Portfolio analysis, or modern portfolio theory (MPT), is a mathematical approach toward investment that advocates diversification to various asset classes and chooses the right combination of stocks to maximize returns and reduce risk. When is portfolio analysis used? Read on to find out.
Portfolio analysis is the study or examination of various asset classes such as cash, bonds, equities, indexes, commodities, futures, options, securities, and mutual funds. Each such asset category has peculiar risk factors and different benchmarks for returns based on returns on investment, market growth rate, and market share. A combination of such asset classes makes for an investment or product portfolio, and portfolio analysis aims at determining the returns and risk levels of such portfolios.
The implementation of portfolio analysis takes place through tools such as the BCG Growth-Share Matrix, the GE Multifactor Portfolio Matrix, Matsushita Strategy Matrix, and road-mapping.
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Risk Management Through Diversification
When is portfolio analysis used?
Portfolio analysis finds use of diversified investments or allocations that, when combined, provide for a lower risk than such individual investments or projects considered separately. It identifies the portfolio with the lowest possible risk for every level of return and the portfolio that offers the highest level of return for every level of risk.
Portfolio analysis identifies two types of risks: Systematic risks such as interest risk, recession, and war; and unsystematic risks that remain specific to individual stocks and projects. Portfolio analysis attempts to reduce unsystematic risks through diversification, by ensuring that the risk from individual stocks and projects in a well-diversified portfolio contributes little to overall portfolio risk.
The extent of diversification undertaken depends on the risk appetite. For instance, an investor with a very low propensity or inclination to risk might include two asset class in the portfolio, one which performs when it rains, and another which performs when it does not rain. Such a positioning balances out the risks. These investment classes taken independently present high risk options, but the inclusion of both in the portfolio balances the risk, making the portfolio a low or zero risk option.
Managing Optimal Returns
One major application of portfolio analysis is to make optimal allocation of available resources. Portfolio analysis involves quantification of the operational and financial impact of the investment portfolio, to evaluate the performance of the investment or product against set investment goals, and time returns effectively. Such quantification and evaluation of performance helps achieve the best trade-off between risk tolerance and returns.
When is portfolio analysis used in such situations? It is used to:
- Analyze existing business portfolio to separate efficient and inefficient portfolios.
- Decide whether businesses or projects require more investment, less investment, or scrapping.
- Develop strategies to fuel growth by adding new products and/or businesses to the portfolio as well as dropping some existing investment products and businesses.
Portfolio analysis also caters to a periodic review of investments, usually annually, to balance the portfolio and prevent dominance or heavy skew toward one asset or asset class.
Portfolio analysis is a popular tool, but it is fallible. The biggest fallacy in managing risk is the assumption that performance of individual stock remains independent of other investments in the portfolio. A cursory glance of real life market history reveals that there exists no such instruments; and in times of market crash or spurts, supposedly independent investments act as if related.
Similarly, while portfolio analysis makes provision for zero risk investing, in real life no investment is without risks. Even government-backed bonds, gilt, and Treasury bonds, all perceived as risk-free, do have default risks.
A review of the advantages and limitations of portfolio analysis reveal that shortcomings notwithstanding, portfolio analysis finds wide acceptance in the industry, and Harry Markowitz, who introduced this theory in 1952, received the Nobel prize for this work in 1990.
Markowitz, Harry, M. (1959.) "Portfolio Selection: Efficient Diversification of Investments." John Wiley & Sons, Inc., New York; Chapman & Hall, Limited, London. Retrieved from http://cowles.econ.yale.edu/P/cm/m16/index.htm on 18 January 2011.