Portfolio theory is an investments theory that seeks to explain how investors can minimize investment risks while at the same time maximizing returns on their investments (Elton, 2007, Markowitz, 1952). Under the same concept fund managers have a chance to make rational decisions to prevent them from running their organisations into loss making? The theory is based upon the diversification concept whereby investors choose a collection of assets to invest in rather than a single asset. They are usually in the form of unit trusts.
Analysis
Due to the fact that different assets change in value differently a collection of them may have an overall smaller risk than each individually. For example the prices in the stock markets usually increase while the prices in the bond markets decrease. Thus a combination of assets from these two categories may produce a better pay off matrix than the individual assets traded independently (Sharpe, 1964).
In financial markets, the capital asset pricing model is a mathematical model that is used to determine a theoretical expected rate of return for a specific asset. This is usually so if the asset is to be incorporated into an asset portfolio that is well diversified and as long as the asset has a non-diversifiable risk (Bodie et al., 2008). The non –diversifiable risk is a requirement for assets that are to be traded in financial markets as equities (Cuthbertson and Nitzsche, 2008).
Relevance
The portfolio theory and the capital assets pricing model are based on some assumptions. These include the assumption that investors are rational, price takers, markets are efficient, existence of perfectly competitive markets. These assumptions have been deduced to lead to the existence of some shortcomings.
Regardless of their shortcomings the portfolio theory and the capital asset pricing model are very useful to investors and fund managers. Firstly they are important in estimating possible or expected returns of an asset as well as the possible risk associated with the asset in due time (Mandelbrot and Hudson, 2004). This allows for investors to choose a portfolio of assets with a higher expected return as well as a lower risk. To a fund manager they are relevant in assisting them to create asset baskets that are less likely to be influenced by investors’ money or choices (Hubbard, 2007).
Capital asset pricing model is also important in determining whether an asset is correctly priced, overvalued, or undervalued. If the pricing is done correctly then investors and or fund managers have a chance of deciding whether to buy or sell the assets at the estimated prices (Tobin, 1958).
Depending on the predictability (represented as variance in the model) of an asset fund managers and or investors can decide on their credit worthiness or their potential to borrow or loan money to potential investors. The portfolio theory and the capital asset pricing model are also important to investors and fund managers in the context of the calculation of an assets net present value (Chandra and Shadel, 2007). The net present value allows the two to calculate the value of an asset especially government securities at the present day as well as their discounting rates (Lintner, 1965).
The portfolio theory and the capital asset pricing model have not only been in use in the financial markets sector only. Over the years they have been widely used in the behavioural sciences as well as other disciplines (Sciulli and Etzioni, 1996).
References
BODIE, Z., KANE, A. & MARCUS, A. J. 2008. Investments, Boston, McGraw-Hill/Irwin.
CHANDRA, S. & SHADEL, G. 2007. Crossing disciplinary boundaries: Applying financial portfolio theory to model the organization of the self-concept. Journal of Research in Personality, 41, 346-373.
CUTHBERTSON, K. & NITZSCHE, D. 2008. Investments, Chichester, England ; Hoboken, NJ, Wiley.
ELTON, E. J. 2007. Modern portfolio theory and investment analysis, Hoboken, NJ, J. Wiley & Sons.
HUBBARD, D. W. 2007. How to measure anything : finding the value of “intangibles” in business, Hoboken, N.J., John Wiley & Sons.
LINTNER, J. 1965. The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets. Review of Economics and Statistics 47, 13-39.
MANDELBROT, B. B. & HUDSON, R. L. 2004. The (mis)behavior of markets : a fractal view of risk, ruin, and reward, New York, Published by Basic Books.
MARKOWITZ, M. 1952. Portfolio Selection. Journal of Finance 7, 77-91.
SCIULLI, D. & ETZIONI, A. 1996. Macro socio-economics : from theory to activism, Armonk, N.Y., M.E. Sharpe.
SHARPE, F. 1964. Capital asset prices: A theory of market equilibrium under conditions of risk. Journal of Finance 19, 425-442.
TOBIN, J. 1958. Liquidity preference as behavior towards risk. The Review of Economic Studies 25, 65-86.