Thus, a portfolio may be defined as a combination of securities with varying risk and return characteristics which in turn contribute to the net worth of the investor. (Swisher, 2005)
The topic of discussion in this paper is Modern Portfolio Theory or Investment Theory, which may be defined as the concepts that revolve around educating an investor regarding the steps that must be taken in order to develop a portfolio that will speak of rational choices and optimisation of financial resources. Before going any further, it is imperative to point out that investement brings a certain degree of speculation, especially in today’s economic scenario where there has been a boom in the information transmission trends due to an increase in the number of people from various quarters flocking towards investing in portfolios. This paper will endeavor to study modern portfolio theory (MPT), in terms of its various elements like Markowitz diversification, the efficient frontier as well as concepts like the Capital Asset Pricing Model, better known as CAPM. The tools used in the course of application of these concepts include the Capital Market Line and the Security Market Line apart from alpha and beta coefficients which help measure mean, variance, risk and returns of the portfolio as a whole.
To begin with, the paper will introduce the Modern Portfolio Theory as propounded by Harry Markowitz in the early 1950s, before moving on towards defining the elements like beta, risk and return that are concerned with the various concepts of Modern Portfolio like diversification and Capital Asset Pricing Model or CAPM. (Swisher, 2005) The intorduction of the key elements before discussing and analysing the actual concepts has been carried out so as to ensure that there is full understanding of the tools that will be used in the study of the Modern Portfolio Theory. The paper will progress through a series of headings that are relevant to introduce new topics. These topics are linked with each other through the tools like beta, risk, return, mean and variance, among others. There will illustrations in terms of formulae and diagrams for all sections of the paper.
Markowitz and Modern Portfolio Theory
Modern Portfolio Theory has come up a practical model for the measurement of the various trends affecting the portfolio market. As a body of concepts and tools, it is concerned with the identification of markets that have high return potential and those which have a heavy risk factor, so as to help the investor choose more wisely. At the same time, the modern portfolio theory also brings us face to face with the fact that it is equally concerned with varying combinations of assets to zero in on the favourable markets and customers. (Markowitz, 1952)
Born in the year 1952, the modern portfolio theory was the brainchild of Harry Markowitz who recognised the need for a certain set of parameters within which the obvious diversification trends may be