Page 215 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes jewellery, and anything with any worth, as the theoretical market being referred to would
be the world market. As a result, proxies for the market (such as the FTSE100 in the UK or
the S&P 500 in the US) are used in practice by investors. Roll’s critique states that these
proxies cannot provide an accurate representation of the entire market.
The concept of a market portfolio plays an important role in many financial theories and
models, including the capital asset pricing model, where it is the only fund in which
investors need to invest, to be supplemented only by a risk-free asset (depending upon
each investor’s attitude towards risk).
Often, the concept of a market portfolio is discussed in theoretical terms only. For
investment purposes, a true market portfolio would need to include every conceivable
asset. As such, the market for such a portfolio would be the world market. The market
portfolio concept is important in a variety of financial theories, including Modern Portfolio
Theory (MPT). According to the MPT, investors should concentrate on choosing portfolios
based on overall risk-reward concepts, rather than focusing on the attractiveness of
individual securities.
MPT involves the concept of the efficient frontier on which the market portfolio sits.
Introduced by Harry Markowitz, the pioneer of MPT, the efficient frontier is a group of
optimal portfolios that serves to maximize expected return for a given level of risk. The
Sharpe ratio is a term used to indicate the level of additional return offered by a portfolio,
relative to the level of risk it entails. The market portfolio, also called the super-efficient
portfolio, has the highest Sharpe ratio on the efficient frontier.

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Caution When combined with the risk-free asset, it is said that the market portfolio will
produce a return rate above the efficient frontier. The risk-free asset is a hypothetical
concept. Essentially, the market portfolio would provide for higher return rates than a
riskier portfolio on the frontier.
Modern portfolio theory, or MPT, is an attempt to optimize the risk-reward of investment
portfolios. Created by Harry Markowitz, who earned a Nobel Prize in Economics for the
theory, modern portfolio theory introduced the idea of diversification as a tool to lower
the risk of the entire portfolio without giving up high returns.
The key concept in modern portfolio theory is Beta. Beta is a measure of how much a
financial instrument, such as a stock, changes in price relative to its market. This is also
referred to as its variance. For instance, a stock that moves 2%, on average, when the S&P
500 moves 1%, would have a Beta of 2. Conversely, a stock that, on average, moves in the
opposite direction of the market would have a negative Beta. In a broad sense, Beta is a
measure of investment riskiness; the higher the absolute value of Beta, the riskier the
investment.
Modern portfolio theory constructs portfolios by mixing stocks with different positive
and negative Betas to produce a portfolio with minimal Beta for the group of stocks taken
as a whole. What makes this attractive, at least theoretically, is that returns do not cancel
each other out, but rather accumulate. For example, ten stocks, each expected to earn 5%
but risky on their own, can potentially be combined into a portfolio with very little risk
which preserves the 5% expected return.

Modern portfolio theory uses the Capital Asset Pricing Model, or CAPM, to select
investments for a portfolio. Using Beta and the concept of the risk-free return (e.g., short-
term US Treasuries), CAPM is used to calculate a theoretical price for a potential investment.
If the investment is selling for less than that price, it is a candidate for inclusion in the
portfolio.

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