MMUBS ELECTRONIC SUBMISSION ASSESSMENT COVER SHEET

Student Name: Agreed mark Late penalty Final mark

KUHAN DEVADOSS
Programme Title: Unit Title:

BAAF
Registration Number:

Corporate Finance
Assessment Title/Number:

11063558

Portfolio Theory

Year/Stage:

Due Date:

25/01/2012

Unit Leader/Dissertation Supervisor/Subject Tutor:

John Keenan / Steven Wynne

Declaration: I/We declare that this assignment is all my/our own work, that it has not been copied from elsewhere and that any extracts from books, papers or other sources have been properly acknowledged as references or quotations. In addition I/we agree that this assignment may be subject to electronic analysis for the detection of collusion, plagiarism and other forms of unfair advantage.

Please tick the box to confirm acceptance of the above declaration.

Date:

20

Jan. 12

Investment Portfolio Diversification Reduce or remove unsystematic risk in investment is the logical or precise way to correspond about Investment Portfolio Diversification. Furthermore a risk which is not linked to the price variability of the whole securities markets might well furthermore be lessened. Unsystematic risk is the risk which associates to company-specific risk factors, such as more or bigger competition, such as labour strikes, corrupt organisation decisions, unfavourable technological changes and many more. possessing a very largely expanded portfolio comprising the securities of various corporations appearing in diverse economic fields, therefore the risk that appear in a portfolio can be significantly be lowered. Unsystematic risk can be fully eliminated, by means of hanging on the full market in a portfolio through broad-based index funds. (Personal Investment Management and Financial Planning)[Online] Unsystematic risk can be getting rid of, for the reason that there is no correlation involving the opportunities and risk elements which involve each certain company. To the level that when keep over one company in a portfolio along with a very large number of them, as a consequence the firms detailed price changes have a habit of to cancel out the securities price fluctuations of other firms. As a result, the securities market risk measured by its market price instability will remain, when its fully diversified. (Markowitz, 1991) Markowitz portfolio theory Markowitz portfolio theory or modern portfolio theory is a theory that deals with the value as well as risk of portfolios instead of individual securities. The significant outcome in portfolio theory is that the instability of a portfolio is less than the weighted average of the instabilities of the securities it contains. (Markowitz, 1991); ( MONEYTERMS) [Online] Diversification reduces risk because of the expected returns of the securities, for example supposing the covariance remains less than one, and therefore it would remain less than the weighted average of the standard deviation of the expected returns of the securities. Moreover, other significant consequences in Markowitz portfolio theory, is the one deals with the comprehension of effective portfolios. Regardless of being the standard textbook description of portfolio risk and return, the Markowitz portfolio theory was not generally recognised worldwide. Markowitz himself assumed in general, that scattered variance is an insufficient measure of risk. Samples has been come up with, so that it can be used in uneven and probability distribution or better known as the fat tailed distributions. In addition to it, there were also added fundamental complaints, as well as an alternative behavioural portfolio theory. [Elton et al. (1978)] Therefore any theory or strategy that suggests it is likely to overtake the market without taking extra risk will cancel out Markowitz portfolio theory, as well as the data for the value effect or the presence of continuing taking advantage of a price difference between two or more markets.

Markowitzs analysis of portfolio theory on process and purpose of investment portfolio diversification Markowitzs Portfolio theory permits investors to evaluate mutually the estimated risks as well as the returns, as evaluated statistically, for their investment portfolios. Markowitz described in what manner to relate assets into economically diversified portfolios. Moreover

it have being his view that a portfolio's risk may possibly come about to be decreased as well as the expected rate of return may well be developed if the outlays holding unrelated price movements happened to merged. [Faboozi and Markowitz (2004)] Markowitz also made clear on in what best way to bring together a diversified portfolio as well as proved that such a portfolio would to be expected do positively. Markowitzs Portfolio theory investment process is get expected return model along with Volatility and constraints correlation estimates and also Constraints on portfolio. This will lead to Portfolio Optimization, and then to risk return efficient frontier and finally the choice of portfolio. How to Identify Efficient Frontier The efficient frontier meant for the collection of assets had been selected to be your investment. The group of portfolios which is able to construct from that investment. The estimated earnings are greater than the other possible portfolios with comparable levels of risk. They are proficient on a reward to inconstancy basis, which was in the modern portfolio theory, which uses mean-variance method to identify the efficient frontier. International Investment and the Efficient Frontier Curve Financing in overseas markets profits financiers or investors who would want to diversify their risk, these can bring high risk as well as reward. It increases to an individuals portfolio aimed at prospects in an international market. Investing internationally brings diversification benefits and creates a major impact on the efficient frontier curve. The efficient frontier is a combination of assets.it has the best possible expected level of return for its level of risk. at this point, each and every potential grouping of risky assets, deprived of involving at all any investments of the risk-free asset, can be conspired in riskexpected return space, moreover the collection of all such probable portfolios describes a section here. The upward curve part of the left boundary of this region, called the "efficient frontier". (Wikipedia)[Online] To get the highest returns, it must take on the highest risk whereas the low risk will bring low returns, and as we continue up the curve, the larger the quantity of risk, the profit our portfolio gains. Whatsoever exceeding the efficiency curve is impractical. The portfolio will not surpass the efficient frontier curve for the reason that there is definitely a thing as low risk bringing high returns for example you dont get salary by not working. However, international investing is able to uplift the efficient frontier curve to get more risk and higher returns. Its good to be investing globally, as its a great opportunity to see each countries business stages. Its because, they can diversify the risk into nations with stronger operating markets. Moreover its a portfolio managers duty to decide if the country they are investing in, is in a narrowing our growing cycle. Given that, investing nationally can only bring on systematic risk, however investing globally gives the portfolio manager unsystematic or diversifiable risk as the cross-market connections are low. (Wikipedia)[Online]

