Free Essay

Portfolio Theory Assumptions

In: Business and Management

Submitted By sallysh
Words 352
Pages 2
To reiterate some of the assumptions that Ellie mentioned earlier plus a few more. These misleading assumptions have been proven wrong so they weaken the theory. * Assumptions: * All investors act rationally and are risk-averse.
Proven wrong by behavioural economists. * Investors all have access to the same sources of information for investment decisions
False because market is asymmetrical with information – due to insider trading and some investors are more informed than others. Many online publications charge members to access their sites, such as The Wall Street Journal or Bloomberg. So investors who don’t pay the additional fee are not as informed. * Investors base decisions solely on expected return and risk (derived from historical returns).
The drawback is that optimal asset allocations are highly sensitive to small changes in inputs, especially expected returns. Portfolios may not be well diversified. * Investors can borrow and lend at a risk-free rate.
The drawback is that borrowing rates are always higher than lending rates. Certain investors are restricted from purchasing securities on margin. * Investors can buy securities of any size.
False as some securities have minimum order sizes. And securities cannot be bought or sold in fractions. Also, each investor has a credit limit so they cannot lend or borrow unlimited amounts of shares. * Single-period perspective.
Investors rarely have a single-period perspective in determining their asset allocation. * Constant returns to scale and infinitely divisible projects.
Not guaranteed, may not occur every time. In reality, most projects cannot always be divided as demanded by the optimum results. * Expected values calculated based on past performance to measure correlation between return and risk.
Not a guarantee of future performance. Leaves out current situations that were not available at the time of collection of the old scenarios. * Ignores various other types of risk.
The definition of risk in the theory is limited to price volatility. It ignores any potential social or environmental risks that investment may have, just focuses on financial risk. EX: BANKRUPTCY * Risk measurement is probabilistic, not structural.
Tells about the likelihood of losses, but not the reasons or explanations why or how it works.…...

Similar Documents

Premium Essay

Portfolio Theory

...6053 BAUSAE Personal Finance Portfolio Report on Trading Investment Strategy Oct-Nov 2012 Nicola Kirk-420355 Word count-2870 Contents Justification of Strategy 3-4 EMH Portfolio Performance 5-9 Taxation Calculations Evaluation of portfolio performance 10-11 Jensen Treynor Sharpe Appendix 12 Bibliography 13 Justification of strategy After receiving the inheritance of £100,000 the first major financial decision was to select an account to invest the total amount in. I placed it in an instant access account with Derbyshire Building Society with an annual interest rate of 2.5% AER which included a 1% bonus for the first year. This allowed unlimited free withdrawals and a minimum balance of £1(after the initial opening balance of £1,000). This is a very low risk investment, as the first £85,000 would be protected also giving a small but constant and reliable income from the interest. In addition to this the account can be very easily liquidated when required. Hargreaves Lansdown was the stockbroker chosen for all trading as they offered competitive rates. They charge £11.95 for 0-9 transactions, £8.95 for 10-19 transactions and £5.95 for 20+ transactions. When deciding what assets to invest in I decided not to invest in currency, as they are extremely volatile, unpredictable and wouldn’t give as significant a return......

Words: 3296 - Pages: 14

Premium Essay

Relationship Between Accounting Assumption, Principles, and Theories

...The objective of this individual assignment is to understand the relationship between accounting assumption, principles and how does they assist in financial reporting. It is also to understand what types of accounting theory that relevant with the accounting principles. Going concern assumption is one of accounting assumptions which is about financial activities of a business are assumed to be in operation for long period of time. This assumption is allows a business to operate in long term view. This assumption is very critical where there is no short term end of point. (Simple studies, 2010). Full disclosure principle is one of accounting principles that constitute with going concern assumption. The principle is about all past, present and future information that may have made an impact on the financial performance of the company needs to be fully disclosed. Even though the historical performance of company is readily available, but the numbers does not always provide the entire picture of company. Full disclosure of information is need because it is reflect the economic condition of company. This principle is also important in order to assist decision maker to make decision. (Simple studies, 2010). In this condition where full disclosure principle is coherent with going concern assumption can be relate with accounting rule FRS136, which is about impairment of assets. This standard is to ensure the values of assets are disclosed in the balance sheet, where the......

