Page 274 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 11: Capital Market Theory

Introduction Notes

We saw how the risk and return of investments may be characterized by measures of central
tendency and measures of variation, i.e. mean and standard deviation in the previous units. In
fact, statistics are the foundations of modern finance, and virtually all the financial innovations
of the past thirty years, broadly termed “Modern Portfolio Theory,” have been based upon
statistical models. Because of this, it is useful to review what a statistic is, and how it relates to
the investment problem. In general, a statistic is a function that reduces a large amount of
information to a small amount. For instance, the average is a single number that summarizes
the typical “location” of a set of numbers. Statistics boil down a lot of information to a few useful
numbers – as such, they ignore a great deal. Before modern portfolio theory, the decision about
whether to include a security in a portfolio was based principally upon fundamental analysis of
the firm, its financial statements and its dividend policy. Finance professor Harry Markowitz
began a revolution by suggesting that the value of a security to an investor might best be
evaluated by its mean, its standard deviation, and its correlation to other securities in the
portfolio. This audacious suggestion amounted to ignoring a lot of information about the firm
– its earnings, its dividend policy, its capital structure, its market, its competitors – and calculating
a few simple statistics. In this unit, we will follow Markowitz’s lead and see where the technology
of modern portfolio theory takes us.
The Risk and Return of Securities: Markowitz’s great insight was that the relevant information
about securities could be summarized by three measures: the mean return (taken as the arithmetic
mean), the standard deviation of the returns and the correlation with other assets’ returns. The
mean and the standard deviation can be used to plot the relative risk and return of any selection
of securities. Consider six asset classes:

This figure was constructed using historical risk and return data on small stocks, S&P stocks,
corporate and government bonds, and an international stock index called MSCI, or Morgan
Stanley Capital International World Portfolio. The figure shows the difficulty an investor faces
about which asset to choose. The axes plot annual standard deviation of total returns, and
average annual returns over the period 1970 through 3/1995. Notice that small stocks provide
the highest return, but with the highest risk. In which asset class would you choose to invest
your money? Is there any single asset class that dominates the rest? Notice that an investor who
prefers a low risk strategy would choose T-Bills, while an investor who does not care about risk
would choose small stocks. There is no one security that is best for all investors.
Figure 11.1: Risk vs. Return

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