Investment Portfolio: Modern Portfolio Theory, CAPM, And Multi-Factor Models

Variance and standards deviation computation

Investment portfolio is not a new term for investors. It is a collection or combination of income producing assets that are bought to meet he financial goals. In the investment market the major risk is the deviation of purchased stokes. The investors always have a risk of stokes getting deviation lower than the average value of stokes. The modern portfolio theory is the tool to identify the risks of investment market using different theories or other market analysis (Petkovi?, 2015). Modern portfolio theory defined in the hypothesis made by Harry Markowitz in his research paper “Portfolio Selection”, as an investment practice theory which is based on idea that the investors concerned with risk-averse can construct a portfolio in order to maximize or optimize their expected return on their stokes in market. Modern portfolio theory or the portfolio management theory suggests that it is not impossible to create or construct an efficient frontier for the most favourable portfolio which can give you the expected return for your investment. This theory includes only four pages of theory assessment and rest 8 pages are describing the different graphs and analytical discussion about the market progress or behaviours. This complex structure makes it difficult to understand for individuals not belonging from the investment market. But in investment market it is the key element used to make a good profit using its theories for portfolio preparation (Omar,et al. 2014).

 The optimal portfolio simply does not include the securities of potential return or low risk securities. Instead of this, it aims to balance the securities of greatest potential returns with the lowest degree of risk or an acceptable degree of risk (Magni, 2016).

The capital asset pricing model was first worked out by the financial economist, William Sharpe. He discussed about his work in his book “Portfolio Theory and Capital Marketers” on the capital asset pricing model. The capital asset pricing model defines that the individual investment in the market is associated with two major risks which are as

• Systematic risk: This type of risks cannot be diversified. The reduced interest rates, wars, and recession in the market (Irvin, 2016).
• Unsystematic risks: These risks also known as the Specific Risk as this risk is specified for an individual stock and can be diversified using the modern portfolio theory in which investors use a number of stocks in their portfolio (Higgins, (2012).

On the analysis of two types of risks the capital asset pricing model presents a simple theory which is used to deliver simple results. The theory of CAPM suggests that the only reason, an investor should earn more from one stock rather than the other one, is that the one giving more earning is riskier. Although the model has dominated the modern financial theories but still it is not clear that the model will work all the time. Some studies on CAPM show doubts on the model but still it is used by most of the investors and making money for them as well. Since the theory of capital asset pricing model is not perfect but its spirit is correct (Gotze, Northcott, & Schuster, 2016).

Arithmetic and Geometric Average Returns Calculation

It presents a usable measure of risk which helps investors to determine about the kind of returns they deserve for the money they put at risk in the market. According to the theory of capital asset pricing model, he expected return of a particular portfolio or security is given by the rate on the risk free security plus the risk premium associate with the riskier stock (Storey, & Greene, 2010).  In this theory if the portfolio or security fails to meet or exceed the required or expected return then the investment should not be made in that particular portfolio. This model can be summarised by the formula (Goldmann, 2017).

Required or expected return= RF rate + (Market return-RF rate)*Beta

Here market return-RF rate is defined as the risk premium (Goldmann, 2017).

Expected return calculated using the CAPM formula is representing the expected return of the capital asset for the given time. It is a long term assumption describing the behaviour of investment having over its life time. Risk free rate is equal to yield based on 10 years government bond. And the beta notation is the presentation of the risk availability in market. For every investment there are some market risks associated with it, if not then the beta value will be zero otherwise it will have a real number value (Gitman, Juchau, & Flanagan, 2015).

This CAPM if often used in finance industry by the professionals of the industry like investment bankers, accountants, and financial analysts. This is a part of the weighted average cost of capital (WACC) as it calculates the equity cost for the investment (Finnie, 2012).

The modern portfolio theory is used to construct a portfolio of different stocks to be used for the selection. In similar way multi-factor model is a financial model which applies multiple factors for the calculation, used to explain the equilibrium asset pieces and/or market phenomena (Sartori, et al. 2014).  This model can be divided into three different categories as: macroeconomic model, statistical model and fundamental models. The fundamental model analyse relationship between a security return and its underlying financials like earnings etc. Macroeconomic model compares the security return for the factors like employment, interest, inflation etc. And the Statistical models are used to compare returns of different securities based on the statistical performance of each security (Enqvist, Graham, & Nikkinen, 2014).

The formula used in multiple-factor model is given as:

Gain or Loss Computation based on Last Market Price

Ri=ai+_i(m)*Rm+_i(1)*F1+_i(2)*F2….+_i(N)*FN+ei

Where

Ri is the return of security i

Rm is the Market return

F(1,2,3,….N) is used for each of the factors used in the model

e is denoting the error term in the formula

a is the intercept (Dayananda, 2012).

