This essay is concerned with understanding the key issues relative to portfolio analysis and investment. The scope of this essay will be limited to the U. S. Stock markets only. This essay will be built upon extant portfolio theory and will discuss different types of risks that investors might face and how they go about managing such risks. Under consideration will be topics such as efficient frontier and optimal portfolios as well as their relevance to investment theory, under the assumption of direct investment in the stock market.
DETERMINING THE PURPOSE OF YOUR INVESTMENT
One of the steps in building an investment portfolio is to establish investment goals. ...view middle of the document...
MPT utilizes several basic statistical measures to develop a portfolio plan (Gitman, et al, 2005). Included are expected returns and standard deviations of returns for both securities and portfolios, and the correlation between returns (Gitman, et al, 2005). Detailing the mathematics of diversification, Markowitz proposed that investors focus on selecting portfolios based on their overall risk-reward characteristics instead of merely compiling portfolios from securities that individually have attractive risk-reward characteristics (riskglossary.com, 2006). This theory proposes that the risk of a particular stock should not be looked at on a standalone basis, but rather in relation to how that particular stock's price varies in relation to the variation in price of the market portfolio (investorwords.com, 2005). The theory goes on to state that given an investor's preferred level of risk, a particular portfolio can be constructed that maximizes expected return for that level of risk (investorwords.com, 2005).
The MPT model assumes that investors are risk averse (Wikipedia.com, 2006). This means that given two assets that offer the same return, investors will prefer the less risky one (Wikipedia.com, 2006). Thus, an investor will take on increased risk only if compensated by higher expected returns (Wikipedia.com, 2006). Conversely, an investor who wants higher returns must accept more risk (Wikipedia.com, 2006). The implication is that a rational investor will not invest in a portfolio if a second portfolio exists with a more favorable risk-return profile (Wikipedia.com 2006). Two important aspects of MPT are the efficient frontier and portfolio betas (Gitman, et al, 2005).
THE EFFICIENT FRONTIER
The efficient frontier can, in theory, be used to find the highest level of satisfaction the investor can achieve given the available set of portfolios (Gitman, et al, 2005). This concept considers a multitude of risky investments and explores what might be an optimal portfolio based upon those possible investments. An optimal portfolio is such that it "provides the highest return for a given level of risk or provides minimum risk for a given level of return (Gitman, et al, 2005); achieving the best possible trade-off between risk and return. The notion of "optimal" portfolio can be defined in one of two ways (riskglossary.com, 2006):
Definition 1 produces an optimal portfolio for each possible level of risk: for any level of volatility, consider all the portfolios which have that volatility. From among them all, select the one which has the highest expected return.
Definition 2 produces an optimal portfolio for each expected return: for any expected return, consider all the portfolios which have that expected return. From among them all, select the one which has the lowest volatility.
Each definition produces a set of optimal portfolios (riskglossary.com, 2006). That set of optimal portfolios is called the efficient...