Philippine Christian University: Dasmarinas Campus
Philippine Christian University: Dasmarinas Campus
Philippine Christian University: Dasmarinas Campus
Dasmarinas Campus
PORTFOLIO THEORY
Submitted by:
Name
PRIMITIVO MACALINDONG DAYANDAYAN
(MMPA TRECE 1B7)
Date Submitted
March 05, 2023
TABLE OF CONTENTS
CHAPTER Page
I. Introduction 1
II. Basic Characteristics of Traditional Portfolio Theory 3
III. Advantages And Limitations of MPT 5
IV. Assumptions Hide the Key Shortcomings of MPT 7
V. Scope Of the Post-Modern Portfolio Theory 8
VI. Insights what you have learned about the topics 12
Reference 14
I. INTRODUCTION:
Given the above, the research subject is the analysis of the evolutionary
process of portfolio theory that took place through the three previously
described phases, with the aim of providing a systematic overview of the
development of academic thought within this area. The research will use
a method of qualitative economic analysis with the intention to
investigate the relevant financial literature and present the authors’ views,
all to come to valid conclusion on the research subject. Considering the
defined research subject and aim, the paper will, after the introductory
remarks, present the basic characteristics of TPT. The following step will
be the presentation of the potential advantages and limitations of MPT,
which focuses on a rational investor who is unwilling to accept higher
1
risk if compensation for taking risk is not higher return. The fourth part of
the paper will deal with PMPT that appeared to eliminate the
shortcomings and limitations of MPT.
Finally, the final part of the paper, conclusion, will summarize the views
expressed and open questions considered important for future research.
2
return, the portfolio consisted of securities with the best performance, i.e.
with the highest expected return. However, the choice of investment
based on its expected return was not sufficient. The fact that most
investors invest funds in several different securities suggests that there
are factors other than return, which must be considered. Investors prefer
return but have risk aversion. Investing in two or more securities
indicates that investors were aware of the existence of risk but rated
portfolio performance only on the basis of the rate of return.
TPT did not recognize that the risk of individual investment is much less
important than its contribution to the overall portfolio risk. Also, TPT did
not see the importance of correlation, i.e. degree of connection of return
on individual securities, when constructing a portfolio. Correlation is
important, because it is important to think and decide in the context of a
portfolio, not in the context of individual securities.
4
sale,
e) maintenance of liquidity.
• Simple diversification – reduces return volatility, i.e. risk;
• Choice of individual investment – is done on the basis of:
a) determining the internal value of shares and the comparison of that
value with the current market value (fundamental analysis).
b) experts’ advice.
c) insider information.
d) newspaper advice on a good history of companies.
5
are correlated mutually. Instead of investing in a large number of different
securities, the MPT creator suggests investing in securities with low
return correlation. In other words, instead of simple diversification of
investment, Markowitz proposes efficient diversification of investment. In
his 1952 paper, Markowitz provided mathematical proof that appropriate
diversification can minimize portfolio variation at the given return level.
He was the first to formally quantify trade-off between return and risk.
Paying attention to how return on assets is correlated with other assets
enabled the creation of a set of efficient portfolios that minimize risk at
the given level of return, i.e. maximize return at the given risk level.
The last shortcoming of MPT is also the biggest, because if MPT does
not work, then when the investor needs risk protection most, the question
of its general utility is raised.
7
an irreplaceable instrument of modern portfolio management. The real
controversy is that MPT, although many of its influential advocates have
acknowledged its flaws and constraints, is widely accepted by the
participants on the capital markets that rely on it when making important
financial decisions. MPT is rooted in the financial system, and its
mathematical base and precise nature of results give a sense of security
and comfort.
PMPT is an extended and advanced MPT. PMPT avoids the known MPT
errors and provides a stronger and more precise framework for
constructing optimal portfolios. It was developed in the nineteen-eighties
at the Pension Research Institute in the USA in order to adjust MPT to
market reality. Prior to PMPT, it was assumed that investors had
homogeneous expectations, that variance and standard deviation were
reliable risk measures, and that returns on financial assets followed
normal distribution. The lack of compatibility of these assumptions and
market reality has imposed the need to develop PMPT as an extended
return-risk paradigm.
MPT defines risk as the total return volatility around the mean value and
is measured by variance or by standard deviation of return. MPT treats
all uncertainties in the same way: deviation above the mean value is
treated the same as deviation below the mean value. Unlike MPT that
associates risk with achieving an average return, PMPT claims that the
investment risk should be linked to the specific objective of each investor,
and that returns above this objective do not represent an economic or
8
financial risk. According to PMPT, only volatility below the investor target
return is considered risk. Return above the target creates uncertainty,
which is nothing but a risk-free opportunity to achieve unexpectedly high
return.
Thus, while MPT defines risk in the broader sense, i.e. as the possibility
that the funds invested will yield a return that is different from the
expected, PMPT sees risk in the narrow sense, i.e. as the possibility that
the invested funds yield return lower than expected – i.e. lower than MAR.
According to Todoni, return above MAR does not bring concern, but on
the contrary, it represents a premium for bold investment – the so-called
“good surprise”.
In other words, PMPT does not treat any volatility around the mean value
as a risk, but only volatility below MAR (Figure 1). PMPT distinguishes
between good and bad volatility, i.e. between the upside risk and the
downside risk, and only treats the downside risk. On the other hand,
MPT treats the overall risk (upside and downside).
Upside risk is the risk of a positive return deviation relative to MAR, and
the downside risk is the risk of negative deviation of return relative to
MAR. The concept of downside risk, as the key concept of PMPT, is not
new. According to Sing and Ong [19], the concept of downside risk dates
back to 1952, and has experienced its full affirmation with the emergence
of PMPT. The upside risk will be symmetrical to the downside risk only if
the mean value and MAR are the same numbers.
9
Figure 1 – Post-modern understanding of risk. It is important to note that
MPT, by equal treatment of positive and negative deviation from the
mean value, overestimates the risk and imposes unnecessary conditions
that exclude efficient portfolios when there is only a downside risk. It
follows that, according to PMPT, variance and standard deviation are
inappropriate risk measures. There are two key reasons why standard
deviation cannot accurately represent risk:
• Financial asset returns do not follow a normal distribution;
• Even if financial returns were perfectly symmetrical, standard
deviation would still fail to describe human risk. Standard deviation
represents a poor approximation of the investor’s risk understanding.
10
in financial theory, and downside deviation is semi-deviation. Downside
deviation can be defined as a standard deviation of negative return, i.e.
return below MAR. Unlike variance as symmetric risk measure, semi-
variance is an asymmetric risk measure. The downside risk statistic
consists of the following components:
11
portfolio.
TPT is the first stage in the development of a portfolio theory that lacked
mathematical-statistical foundation, normative modeling, portfolio
analysis, efficient diversification of investment, and precise answers that
would breed trust.
12
The mentioned deficiencies of TPT were eliminated by MPT, which
provided an objective systemic approach to constructing an optimal
portfolio. By respecting the investor’s unwillingness to accept the high
risk and their desire for the highest possible return, MPT enabled
optimization of the ratio of the expected return and the assumed risk, i.e.
the formation of a set of efficient portfolios, as well as the selection of an
optimal portfolio that maximizes the investor’s utility function.
13
REFERENCES:
Hicks J. R, A Suggestion for simplifying the theory of money. Economica,
Vol. 2, No. 5, pp. 1-19, 1935.
14