The only factor which makes the Fama and French Three Factor model extraordinary if that id provides the strategy for using the primary factors which drive the stock return calculated from the same as well as the other models. This unique feature of Fama and French three factor model is only of this kind in other multi-factor models. The Fama and French three factor model expands on CAPM with addition of the size and value factor to the market factor of CAPM. By adding these two factors the model is adjusted for the outperformance tendency which is the key tool making it better tool for the evaluation of manager performance. This can be stated that theism model is based on the arbitrage pricing theory and one which is widely used multi-factor model (Brown, 2018).  The arbitrage pricing theory stated that the systematic risk is multidimensional in character and therefore dependent on various economic risk factors. This model concerned about three factors as; book to market value, excess return on the market, and size of the firms or these three factors can be defined as SMB (small minus big), the portfolio’s return lass the risk free rate of return, and HML ( high minus low) (REDDY, & SHARMA, 2014).

These risk factor used in this model are defined as Beta is a measure of volatility of the stock compared to the market volatility as a whole, Size is the extra risk associated with the small companies (Pollitt, & Bouckaert, 2017).  It is assumed that the larger companies have a low risk in comparison to the small companies. Value is defined as the owning of the out-of-favour stocks due to their attractive valuation. The value stocks are of the companies which tend to have a lower growth rate, lower price compared to their book value, and higher dividends (Brooks, 2015). 

This model found that on an average Beta is the only reason for almost 70% of the stock returns. But the non-satisfaction made the investors to think about the better explanation and they discover this method to increase this number to 95% using the size and value factor with beta (Adekola, Samy, & Knight, 2017).

References

Adekola, A., Samy, M., & Knight, D. (2017). Efficient working capital management as the tool for driving profitability and liquidity: a correlation analysis of Nigerian companies. International Journal of Business and Globalisation, 18(2), 251-275.

Brooks, R. (2015). Financial management: core concepts. Pearson.

Brown, D. R. (2018). Evaluating institutional sustainability in development programmes: Beyond dollars and cents. Journal of International Development, 10(1), 55-69.

Dayananda, D. (2012). Capital budgeting: financial appraisal of investment projects. Cambridge University Press.

Enqvist, J., Graham, M., & Nikkinen, J. (2014). The impact of working capital management on firm profitability in different business cycles: Evidence from Finland. Research in International Business and Finance, 32, 36-49.

Finnie, J. (2012). The role of financial appraisal in decisions to acquire advanced manufacturing technology. Accounting and Business Research, 18(70), 133-139.

Gitman, L. J., Juchau, R., & Flanagan, J. (2015). Principles of managerial finance. Pearson Higher Education AU.

Goldmann, K. (2017). Financial liquidity and profitability management in practice of polish business. In Financial Environment and Business Development (pp. 103-112). Springer, Cham.

Goldmann, K. (2017). Financial liquidity and profitability management in practice of polish business. In Financial Environment and Business Development (pp. 103-112). Springer, Cham.

Gotze, U., Northcott, D., & Schuster, P. (2016). INVESTMENT APPRAISAL. SPRINGER-VERLAG BERLIN AN.

Higgins, R. C. (2012). Analysis for financial management. McGraw-Hill/Irwin.

Irvin, G. (2016). Modern cost-benefit methods: an introduction to financial, economic and social appraisal of development projects. Macmillan Education Ltd..

Magni, C. A. (2016). An average-based accounting approach to capital asset investments: The case of project finance. European Accounting Review, 25(2), 275-286.

Mathuva, D. (2015). The Influence of working capital management components on corporate profitability.

Omar, N., Koya, R. K., Sanusi, Z. M., & Shafie, N. A. (2014). Financial statement fraud: A case examination using Beneish Model and ratio analysis. International Journal of Trade, Economics and Finance, 5(2), 184.

Petkovi?, D. (2015). Adaptive neuro-fuzzy optimization of the net present value and internal rate of return of a wind farm project under wake effect.

Pollitt, C., & Bouckaert, G. (2017). Public Management Reform: A Comparative Analysis-Into the Age of Austerity. Oxford University Press.

REDDY, T., & SHARMA, P. (2014). PROJECT APPRAISAL AT DURGAPUR STEEL PLANT. Journal on Management, 9(2).

Sartori, D., Catalano, G., Genco, M., Pancotti, C., Sirtori, E., Vignetti, S., & Bo, C. (2014). Guide to Cost-Benefit Analysis of Investment Projects. Economic appraisal tool for Cohesion Policy 2014-2020.

Storey, D. J., & Greene, F. J. (2010). Small business and entrepreneurship. Financial Times/Prentice Hall.

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