Over the last two decades, there has been a rampant increase in the rate of investment. This has resulted in the emergence of diverse investment vehicles to meet the different needs of the investors. One of the investment sectors that have witnessed rampant growth is the financial sector. This is mainly associated with its lucrative nature in terms of return and a high liquidity rate (Cuthbertson & Nietzsche 10). According to Grabel, the increased investment in a financial instrument has resulted in the emergence of the concept of portfolio investment (1). Portfolio investment entails investing in corporate stocks and bonds. Grabel asserts that by investing in these financial assets, the investor does not attain any controlling interest of the issuing company (1).
The increased rate of globalisation has increased investment scope. As a result, the volume of the international flow of funds has increased significantly. For instance, there has been an increase in the net volume of portfolio investment into emerging economies from a low of $800 million in 1987 to a high of $7.2 billion by 1991. This trend continued with the international flow increasing to $45.7 billion in 1996.
The increase in the types of financial instruments in the market has resulted in the complexity of investing these assets. Because the investors’ objective is to maximise their returns, various ways have been devised to help them attain this objective. This has resulted in the emergence of the concept of portfolio theory and the capital asset pricing model (CAPM). The discussion of this paper is aimed at analysing the relevance of the portfolio theory and the capital asset pricing model to the investors and the fund managers in the equity markets.
What is portfolio theory?
This theory is also referred to as the Modern Portfolio Theory (MPT) and was advanced by Harry Markowitz. The theory suggests that investing in financial assets should be based on how the financial assets are related to one another and not on their performance. According to Wang, portfolio theory makes it possible to analyse the investors demand assets given the assets returns of the assets (113). According to this theory, there is a possibility of risk-averse investors maximising their expected returns despite the existence of a given degree of risk. According to Markowitz, the risk is inherent in the investment. In addition, the higher the degree of risk, the higher the returns (Para. 1).
Definition of capital asset pricing model
The capital asset pricing model is a model that is used to describe how risk and returns are related to one another. This model is mainly used to price risky securities. The CAPM is based on the concept that investors should be compensated based on risk and the value of money. According to this model, the return of a particular security is composed of two parts. These include the risk-free part and the risky part. The returns of a particular security are determined by the following RA =Rf+B (Rm -Rf) where RA = the expected return of the asset, Rf= rate of return that is exclusive of the risk and Rm = the market rate of interest and B= beta which represents the degree of sensitivity of the asset to the movements in the market that is the systematic risk. (Rm -Rf ) represents the risk premium.
Systematic risk refers to the risk that is inherent within a given market segment. This risk cannot be eliminated by diversification (Brown & Goetzmann 34).
Relevance of portfolio theory and CAPM
Understanding the importance of diversification in a portfolio
For investors to maximise the level of their returns, they need to incorporate the concept of diversification. Diversification refers to the process through which an investor mixes a variety of securities in his portfolio. The idea behind the concept of diversification is that different types of securities will yield relatively higher returns compared to investing in a single security. In addition, diversification results in the minimisation of the degree of risk expected in a particular asset. Therefore, diversification culminates in the reduction of the unsystematic risk. In addition, portfolio theory helps investors and fund managers in understanding that risk cannot be eliminated through diversification.
Unsystematic risk refers to the risk inherent in a particular investment. By understanding the portfolio theory, the investors and fund managers gain knowledge concerning the unsystematic risk effectively. For example, portfolio theory enables the investors and fund managers to understand the various sources of unsystematic risk. Unsystematic risk results from internal and external sources. The internal sources relate to the size of the firm.
According to Warren, the degree of risk is inversely related to the size of the company. If a company is small, the degree of risk an investor faces by investing in such a firm tends to be high. Alternatively, by investing in a large firm, the investor minimises the degree of risk (Para. 6). The external sources of unsystematic risk include the macro-environmental forces such as demographics, economic, social-cultural, technological, and political.
By understanding the unsystematic risk, the investors and fund managers can select an effective investment destination that culminates into effective diversification. This is since they can combine their investment by investing in both large and small companies. In addition, understanding the concept of diversification enables the investors and fund managers to invest in a variety of securities in different economic sectors such as stocks, bonds and real assets.
Creating an efficient portfolio through portfolio optimisation
Investing in securities demands an effective understanding of how the securities market operates. The CAPM enables the investors and fund managers to construct an efficient portfolio that is well diversified. According to Markowitz, an efficient portfolio refers to a portfolio whose expected returns are the highest concerning a given degree of risk or which has a low degree of risk relative to the expected returns (Para. 6).
Markowitz asserts that an efficient portfolio is a combination of a set of assets which the minimum variation with one that has the maximum returns. Portfolio theory enables investors and fund managers to construct a portfolio that is closer to the efficient frontier. Efficient frontier enables them to analyse the relationship between the expected returns and the risk. Constructing a portfolio on the efficient frontier enables the investor to achieve the best returns from his investment.
Effective management of investors’ funds
For fund managers, understanding portfolio theory is important in that they can manage the funds of the investors effectively. Because these managers manage funds of investors with diverse risk to return preferences, they can be able to effectively meet the investors’ demands. For example, some investors are more risk-averse and demand higher compensation for them to be able to take more risk while others are less risk-averse.