Words: 934 - Pages: 4

Premium Essay

Portfolio Theory

...PORTFOLIO THEORY Let us begin our discussion on Portfolio Theory with an example of two investments (assets or securities) – Ace and Bravo. Their return expectations are given in the table below. You will notice that both Ace and Bravo are risky investments because they do not offer a certain return. You can begin by comparing the expected return and risk of Ace and Bravo: State of Probability Return Economy of occurrence Ace Bravo Boom 0.2 +20 -15 Growth 0.6 +5 +5 Recession 0.2 -10 +25 1. What kind of a correlation do you observe between the two securities? 2. Calculate the expected return and standard deviation of both Ace and Bravo. Interpret the results. Expected Return = E(R) = ∑ ri.pi for each state of the economy Standard Deviation = σ = √ [∑(ri – E(R))2 .pi] Thus calculated, we have the following results: |Security |Expected Return |Expected Risk | | | |(measured by σ) | |Ace |5% |±9.49% | |Bravo |5% |±12.65% | Ace is better than Bravo when viewed in the risk-return framework, because it......

Words: 3035 - Pages: 13

Premium Essay

Mean-Variance Portfolio Theory

...2. Mean-variance portfolio theory (2.1) Markowitz’s mean-variance formulation (2.2) Two-fund theorem (2.3) Inclusion of the riskfree asset 1 2.1 Markowitz mean-variance formulation Suppose there are N risky assets, whose rates of returns are given by the random variables R1 , · · · , RN , where Rn = Sn(1) − Sn (0) , n = 1, 2, · · · , N. Sn(0) Let w = (w1 · · · wN )T , wn denotes the proportion of wealth invested in asset n, N with n=1 wn = 1. The rate of return of the portfolio is N RP = n=1 wnRn . Assumptions 1. There does not exist any asset that is a combination of other assets in the portfolio, that is, non-existence of redundant security. = (1 1 · · · 1) are linearly independent, otherwise 2. µ = (R1 R2 · · · RN ) and RP is a constant irrespective of any choice of portfolio weights. 1 2 The first two moments of RP are N N µP = E[RP ] = n=1 E[wn Rn] = n=1 N wnµn, where µn = Rn, and 2 σP = var(RP ) = N N N wiwj cov(Ri, Rj ) = i=1 j=1 i=1 j=1 wiσij wj . Let Ω denote the covariance matrix so that 2 σP = wT Ωw. For example when n = 2, we have (w1 w2 ) σ11 σ12 σ21 σ22 w1 w2 2 2 2 2 = w1 σ1 + w1w2(σ12 + σ21) + w2 σ2 . 3 Remark 2 1. The portfolio risk of return is quantified by σP . In mean-variance analysis, only the first two moments are considered in the portfolio model. Investment theory prior to Markowitz considered the maximization of µP but without σP . 2. The measure of risk by variance would place equal weight on the upside deviations and......

Words: 4368 - Pages: 18

Premium Essay

Investment & Portfolio Theory

...000219978 | 0.03294225 | Question 4 Portfolio weights for given Expected returns (generated via Solver) | Min Variance | Portfolio 1 | Portfolio 2 | Portfolio 3 | Portfolio 4 | Portfolio 5 | Portfolio 6 | Portfolio 7 | Portfolio 8 | Expected Return | 0.077691577 | 0.08 | 0.085 | 0.09 | 0.095 | 0.1 | 0.105 | 0.11 | 0.115 | Variance | 0.072897979 | 0.073085745 | 0.074755718 | 0.078050518 | 0.082776348 | 0.088704786 | 0.095612388 | 0.103302919 | 0.111614658 | Slope | 1.065757625 | 1.0946047 | 1.137036767 | 1.153099335 | 1.14767083 | 1.127334888 | 1.098184055 | 1.064829543 | 1.030330622 | | | | | | | | | | | US Equity | -0.069956996 | -0.047943261 | -0.000660991 | 0.046621225 | 0.093903482 | 0.141185707 | 0.188467905 | 0.23575012 | 0.28303232 | Foreign Equity | 0.164559275 | 0.168031017 | 0.175315021 | 0.182599062 | 0.189883125 | 0.197167128 | 0.204451215 | 0.211735309 | 0.21901937 | Bonds | 0.491324288 | 0.454525668 | 0.374486506 | 0.294447346 | 0.214408212 | 0.134369047 | 0.054329898 | -0.025709253 | -0.105748401 | REITs | 0.236442634 | 0.234646115 | 0.231661995 | 0.228677873 | 0.225693681 | 0.222709578 | 0.219725426 | 0.21674127 | 0.213757121 | Commodities | 0.177630798 | 0.190740461 | 0.219197469 | 0.247654494 | 0.2761115 | 0.304568541 | 0.333025555 | 0.361482554 | 0.38993959 | This data displays a typical efficient frontier for different combinations of risky assets. It can be observed that these portfolios effectively manage to......

