Mean Variance Analysis (Corporate Finance)

Introduction

Portfolio theory was formulated by Harri Markowitz in 1952 as a development of the theory of the allocation of funds under uncertainty, which dealt with the selection of the best investments based on expected profit and risk later. Modern portfolio theory or portfolio theory simply explains how rational investors use the principle of diversification to optimize their investment portfolios, and as a risky asset should be priced. Diversification is an effective way to reduce risk, because the yields offered by the different assets move together (Tirole 39-45). As a precaution, investments must be diversified, investing in various asset classes allow different rates of return and reduce risk, so the investment will be safer and security will be higher. Diversification of investments is "the distribution of investments among different investment objects, in order to reduce the risk of potential losses of capital or income from it." Simply put, this is the practical realization of the principle of "do not lodge all your eggs in one basket.". This paper explores some of the fundamental principles of investment portfolio diversification, and provides practical examples of how portfolios could be diversified with the help of portfolio theory.

Discussion

Diversification of investment portfolio means that the investor is trying to select objects for your investment portfolio so that if one investment will bring a loss, while the other should automatically be profitable. In this case, the overall result of the portfolio always will be, at least not bad. Many believe that without a huge capital, diversified funds are not effective to achieve. The idea is somewhat controversial, at least. Markowitz argued that diversification is effective only when the ratio correlation included in the portfolio of assets is minimal (at best - negative) value. The principle of diversification can reduce the risk of an investment portfolio without compromising expected return

The effect of excessive diversification is characterized by excessive growth rate of costs to implement it over the pace of growth in portfolio yield, which is associated with increasing complexity of quality portfolio management with an increase in the number of securities, an increase in the probability of purchasing low-quality securities, higher costs for the selection of securities, to purchase small lots of stock securities and other negative phenomena. In diversifiying portfolios, the investors must be aware of the expected returns on each security. The level of expected return on securities, as is known, is in inverse proportion to the interest rate that determines the importance of taking into account possible changes of this parameter in the formation of an investment portfolio. Lending rate is an important component of the current rate of return on financial investments, which establishes the boundary of acceptability of the economic consideration of the securities. Therefore, the risk of rising interest rates may require adjustment of the stock portfolio.

Markowitz portfolio analysis method allows to determine the so-called. effective investment portfolio that allows you to be very likely to appoint a portfolio of companies, where investment should be profitable. Modern portfolio ...