Investment Concepts

This article focuses on investment concepts such as modern portfolio theory and post modern portfolio theory. Modern Portfolio Theory (MPT) provides an opportunity for investors to utilize diversification in order to maximize the potential of their portfolio, and assumes that the investor is adverse to risk. Post modern portfolio theory guides the path toward an enriched science of investment that assimilates DRO and behavioral finance with other forms of novelty that results in more positive outcomes. There is a discussion of why people should invest as well as an introduction of the capital asset pricing model.

Keywords 401 (k); Investment; Modern Portfolio Theory; Mutual Funds; Portfolio Management; Post-Modern Portfolio Theory; Retirement Plan; Stock Market

Finance > Investment Concepts

Overview

It has been suggested that most Americans do not know how to save or prepare for their future. As a result, many financial investment companies have approached employers as well as individuals in an attempt to educate the masses on the benefits of investing. Some of the tips that have been provided by organizations, such as the American Association of Individual Investors, include:

• Build and advance a cash reserve that can cover short-term dangers and liquidity requirements.
• Develop an overall investment strategy even if it cannot be implemented immediately.
• Select mutual funds that fit into the overall investment strategy, then consider what the minimum initial investments are.
• Choose a balanced fund for those who invest less aggressively and choose a wider-based index fund for those who invest more aggressively. Build the portfolio after this initial investment has been completed.
• Review the rate and level of commitment in relation to each of the stock market segments as a means to decide whether or not to increase the amount of funds given to the initial investment.
• Do not agonize over small deviations from the original allocation plan. Stay the course! (p. 1-2).

Modern Portfolio Theory

Financial counselors may inquire about whether or not an organization has some type of retirement plan, such as a 401 (k) plan, in place for their employees or they may go directly to the employee for supplemental retirement opportunities. One popular approach that has emerged is the modern portfolio theory. Modern Portfolio Theory sounds like it is an academic and analytical concept; however, "it is the accepted approach to investment and portfolio management today" (American Association of Individual Investors, n.d.). The relationship between risk and return tend to form the foundation for investment theory. However, a third dimension, modern portfolio theory, can be added to the equation in order to create a framework that can assess investment opportunities that exist for the sole purpose of making money (Dunn, 2006).

Modern Portfolio Theory (MPT) provides an opportunity for investors to utilize diversification in order to maximize the potential of their portfolio, and assumes that the investor is adverse to risk. Therefore, the investor will only take a risk if he/she has determined that the risk will provide them with a higher expected return. In essence, the investor has to be willing to take on more risk in order to be compensated with higher returns.

Parts of the Modern Portfolio Theory Approach

The concept can be used by both individuals and corporations, and can be used in determining how one can optimize his/her portfolio as well as what the price should be for a risky asset. According to the Association of Individual Investors, there are two parts of this approach and they are:

• First part — focus on the concept that the best combination of assets should be developed by focusing on how the various components perform relative to each other.
• Second part — focus on the belief that the natural outcome of many people searching for under priced securities in the markets should be an "efficient market" in which it is difficult to add value by finding under priced securities, especially since it is expensive to do so (par. 4 and 5).

Harry Markowitz

MPT was introduced by Harry Markowitz, an economist and college professor, when he wrote an article entitled "Portfolio Selection" in 1952. He eventually became a Nobel Prize recipient for his work in the field. Prior to his work, most investors only focused on the best way to assess risks and receive rewards on individual securities when determining what to include in the portfolio. Investors were advised to develop a portfolio based on the selection of those securities that would offer them the best opportunity to gain. Markowitz took this practice and formulized it by creating a mathematical formula of diversification. "The process for establishing optimal (or efficient) portfolio generally uses historical measures for returns, risk (standard deviation) and correlation coefficients" (Money Online, n.d., para. 6). He suggested that investors focus on selecting portfolios that fit their risk-reward characteristics (Markowitz, 1959).

Application

Capital Asset Pricing Model (CAPM)

In order to select investments for a portfolio, modern portfolio theory will use the capital asset pricing model (Wise Geek, n.d.). The capital asset pricing model (CAPM) is utilized to calculate a theoretical price for a potential investment, and has a linear correlation between the returns of the shares and what the stock market earnings as time passes. The model analyzes the risk and return rates that can be expected for individual capital to market returns. It can be used to:

• Institute the preferred equilibrium market price of a company's assets.
• Institute the price that a company’s equity is expected to cost, taking into consideration the risk components involved in a business’s investments.

