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Mean-Variance Analysis

The practical applications of portfolio theory abound in different segments of business and finance. This report seeks to explain the principles of diversification, and discuss some practical applications of portfolio theory in business and finance. Table of Contents Executive Summary 2 Table of Contents 3 Introduction 4 Principles of Diversification 4 Application of Portfolio Theory Mutual Funds 5 Application of Portfolio Theory Capital Allocation 7 Application of Portfolio Theory to Product Portfolio Decisions 8 Recommendations 10 Conclusion 10 References 11 Introduction Diversification is the premise that underlies portfolio theory (Markus, 2008). A portfolio is a combination of assets with a unified risk and return value expectation. Diversified portfolios ensure that loses are minimized if they occur (Hill, 2010). Mean-variance analysis helps determine the viability of an investment portfolio through the analysis of the portfolio risk. The theory relies on the use of portfolio’s variance by comparing how assets in the portfolio vary with regard to each other (Diether, 2010). Mean-variance analysis for a diversified portfolio measures the portfolio’s efficiency. The most efficient portfolio has the highest expected return for a certain standard deviation. Mean-variance analysis application in business and finance helps in making the optimum decisions about the riskiness of a portfolio. This report seeks to demonstrate the practical applications of mean-variance analysis in portfolio theory. Principles of Diversification One of the principles of diversification is the belief that the portfolio, as a whole, is more important than the individual assets (Sumnicht, 2008). Secondly, investors are risk averse, and therefore will only invest in those portfolios which they belief will be adequately commensurate to their returns. Investment should be for the long term, probably up to ten years into the future (Sumnicht, 2008). Diversification presumes that markets are efficient, and will not have any unforeseen disruptions. Finally, each risk level bears its own unique optimal allocation with regard to asset class at which the portfolio bears maximum returns. Application of Portfolio Theory Mutual Funds Mutual funds are actively managed investment options in which investors pay investment companies to invest their money in stocks and pay a return on the same. The financial analysts at the mutual fund companies make use of portfolio theory in calculating risks on their clients’ portfolios. The portfolio theory offers a robust and comprehensive model on which to calculate risk and make sound investment decisions from the results (Sumnicht, 2008). However, mutual funds offer a unique challenge to the effectiveness of the portfolio theory in that the final return faces significant distortions due to high fees, hidden costs, unpredictable taxes, and uncertain stock investments (Rutner, 2004). A major part of the modern portfolio theory is the frontier curve. The frontier curve plots risk and return (FundsMover, 2012). According to the portfolio theory, the funds that lie on the curve form the maximum yield potential for a given level of risk, measured as standard deviation. The curve flattens as the return rises. The rate of return per risk decreases, and at some point the amount of risk an investor exposes himself/herself to increases considerably for a slight increase in the return. The standard deviation indicates the volatility of the mutual fund.
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