Words: 927 - Pages: 4

Premium Essay

Modern Portfolio Theory

...Assumptions of Portfolio Theory • Investors are rational. • Investors are basically risk averse. • Investors wants to maximize the returns from his/her investments for a given level of risk. • Investor portfolio includes all of his/her assets and liabilities. • The relationship between the returns of assets in the portfolio is important since the returns from these investments interact with each other. Risk Aversion • Portfolio Theory assumes investors are basically risk averse. • Risk aversion means an investor, given a choice between two assets with equal rates of return, will select the asset with the lower level of risk. • Does not imply everybody is risk averse. • Most investors when committing large sums of money in developing an investment portfolio are risk averse. • This means investors expect a positive relationship between expected return and expected risk. Definition of Risk • Risk is the uncertainty of future outcomes. • Probability of an adverse outcome. Markowitz Portfolio Theory • Developed by Harry Markowitz in the 1950s. • Won a Nobel Prize for his work. • Basic portfolio model derived the expected rate of return for a portfolio of assets and an expected risk measure. Markowitz Portfolio Theory • He used variance of the rate of return as a measure of portfolio risk under a reasonable set of assumptions. • He also derived the formula for computing variance of a portfolio. Assumptions of Markowitz Model • Investors consider each......

Words: 5071 - Pages: 21

Premium Essay

Modern Portfolio Theory

...long haul contributing is the conservation of capital. Warren Buffett, ostensibly the world's most excellent mogul, has one standard when contributing - never lose cash. This doesn't mean you ought to offer your venture property the minute they enter losing region, yet you ought to remain definitely mindful of your portfolio and the losses you're ready to persevere in an exertion to expand your riches. While it is difficult to stay away from danger completely when putting resources into the business sectors, these five strategies can help protect your portfolio. One of the foundations of Modern Portfolio Theory (MPT) is diversification. In a business downturn, MPT pupils accept a generally expanded portfolio will beat a thought one. Speculators make deeper and all the more extensively broadened portfolios by owning countless in more than one asset class, along these lines decreasing unsystematic danger. This is the hazard that accompanies putting resources into a specific organization instead of deliberate danger, which is the danger connected with putting resources into the businesses by and large. As per some money related specialists, stock portfolios that incorporate 12, 18 or even 30 stocks can take out most, if not all, unsystematic danger. Shockingly, methodical danger is constantly present and can't be differentiated away. On the other hand, by including non-associating asset classes, for example, securities, items, monetary standards and land to a......

Words: 1326 - Pages: 6

Premium Essay

Report on Portfolio Theory

...and Standard Deviation--------------------------------------------------Page 9 Correlation Coefficient and Covariance----------------------------------------------------Page 9 Portfolio Risk and Return-------------------------------------------------------------------Page 11 Efficient Frontier-----------------------------------------------------------------------------Page 13 Calculated Beta and Comparison with Market Beta-------------------------------------Page 14 Required Return using CAPM--------------------------------------------------------------Page 15 Conclusion---------------------------------------------------------------------------------------------Page 16 Bibliography------------------------------------------------------------------------------------------Page 17 Introduction This project was conducted to analyze various theories of portfolio analysis. A portfolio of 10 companies, that was enlisted in the DSE and traded for at least 10 years, was selected. Through this project we found out the Holding Period Return, the Arithmetic Mean and the Standard Deviation of these 10 companies. After that we calculated the correlation coefficient, covariance of these stocks and also of the Dhaka Stock Exchange Index (DSEX).Then using the Markowitz Model we found out the portfolio risk and return and used the information to make an efficient frontier. Finally we found out the Beta of each stock using regression analysis and compared it to the available......

