This approach also incorporates the fact that assets

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Unformatted text preview: The method is named after a 1990 Nobel Prize recipient, a financial theorist, who first introduced the technique in his 1952 paper entitled Portfolio Selection. Markowitz diversification is less intuitive than simple diversification and uses analytical portfolio techniques to maximise portfolio returns for a particular level of risk. This approach also incorporates the fact that assets with 106 low correlation to each other when combined have a much lower risk relative to their return (Whiteside, 1997). Using these principles, portfolio optimisation is a methodology from finance theory for determining the investment program and asset weightings that give the maximum expected value for a given level of risk or the minimum level of risk for a given expected value. This is achieved by varying the level of investment in the available set of assets. The efficient frontier is a line that plots the portfolio, or asset mix, which gives the maximum return for a given level of risk for the available set of assets. Portfolios that do not lie in the efficient frontier are inefficient in that for the level of risk they exhibit there is a feasible combination of assets that result in a higher expected value and another which gives the same return at lower risk. (Note, in reality, due to real world constraints such as the indivisibility of assets, trading costs and the dynamic nature of the world, all practical portfolios are inefficient). To calculate the efficient frontier it is imperative to determine the mean return of each asset (usually the EMV in industrial applications), the variance of this value (defined as risk in finance theory) and each asset’s correlation to the other assets in the available set of investments (Whiteside, 1997). This classification of risk assumes that: • Firms’ long run returns are normally distributed and can, consequently, be adequately defined in terms of the mean and variance. In reality, it is likely that the distribution describing long run returns would be “skewed”. • Variance is a useful measure of risk. In calculating variance, positive and negative deviations from the mean are equally weighted. In fact, decision-makers are often more pre-occupied with downside risk – the risk of failure. A solution to this problem is to determine the efficient set of portfolios by using another risk measure. A group of suitable risk measures that only takes the dispersions below a certain target into account are the downside risk measures. In the mean downside risk investment models the variance is replaced by a downside risk measure then only outcomes below a certain point contribute to risk. 107 • There is enough information to estimate the mean and variance of the distribution of outcomes. This does require a high level of information that, in some cases, is not available (Ross, 1997). However, provided that the assumption that variance is a useful approximation of risk is accepted, the aim is to maximise the expected return under a c...
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