Week 04 - Modern portfolio theory


In the fourth week of lectures we were taught on the topic modern portfolio theory. This theory is an investment theory, based on the idea that risk-averse investors can create portfolios to max out the expected return based on a given level of market risk  considering that this risk is part of the reward.  This is one of the most important theories behind finance and investments. Another factor that this theory suggests is that investors given two portfolios would prefer the less risky one over the other. Therefore this suggests that investors will be willing to go for high risk portfolios if the return is fairly high compared to the other. this means that an investor must undergo a higher risk if they are aiming for a higher reward.  The same theory applies for each and every investor. Each investor will evaluate this theory in many different ways. A method which could be used to reduce the portfolio risk would be  by holding combinations of instruments that are not perfectly positively correlated. This theory is one of the most important theories in economy to deal with finance and investments. The modern portfolio theory was initially developed by Harry Markowitz and published in 1952. This theory suggests that it is wiser to invest on several assets possessing lower risks simultaneously rather than investing on a single asset which poses a higher risk. This will benefit the portfolio. Therefore the main objective of MPT is to choose the right combination of portfolios in order to obtain maximum advantage.
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Bondie et al., (2009) states that this theory is mostly based on examining the risk- reward characteristics of a portfolio rather than it is on individual securities.  It is said that investors must not hold single asset must instead have groups or portfolios of assets. If this method was followed by the investors, they might be able to gain diversification, which means that the particular individual will posses a lower level of risk of his portfolio of assets compared to any of the  individual assets.
When dealing with this theory there are few assumption based on it such as;

  • Investors ask for maximizing the expected return of their wealth
  • All investors have the similar expected single period investment horizon
  • All investors are risk-averse, which means that they only accept a higher risk if they are compensated with a higher expected return
  • Investors prefer higher returns to lower returns for a given level of risk


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