There will always be some type of risk associated with an investment portfolio. The degree of risk can fluctuate between industries as well as between companies. A portfolio's risk is divided into two categories — systematic and unsystematic risk. Systematic risk refers to investments that are naturally riskier than others, and unsystematic risk refers to when the amount of risk can be minimized through diversification of the investments.

CAPM Assumptions

The CAPM operates on a set of assumptions such as:

• Investors are risk adverse individuals who maximize the expected utility of their end of period wealth, which implies that the model is a one period model.
• Investors have homogenous expectations about asset returns, which indicate that all of the investors perceive themselves to have the same opportunity sets.
• Asset returns are distributed by the normal distribution.
• A risk free asset exists and investors may borrow or lend unlimited amounts of this asset at a constant rate, which is the risk free rate.
• There are definite numbers of assets and their quantities are fixed within the one period model.
• All assets are perfectly divisible and priced in a perfectly competitive market.
• Asset markets are frictionless and information is costless and simultaneously available to all investors.
• There are no market imperfections such as taxes, regulations, or restrictions on short selling (Value Based Management.net, n.d., p. 7).

In addition, the CAPM model includes the following propositions:

• Investors in shares require a return in excess of the risk free rate, to compensate for the systematic risk.
• Investors should not require a premium for unsystematic risk because it can be diversified away by holding a wide portfolio of investments.
• Since systematic risk varies between companies, investors will require a higher return from shares in those companies where the systematic risk is greater.

The same propositions can be applied to capital investment by companies:

• Companies expect a return on a project to exceed the risk free rate so that they can be compensated for the systematic risk.
• Unsystematic risk can be diversified away, which implies that a premium for unsystematic risk is not required.
• Companies should strive for a bigger return on projects when the systematic risk is greater (Value Based Management.net, n.d., p. 7).

Disadvantages of CAPM

However, there are some disadvantages to the CAPM, which include:

• The model assumes that asset returns are normally distributed random variables. However, it has been observed that returns in equity and other markets are not normally distributed, which results in large swings in the market.
• The model assumes that the variance of returns is an adequate measurement of risk.
• The model does not appear to adequately explain the variation in stock returns.
• The model assumes that given a certain expected return, investors will prefer lower risk to higher risk.
• The model assumes that all investors have access to the same information and agree about the risk and expected return of all assets.
• The model assumes that there are no taxes or transaction costs. However, this assumption may be relaxed with more complicated versions of the model.
• The market portfolio consists of all assets in all markets where each asset is weighted by its market capitalization.
• The market portfolio should in theory include all types of assets that are held by anyone as an investment and people usually substitute a stock index as a proxy for the true market portfolio.
• Since CAPM prices a stock in terms of all stocks and bonds, it is really an arbitrage pricing model which throws no light on how a firm's beta is determined (Value Based Management.net, n.d., p. 7).

Viewpoint

Post-Modern Portfolio Theory

Although modern portfolio theory has been instrumental and valuable in the investment world, there are limitations. "MPT is limited by measures of risk and return that do not always represent the realities of the investment markets" (Rom & Ferguson, n.d., p. 349). As a result, there has been a paradigm shift that expands on the risk-return formula. The new model is referred to as the post-modern portfolio theory.

According to Swisher and Kasten (2005), some of the highlights of the post-modern portfolio theory are:

• The theory presents a new method of asset allocation that optimizes a portfolio based on returns versus downside risk instead of mean-variance optimization.
• The core innovation of post modern portfolio theory is its recognition that standard deviation is a poor proxy for how people experience risk.
• Downside risk is a definition of risk derived from three sub-measures, which are downside frequency, mean downside deviation, and downside magnitude. Each of these measures is defined with reference to an investor-specific minimal acceptable return (MAR).
• Portfolios created using a mean-variance optimization model and downside risk optimization are often similar and the differences in absolute risk and return values are small, which means that diversification works regardless of how it is measured.
• Post modern portfolio theory points the way to an improved science of investing that incorporates not only DRO but also behavioral finance and any other innovation that leads to better outcomes (Swisher & Kasten, 2005, p. 1).

