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Index of concepts
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Subject: Portfolio Management
Chapter/Topic: Portfolio Analysis
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Concept Definition and Explanation
According to Benjamin Graham, considered by many as the dean of Wall Street, analysis means decision making based on facts and standards.
Portfolio analysis can be explained as decision making related to portfolio formation and modification.
There is traditional portfolio analysis and modern portfolio analysis.
Traditional Portfolio Analysis
Traditional portfolio analysis can be conveyed by the statement of Benjamin Graham that commitment to a single security is neither investment nor rational speculation.
Both investment and speculation have to be done at portfolio level, i.e. commitments have to be diversified. They have to be in multiple securities. The concept of diversification further developed into geographical diversification (investment in securities of companies in various regions) and industry diversification.
Modern Portfolio Analysis
Harry Markowitz proposed modern portfolio analysis. He was given the Nobel for Economics for his theoretical exposition of modern portfolio theory.
Markowitz concluded that return on equity shares follows a normal distribution. Thus probability distribution of return on security can be described by expected value and variance (standard deviation). Expected value represents return and variance represent the risk. The expected value and variance of return at portfolio level can be calculated and thus return and risk of portfolios can be calculated provided return and risk of individual securities is available.
Rational investors want to have a portfolio with the highest expected return for a given risk level they are taking. Similarly, if an expected return level is specified, investors want the lowest risk level.
Markowitz developed mathematical procedures for finding the set of portfolios that have increasing expected return or increasing risk levels. This set of portfolios from which an investor can choose a portfolio is called efficient frontier.
Modern portfolio analysis takes expected return estimates from security analysis. Then it calculates variance from the past data and these objective estimates of variances can be modified by security analysts. Then this input is fed into a computer program to get the efficient frontier.
References:
Reilly, Frank and Keith Brown, Investment Analysis and Portfolio Management, 7th Edition, Thomson-South Western, 2003
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Knols
Related Knols
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Books
Elton and Gruber, Modern Portfolio Theory
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Research Papers
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Concept Articles
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