How to Identify Optimal Portfolio Investors main aim is to maximising their profit, therefore they believe that they can actually attempt to reduce the risk though getting a huge profit. No two tigers are the same, likewise not all portfolios are alike, and they have variable degree of risk and return. Each investor must allocate their portfolios depending on how much risk they can manage, and thus diversify them. (Investopedia) [Online] The optimal-risk portfolio is normally set to be around the middle of the curve. Its because at the high end of the curve, its higher risk therefore higher return worth taking the risk by the investors. Where else the other end of the curve which is the low end, the risk is low, therefore the portfolios worthless to invest for. [Elton et al. (1978)] Calculating the Optimal Portfolio is not easy as it looks like, its needs a program to do it. This is because its determined by different expected risk and return which deals with thousands. [Elton et al. (1978)](Investopedia) [Online]

(Investopedia) [Online]

Assumptions and Limitations of Portfolio Theory Assumptions The Portfolio Theory is has so many assumptions, most of which damage the Theory to certain point. The key assumptions are:

All investors aim to maximize profit and minimize risk. All investors act rationally and are risk averse. All investors have access to the same information at the same. Correlations between assets are fixed and constant forever. There are no taxes or transaction costs. Any investor can borrow unlimited amounts of shares with no credit limits and at the risk free rate of interest.

Limitations Firstly the connections between risk and return are constructed by past performance, therefore it doesnt promise a good future for the investors. Its also mathematically calculated and the values are based on past performance Secondly, the proposition of investors being able to buy securities of any sizes is not realistic because certain securities have minimum order sizes and securities cannot be bought or sold in portions. Furthermore investor cant borrow unlimited amounts of shares cause of their credit limits.

Then, the theory that the actions of investors have no impact on the market is also completely rubbish, as great volume of sale or purchase of individual securities effect the price of the security. Finally, connections concerning assets are never permanent and changes with the international demand that occur concerning important assets. Furthermore, its been monitored that the return on assets is not constantly allocated because of the repeated shifts in international level. ( Portfoliotheory) [Online]

Conclusion The Portfolio Theory describes the connection linking risk and reward, that has laid the basis for management of portfolios as it is done today. It stresses on the importance of the relationship between securities and diversification to create optimal portfolios and reduce risk. It derives two main conclusions which are of significance even today. The first being that instability is risky if the time limit is short and the second being that diversification reduces risk as the risk value of a diversified portfolio is excluding the average risk of each of its section securities. Nevertheless the theory was not entirely useful because of the limitations in its assumptions; it smoothed method of value at risk measures now. The theory has also undertaken many efforts to makeshift with more accurate hypothesises.

Bibliography

Books
1. Edwin J. Elton, Martin J. Grubber and Manfred W. Padberg, Optimal

portfolios from simple rank devices, Journal of Portfolio Management, Vol. 4, No. 3, Spring 1978, pp. 15-19; [Elton et al. (1978)]
2. Frank J.Faboozi, Harry M. MarkowitzThe Theory & Practice of Investment

Management, 17 Feb 2004 [Faboozi and Markowitz (2004)]

3. Harry M. Markowitz Portfolio Selection, Efficient diversification of

Investment,1991 Webpage

1. Personal Investment Management and Financial Planning (2006) What Is

Investment Portfolio Diversification [Online] [Accessed on 17th JANUARY 2012] http://www.theskilledinvestor.com/wp/what-is-investment-portfoliodiversification-162.htm

2. MONEY TERMS. (2005) Modern/Markowitz portfolio theory [Online] [Accessed

on 17th JANUARY 2012] http://moneyterms.co.uk/portfolio-theory/
3. Wikipedia(2011) Efficient frontier [Online] [Accessed on 17th JANUARY 2012]

http://en.wikipedia.org/wiki/Efficient_frontier

4. Investopedia(2011)The Optimal Portfolio [Online] [Accessed on 20th JANUARY

2012]http://www.investopedia.com/university/concepts/concepts7.asp#ixzz1k1nk 3upF
5. Portfolio Theory (2011) Portfolio Theory, an Overview of Harry Markowitz

Portfolio Selection Work. [Online] [Accessed on 17th JANUARY 2012] http://portfoliotheory.co.uk/

6. London Business School (12 April, 2001) Optimal Portfolios

http://faculty.london.edu/ruppal/PublishedPapers/2001-Uppal-OptimalPortFT.pdf] [Online] [Accessed on 20th JANUARY 2012]