This essay is concerned with understanding the key issues relative to portfolio analysis and investment. The scope of this essay will be limited to the U. S. Stock markets only. This essay will be built upon extant portfolio theory and will discuss different types of risks that investors might face and how they go about managing such risks. Under consideration will be topics such as efficient frontier and optimal portfolios as well as their relevance to investment theory, under the assumption of direct investment in the stock market.
DETERMINING THE PURPOSE OF YOUR INVESTMENT
One of the steps in building an investment portfolio is to establish investment goals. Investment goals are the financial objectives you wish to achieve by investing (Gitman and Joehnk, 2005). In other words, what you want these investments to do for you or why you are investing in the first place. Some common investment goals include (Gitman, et al, 2005): 1) accumulating retirement funds, 2) enhancing current income, 3) saving for major expenditures, or 4) sheltering income from taxes. To get an estimate of the securities suitable for certain levels of risk tolerance and to maximize returns, investors should have an idea of how much time and money they have to invest and the returns they are looking for (Investopedia.com, 2006).
MODERN INVESTMENT THEORY
Modern Investment Theory also known as Modern Portfolio Theory (MPT) was introduced by Harry Markowitz with his paper "Portfolio Selection," which appeared in the 1952 Journal of Finance (riskglossary.com, 2006). Prior to Markowitz's work, investors focused on assessing the risks and rewards of individual securities that offered the best opportunities for gain with the least risk and then construct a portfolio from these (riskglossary.com, 2006).
MPT is defined, according to investorwords.com (2005), as an overall investment strategy that seeks to construct an optimal portfolio by considering the relationship between risk and return, especially measured by alpha, beta, and R². MPT utilizes several basic statistical measures to develop a portfolio plan (Gitman, et al, 2005). Included are expected returns and standard deviations of returns for both securities and portfolios, and the correlation between returns (Gitman, et al, 2005). Detailing the mathematics of diversification, Markowitz proposed that investors focus on selecting portfolios based on their overall risk-reward characteristics instead of merely compiling portfolios from securities that individually have attractive risk-reward characteristics (riskglossary.com, 2006). This theory proposes that the risk of a particular stock should not be looked at on a standalone basis, but rather in relation to how that particular stock's price varies in relation to the variation in price of the market portfolio (investorwords.com, 2005). The theory goes on to state that given an investor's preferred level of risk, a particular portfolio can be constructed that maximizes expected return for that level of risk (investorwords.com, 2005).
The MPT model assumes that investors are risk averse (Wikipedia.com, 2006). This means that given two assets that offer the same return, investors will prefer the less risky one (Wikipedia.com, 2006). Thus, an investor will take on increased risk only if compensated by higher expected returns (Wikipedia.com, 2006). Conversely, an investor who wants higher returns must accept more risk (Wikipedia.com, 2006). The implication is that a rational investor will not invest in a portfolio if a second portfolio exists with a more favorable risk-return profile (Wikipedia.com 2006). Two important aspects of MPT are the efficient frontier and portfolio betas (Gitman, et al, 2005).
THE EFFICIENT FRONTIER
The efficient frontier can, in theory, be used to find the highest level of satisfaction the investor can achieve given the available set of portfolios (Gitman, et al, 2005). This...