sons, p..45-60,Vol .77 Read More