Through the portfolio theory, the fund manager can be able to construct a portfolio based on the risk to return preferences of the individual investors. For instance, by constructing a portfolio on the efficient frontier, the fund managers can manipulate the portfolio as the investors demand. For example, the fund managers can be able to increase the returns for the investors without increasing the level of risk associated with the portfolio. Alternatively, the fund managers can be able to reduce the degree of risk associated with a particular portfolio without reducing the expected returns (Cochrane 23).
Knowledge of portfolio theory enables the investor to make a selection on how to manage his or her portfolio. This can be through the adoption of two main portfolio strategies which include active and passive strategies. Passive strategy refers to a strategy where the investor links the performance of his assets to the performance of a particular market index. There are various indices that the investor can link his assets to such as the Standards and Poor’s and Dow Jones Industrial Average. This strategy assumes that the market is efficient and all the information in the market will be reflected in the price of the securities. On the other hand, an active portfolio strategy enables the investors and fund managers to effectively forecast the performance of a portfolio based on the information available in the market.
Effective valuation of the securities
The Security Market Line
Portfolio theory and the CAPM model enable the individual and fund managers to make an effective valuation of the securities. For example, through the CAPM model, the investors can determine the expected rate of return for a particular security. This enables them to effectively determine the price of the security or a portfolio of securities (Wang 10). This is through the incorporation of the concept of the Security Market Line (SML). The security market is a curve that graphs the systematic risk and the expected returns of an entire market segment during a given period. It is also called the characteristic line.
Wang asserts that a security market line is an important tool for the investors and the fund managers in evaluating particular security (1). This is since it helps them to determine whether the security being offered in the market to be included in the portfolio offers reasonable returns in comparison to the risk associated with it. Through the concept of the security market line, investors and fund managers can be able to determine whether the security is either undervalued or overvalued.
To determine this, the various securities are plotted on this graph. If the corresponding point between the expected return and the risk is above the security market line, the asset is considered as being undervalued. This is because the investor will expect a higher return from the associated risk. On the other hand, if the points are below the SML, the security is overvalued. This is because he or she will be accepting a less return by assuming a given level of risk (Amnec & Le Sourd 37). Therefore, the CAPM model enables the investors and the fund managers to value the securities effectively by considering both risk and the expected return.
Weakness of the portfolio theory and CAPM
Values used in CAPM are subject to change
In determining the expected return of a given portfolio using the CAPM model, values are assigned to the model concerning risk-free rate, the market rate of return, beta and the risk premium. These values are not fixed but are volatile to changes in the economic environment. This means that the investors and fund managers can’t forecast the expected returns of a particular portfolio with 100% accuracy.
The model is also inefficient in utilising a single SML to value the price of securities. This is since there are different investors with different investment preferences and hence there should be different SML’s.
Difficulty in determining the risk premium
It is also difficult to determine the risk premium in determining the expected return of the asset. To determine the risk premium, information from the stock market is utilised. The market rate of return is determined by the mean of dividend yield and capital gain from the stock market. The stock market may depict negative returns rather than positive ones during the short term. This mainly occurs if the dividend yield is outweighed by the fall in share prices. Therefore, long term information is used in determining the risk premium. However, it has been found that the risk premium is subject to changes.
Use of historical information
In portfolio theory, the concept of Mean-Variance Optimisation (MVO) is used to allocate different investments to various assets by determining risk and the expected return. The MVO constantly utilises historical data to determine the relationship between risk and return. The use of historical data ignores the changes in prices over time. The concept of MVO assumes that the relationship between risk and return is constant
This makes portfolio theory to be inefficient in determining the risk and expected return of a portfolio (‘The Tamris Consultancy’ 63). By use of historical data in the portfolio theory, investors are exposed to future risks due to the economic cycles. This means that the theory does not actuary result in the construction of an efficient portfolio. In addition, using the historical averages makes the MVO inefficient in positioning the portfolio. CAPM is supposed to forecast future returns. Therefore, utilising the historical data becomes an inefficient model of forecasting.
Investment in financial assets has become very complex in the recent past. This is due to the increase in the number of securities available in the market. In addition, the degree of volatility concerning financial securities has also increased due to an increase in the rate of globalisation. To maximise the level of returns, investors and fund managers should understand the concept of portfolio theory and CAPM (Fama & Kenneth 25).
Portfolio theory enables the investors and fund managers to appreciate the concept of diversification. Through diversification, the investors can minimise the risk associated with the securities and maximise the returns. Diversification enables the investors to consider investing in securities of firms of different sizes and different economic sectors. Portfolio theory enables the investors and the fund managers to make an effective selection of the investment destination. The theory also enables the fund managers and investors to construct an efficient portfolio. An efficient portfolio enables the fund manager to meet the investment demand of various investors since he or she can be able to maximise the investors’ returns.
In addition, the investor and the fund manager can be able to adjust the portfolio along the efficient frontier. The effect is that there is efficiency in managing the portfolio. The two concepts also enable the investors and fund managers to value the securities through the incorporation of the concept of security market line. The result is that there is they are effective in determining the security to consider including in the portfolio.
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