Words: 3417 - Pages: 14

Premium Essay

Portfolio

...W14232 INVESTMENTS: DELINEATING AN EFFICIENT PORTFOLIO Upasana Mitra and M. Kannadhasan wrote this case solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. This publication may not be transmitted, photocopied, digitized or otherwise reproduced in any form or by any means without the permission of the copyright holder. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Business School, Western University, London, Ontario, Canada, N6G 0N1; (t) 519.661.3208; (e) cases@ivey.ca; www.iveycases.com. Copyright © 2014, Richard Ivey School of Business Foundation Version: 2014-06-20 Hi Rahul! I want your advice in suggesting a portfolio of mutual fund for investment of my retirement fund. Last year, when I retired, I invested the full amount in a balanced fund. As it was a diversified fund, I thought that investment in one balanced fund would allow me to diversify my investment and I would get a decent return. Unfortunately, the fund has given negative return in spite of the fact that the stock index during the period has gone up by 5 per cent. Being a retired person, I cannot take much risk but would like to......

Words: 2998 - Pages: 12

Free Essay

Portfolio Theory

...낮다. 이를 무위험투자의 대용 수치로 사용한다면 각 자산의 상대적으로 높은 수익률은 위험에 대한 보상으로 생각할 수 있다. 이를 위험자산의 초과 수익률 혹은 리스크 프리미엄이라 한다. 과거 20년간의 위험 프리미엄 | |평균 수익률 |무위험 이자율 |위험 프리미엄 | |주 식 |17.68 |10.18 |7.50 | |회사채 |15.12 |10.18 |4.94 | |국 채 |14.10 |10.18 |3.92 | 초과 수익률과 이에 상응하는 위험은 적당한 것인가? 6. 포트폴리오의 기대수익률과 위험 포트폴리오: 여러 투자대상의 집합   - 일반적으로 투자자는 하나의 자산이 아닌 여러 자산을 결합하여 포트폴리오(Portfolio)를      구성하여 투자    - 개별자산의 기대수익률과 위험보다는 포트폴리오 전체의 기대수익률과 위험이 중요한      관심사 1) 두 자산 포트폴리오의 경우 • 맥주회사와 소주회사 |상태 |확률 |맥주회사수익률(r1) |소주회사수익률(r2) | |기온 상승 |0.2 |50% |-20% | |보통 |0.7 |10 |20 | |기온하락 |0.1 |40 |60 | 수익률 기대값, 분산, 표준편차는? [pic] [pic] 맥주회사와 소주회사의 주식으로 포트폴리오를 구성하는 경우 [pic][pic] w는 각 투자대상의 전체 포트폴리오에서 차지하는 비중이다. 따라서 합은 1이 된다. [pic] [pic]은 양의 값......

Words: 414 - Pages: 2

Free Essay

Modern Portfolio Theory (Mpt) and Financial Economics a Theory of Lesser Turf

...Andrey Artemenkov, The department of economic measurements, GYY artemenkov@rambler.ru Modern Portfolio theory (MPT) and Financial Economics: a theory of lesser turf?♣ “In this age, which believes that there is a short cut to everything, the greatest lesson to be learned is that the most difficult way is, in the long run the easiest.” Henry Miller “[These are colossal] disproportions that have accumulated over the last few years. This primarily concerns disproportions between the scale of financial operations and the fundamental value of assets, as well as those between the increased burden on international loans and the sources of their collateral. … In effect, our proposal implies that the audit, accounting and ratings system reform must be based on a reversion to the fundamental asset value concept. In other words, assessments of each individual business must be based on its ability to generate added value, rather than on subjective concepts. In our opinion, the economy of the future must become an economy of real values. How to achieve this is not so clear-cut. Let us think about it together.” From the Address of Vladimir Putin, Prime Minister of Russia, at the Davos Economic Forum (February, 2009) This Part analyzes the pre-analytical foundations and macro-economic impact of the Modern Portfolio Theory1 (MPT) tenets, on which much of the present Western investment theory and financial economics is erected. Our general inference is that while the former are......

Words: 10262 - Pages: 42

Premium Essay

Portfolio Theory and Management

...develops a strategy that would conform to such risk and benefit at the same time. Positive outcome relating to these forms of strategic investments is only determined by keen analysis of market inefficiencies and making use of the vulnerability to gain. This makes Stanyer (2014) to argue that although most investors have been using smart beta to measure their investment portfolios, it is more risk averse than smart alpha. He justifies this using the recent use of smart alpha by most firms to realize and analyse smart beta for their successful investment gains (Stanyer 2014). Superior performance of smart beta on the market Smart beta a passive investment strategy, aiming at minimizing risks in investment by outperforming a benchmark meant for its operation (Weil 2014). As such, it enables an investor to overlook factors that are important in lowering the risk exposed to an investment opportunity. Thus, smart beta follows laid down rules, rebalancing of already existing intervals in a given investment opportunity (Stanyer 2014). Advantages of smart beta I. Smart alpha, which is an active portfolio management, is one advantage associated with smart beta strategy. Smart alpha is rather objective than subjective, that is, steps in the investment are determined by a careful research made on stock and asset investment to determine the correlation between price returns and factor costs (Blitz 2013). II. Smart beta also provides a wider risk base in investment by......

