PORTFOLIO THEORY Essay Example | Topics and Well Written Essays - 2000 words

PORTFOLIO THEORY - Essay Example One of the important implications of the efficient market hypothesis is that portfolio selection does not make for superior investment results; rather, the achievement of high returns is more properly related to the additional risk than to superior stock-selection ability. Although many fundamental and technical analysts would want to take issue with this claim, still many theoreticians believe that this is correct and would be able to cite empirical research findings to support their views. When considering risk, one would want to consider different scenarios about the future and assign probabilities to each one. Normally, companies would thrive when the economy is booming. But there are exceptions. For example, some investments would fare badly during during recessions , and others would thrive under such conditions (such as gold production). It is a good idea, therefore to give weights to alternative possible scenarios and to arrive at a single figure called the Expected Value. Risk for any stock or security is measured by the standard deviation around a given expected value. Where there is wide dispersion of possible outcomes, the standard deviation would be larger, implying more risks. It is common knowledge that the greater the variability of returns, the less certain the actual outcomes would be; so one would prefer less dispersion and variability in the returns for a particular stock. The single figure called the standard deviation provides a clue as to the risk of a particular stock, and stocks could therefore be compared on the basis of its size. For two-asset portfolio of a stock (or projects, as deal with in the attached case), one tries to obtain, firstly the weighted average of the expected returns, and, secondly, the portfolio standard deviation. The two stocks that are combined will interact in such a way that the risk of the two-asset