Conclusion

It has been suggested that most Americans do not know how to save or prepare for their future. Financial counselors may inquire about whether or not an organization has a some type of retirement plan (i.e. 401 (k) plan) in place for their employees or they may go directly to the employee for supplemental retirement opportunities. Some of the most common myths about retirement planning include:

• Myth 1 — You will not need as much money during retirement as you do now. The general rule of thumb is that you will need at least 70% of the income that you earned prior to retiring in order to maintain the type of lifestyle that you have become accustomed.
• Myth 2 — Retirement years will not last long. Today, people are living longer, and the life expectancy is approximately 21 years after the age of 65. Therefore, it is important to plan knowing that there is a strong possibility that one will have time to enjoy the retirement years.
• Myth 3 — It's possible to start planning for retirement a few years before it is time to actually retire. It's never too early. The sooner you start, the better. You will have the opportunity to accumulate and earn more money.
• Myth 4 — Social Security will provide enough income for the retirement years. Social Security only provides approximately 38% of the retirement income.
• Myth 5 — Pension Plan will provide enough income for the retirement years and there is no need to save more. If one does not plan ahead of time, there is no way to determine whether or not the pension plan plus social security is enough for the retirement years. In addition, many employers have replaced defined benefit plans with 401 (k) plans.
• Myth 6 — Medicare will take care of health insurance. Medicare pays less than half of a person's healthcare expenses and a person has to be 65 years old in order to be considered eligible for Medicare.
• Myth 7 — All of a person's assets are in safe vehicles for long-term accumulation and do not need to be watched closely. All investment should be watched in order to determine if changes need to be made. The market can be volatile and people should make sure that they are not positioned to experience devastating risk.
• Myth 8 — A person can use the equity in home to add to retirement income. It is unlikely that the equity will add much to a person's retirement income. The price of homes fluctuates. However, if the home is not used to supplement retirement income, a person should take advantage of all the tax breaks that are available, especially when downsizing.
• Myth 9 — If need be, my family can always help me out. It is not wise to be expecting others to come to your rescue, especially for financial issues. Also, most people do not want to rely on their family members, but use this excuse as a way of delaying retirement planning.
• Myth 10 — Money is everything when it comes to retirement planning. Although money is important, it's actually the lifestyle decisions that a person should be concerned with when planning for retirement.

Modern Portfolio Theory (MPT) provides an opportunity for investors to utilize diversification in order to maximize the potential of their portfolio, and assumes that the investor is adverse to risk. Therefore, the investor will only take a risk if he/she has determined that the risk will provide them with a higher expected return. In essence, the investor has to be willing to take on more risk in order to be compensated with higher returns.

In order to select investments for a portfolio, modern portfolio theory will use the capital asset pricing model (Wise Geek, n.d.). The capital asset pricing model (CAPM) is utilized to calculate a theoretical price for a potential investment, and has a linear correlation between the returns of the shares and what the stock market earnings as time passes. The model analyzes the risk and return rates that can be expected for individual capital to market returns. It can be used to:

• Institute the preferred equilibrium market price of a company’s assets.
• Institute the price that a company’s equity is expected to cost, taking into consideration the risk components involved in a business’s investments.

Highlights of Post Modern Portfolio Theory

According to Swisher and Kasten (2005), some of the highlights of the post-modern portfolio theory are:

• The theory presents a new method of asset allocation that optimizes a portfolio based on returns versus downside risk instead o mean-variance optimization.
• The core innovation of post modern portfolio theory is its recognition that standard deviation is a poor proxy for how people experience risk.
• Downside risk is a definition of risk derived from three sub-measures, which are downside frequency, mean downside deviation, and downside magnitude. Each of these measures is defined with reference to an investor-specific minimal acceptable return (MAR).
• Portfolios created using a mean-variance optimization model and downside risk optimization are often similar and the differences in absolute risk and return values are small, which means that diversification works regardless of how it is measured.
• Post modern portfolio theory points the way to an improved science of investing that incorporates not only DRO but also behavioral finance and any other innovation that leads to better outcomes (p. 1).

Terms & Concepts

401 (k): A retirement plan that employees sponsor in order to receive tax benefits on retirement savings.