Words: 930 - Pages: 4

Premium Essay

Assumptions and Keywords in Game Theory

...A BRIEF INTRODUCTION OF ESSENTIAL ASSUMPTIONS AND DEFINITION OF SOME KEYWORDS IN GAME THEORY There are a number of assumptions in game theory; some of the assumptions identified by Varian (1992) can be explained as follows: we assume that the descriptions of the game (such as the payoffs and the strategies available to the players) are common knowledge. That is, each player knows his own payoffs and strategies, and the other player's payoffs and strategies. Furthermore, each player knows that the other player knows this, and so on. We also assume that it is common knowledge that each player is "fully rational." That is, each player can choose an action that maximizes his utility given his subjective beliefs, and that those beliefs are modified when new information arrives according to Bayes' law. Game theory can be considered as a generalization of standard, one-person decision theory. How should a rational expected utility maximizer behave in a situation in which his payoff depends on the choices of another rational expected utility maximizer? Obviously, each player will have to consider the problem faced by the other player in order to make a sensible and economically rational choice. According to Varian (1992) the strategic form of the game is defined by exhibiting a set of players, a set of strategies, the choices that each player can make, and a set of payoffs that indicate the utility that each player receives if a particular combination of strategies......

Words: 420 - Pages: 2

Free Essay

Modern Portfolio Theory in the Modern Economy: Mpt During the Credit Crisis 0f 2008

...Modern Portfolio Theory in the Modern Economy: MPT During the Credit Crisis 0f 2008 Abstract There are various theories of risk and return as it pertains to measuring and predicting investment return in a portfolio- one of the oldest and most prominent being Modern Portfolio Theory .An example of a hypothetical portfolio utilizing the principles of MPT invested during the credit crisis of late 2008/early 2009 will be utilized in part. In direct application, does Modern Portfolio theory hold strong during a major financial crisis? Past research will be compared to present the mechanics and applications of MPT order to answer the questions poised and to create hypothetical portfolios based on past fund performance during the time period of 2007 -2010. It is expected that a portfolio using MPT would not have performed significantly better than any other less diversified investment. Contents Introduction……………………………………..........................................................................4-7 Credit Crisis Thesis Statement Modern Portfolio Defined Prior Research Prediction Method…………………………………………………….........................................................8-9 Parameters/ Source of Portfolios Results……………………………………………………......................................................10-19 A. Application/ graphs Conclusion…………………………………………...............………………………............19-20 Restatement of Thesis Discussion of......

Words: 2682 - Pages: 11

Premium Essay

Portfolio Theory

...The optimal risky portfolio asked me to shortsell the market for -1.6081 and invest 280.1% of my investable wealth in the active portfolio. Within the active portfolio itself, among 16 different tickers that I chose, my optimal weights were to invest in Kraft, General Mills, Visa, and Walmart. Running a regression of Risky Portfolio HPR against Market Portfolio HPR, we obtain the below line fit plot. Though the fit may not look all that bad, it is actually quite low with a R^2 of roughly 0.3. This does not come as too big of a surprise, though, as the risky portfolio utilizes active portfolio management that itself aims to break from the market. Also, the 16 tickers I used in this exercise could not possibly reflect all of the movements of the S&P market index. To extend our analysis of the relationship between the risky portfolio and market portfolio, we consult the following graph modeling their quantitative movements over roughly the past four months. As one would expect, the Risky HPR fluctuates a lot wilder than the Market HPR does. However, it does not consistently stray in any one direction away from 0%. Interestingly, looking at the dollar paths tells us a completely unexpected story. Usually we would expect an actively managed, risky portfolio to generate higher returns (barring transaction fees) than a passive, market portfolio. Yet here, we see that the dollar path of the market in fact outgrows the dollar path of the risky portfolio. In fact, by......

Words: 379 - Pages: 2