Modern Portfolio Theory

[keith]

Modern Portfolio Theory, CAPM, APT and other Nobel prize winning financial theories have been influential in the financial industry, specifically to the institutional investors.

How can we apply the same theories to improve our investment.

[totoro]

Modern Portfolio Theory, CAPM, APT and other Nobel prize winning financial theories have been influential in the financial industry, specifically to the institutional investors.

How can we apply the same theories to improve our investment.

These are attempts to understand and explain the financial markets and guide corporate investment decisions. Finance professors often joke that nobody has yet seen any one of them strike it rich from knowledge and application of these theories, and quit their daytime jobs. :D

Personally, I'm more interested in personal finance, and leave corporate finance matters to research analysts, investment bankers, fund managers, finance managers and CEOs. :rolleyes:

[keith]

Financial theory can be applied to personal finance. The only problem is that there are many school of thoughts.

For instance:-

Efficient market: If you believe the market is efficient, than there's no point buying actively managed unit trust nor invest in stocks direct. Beating the market would be extremely costly and time consuming. So, instead, one can buy the whole market -- index funds.

Efficient frontier (of MPT): If this MPT holds, then the best asset allocation is as on the efficient frontier. The key is to determine the investment profile, which is difficult to translate into the kind of statitic that MPT uses.

CAPM: Using the beta to determine if one's investment is performing better than the market.


I guess the above theories are already partially implemented in financial planning -- getting the correct asset allocation based on one's investment profile, index investing, and using the beta to determine if one's investment fund is performing better than the market.

By the way, index investing is very popular in US, where it has shown and proven to be very cost effective, and have beaten the majority of the actively managed funds in US.

I'm just wondering if the portfolio theories could be extended any further to help in our investment, as retail investors?

[totoro]

Some bits snipped from an article:

Applying Modern Portfolio Theory to Your Investment Reality

While the idea of an efficient portfolio and the efficient frontier graph make great theory, how can they be applied to your own investment situation? After all, few individual investors can create efficient frontier graphs for themselves, nor determine what their efficient portfolio would be. And even if investors had the time and technology to do so, market prices change, and the riskiness of asset classes isn't static.

What's important here isn't the details of the efficient frontier graph, nor finding the most efficient portfolio for you. Rather, the takeaways from Modern Portfolio Theory are:

1. Risk and return are directly linked. If you want a chance at greater returns, take on more risk.

2. Diversification across securities that do not behave alike reduces your portfolio's overall risk.

Whether you realized it or not, you probably used these two principles to build your portfolio. For example, your asset allocation is the direct result of your time horizon, risk tolerance, and financial goal. To reach that goal in the appropriate amount of time, you must take on a certain level of risk.

Further, you're likely controlling risk in your portfolio by mixing investments that have a low correlation with each other. For example, the stock and bond markets don't usually move in the same direction. By having a portfolio that includes both stocks and bonds, you're one step closer to a more diversified and less risky portfolio.

[IanQ]

Financial theories of course are of course useful. Each imparts a valuable insight to how the financial markets work. One can make use of them by applying them passively in our portfolio.

For example, if one read about APT or CAPM and then pay some attention to the market, one will immedialy come to the conclusion that a (equity) portfolio is heavily correlated to the overall market. PCA will further break down a portfolio's performance to different factors... and if I recall correctly, interest and inflation rates are mentioned as 2 of the important factors. Just reading about them improves one's knowledge as to what influences a portfolio's performance.

As to actually use the methodologies in their full form, we individuals do not have the resources. Need market data (bloomberg terminals come to mind), man power and economic of scale to see any substantial result. Program trading groups in America and Europe are using these theories and are extremely profitable; however, they manage millions to billions of dollars worth of capital.

Btw, I truly believe in the Efficient Market theory (weak form)... else how is it that investment banks and certain portfolio managers are able to rake in so much profit year after year. They have access to the companies that we simply don't have, unless any of us are Buffett. :)

[IanQ]

1. Risk and return are directly linked. If you want a chance at greater returns, take on more risk.



Disagree with the first statement. If one does not put in the time or effort, then yes, more returns implies having to take on more risk. But if one spends some effort, one can get a better return with no risk. A good example is the merdeka bond provided by bank negara. This has no risk at all compared to FD, but with higher rate. (only available to senior citizens, so I guess the risk is do you trust your parents.. :) ) So are bonds issued by GLCs that are well managed.