Investment: The process of investing money or capital into an enterprise in hopes of having the money grow and create a worthwhile profit.

Modern Portfolio Theory: An idea that follows risk-averse investors and their ability to create portfolios to increase the anticipated returns hinging on the market risk level. The theory focuses on risk and the idea that it is an essential and significant piece of gaining higher returns.

Mutual Fund: An investment business that provides new shares and re-purchases current shares based on the requests of the shareholders. The company also utilizes its assets to invest in different and diverse contracts of other businesses.

Portfolio Management: The process of creating and implementing decisions regarding investment mix and related policies. Other responsibilities include corresponding investments to their objectives, allocating assets for people and businesses, and assessing the balance of risk versus performance.

Post-Modern Portfolio Theory: A theory which proposes how rationally thinking investors tend to utilize diversification to their advantage by including it in their portfolios. It also proposes how delicate and unstable assets should be appraised.

Retirement Plan: An approach supplied by an employer that allows its employees to invest in their retirement.

Stock Market: The business transacted at a stock exchange.

Bibliography

American Association of Individual Investors (n.d.). From theory to practice: How to apply MPT concepts to your 401(k) plan. Retrieved September 27, 2007, from http://www.aaii.com/includes/DisplayArticle.cfm?Article%5fId=2974&ro=2245

American Association of Individual Investors (n.d.). Investing basics: Investing questions that every successful investor should know how to answer. Retrieved September 27, 2007, from http://www.aaii.com/faqs/investingbasics.cfm

American Association of Individual Investors (n.d.). The ten myths of retirement planning. Retrieved September 27, 2007, from http://www.aaii.com/includes/DisplayArticle.cfm?Article%5fId=2977&digit=256

Bigda, C. (2012). The end of investing. Money, 41, 84-90. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=82564126&site=ehost-live

Dunn, B. (2006, August). Modern portfolio theory — with a twist: The new efficient frontier. Aquillian Investments, Inc. Retrieved on September 27, 2007, from http://www.aquillian.com/docs/AquillianEfficientFrontier.pdf

Geambasu, C., Sova, R., Jianu, I., & Geambasu, L. (2013). Risk measurement in post-modern portfolio theory: differences from modern portfolio theory. Economic Computation & Economic Cybernetics Studies & Research, 47, 113-132. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=86991912&site=ehost-live

Markowitz, H. (1959). Portfolio selection: Efficient diversification of investments. New York, NY: John Wiley.

Modern portfolio theory. (2007). Money Online. Retrieved September 27, 2007, from http://www.moneyonline.co.nz/calculator/theory.htm

Rom, B., & Ferguson, K. (n.d.). Post-modern portfolio theory comes age. Sponsor-Software Systems, Inc. Retrieved September 27, 2007, from http://www.actuaries.org/AFIR/colloquia/Orlando/Ferguson%5fRom.pdf

Smart investing: It's really as easy as one, two, three. (cover story). (2012). Kiplinger's Personal Finance, 66, 30-34. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=82153660&site=ehost-live

Swisher, P., & Kasten, G. (2005, September). Post-modern portfolio theory. Journal of Financial Planning, 7. Retrieved September 27, 2007, from http://www.fpanet.org/journal/articles/2005%5fIssues/jfp0905-art7.cfm

Value Based Management.net (n.d.). CAPM — Capital asset pricing model. Retrieved September 27, 2007, from http://www.valuebasedmanagement.net/methods%5fcapm.html

Wise Geek (2007). What is modern portfolio theory? Retrieved September 27, 2007, from http://www.wisegeek.com/what-is-modern-portfolio-theory.htm

Suggested Reading

Bland, L. (2005). A modern take on an old portfolio theory. Money Management, 19, 26-26. Retrieved September 27, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=17176205&site=bsi-live

Curtis, G. (2002). Modern portfolio theory and quantum mechanics. Journal of Wealth Management, 5, 7. Retrieved October 5, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=8594085&site=bsi-live

Simon, W. (2005). Illuminating the broad range requirement of ERISA section 404(c) with the language of modern portfolio theory found in the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). Journal of Pension Benefits: Issues in Administration, 13, 87-90. Retrieved September 27, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=18419841&site=bsi-live