Blog 3

Is Modern Portfolio Theory still relevant?

Creating the ‘perfect investment’ consisting of low risk and high reward is something many, if not all, investors aspire to achieve. Even though there have been theories, methods and strategies to achieve this, including the popular and influential portfolio theory, in reality the desired outcome is far from what is achieved. 

The idea of portfolio theory which was developed by Harry Markowitz in 1952, is that in order to reduce risk, investors should spread their investments across a range of assets so if there was bad news concerning one company, the investor will be compensated for, by some extent from good news of another company, according to Arnold. For example, if company A is an umbrella shop and company B is a sunglasses shop, because of the frequent changes in weather, it is likely that when one company performs well the other will not, but this still lessens the volatility than if an investor was to invest into only one of these companies. 

So a question asked by many intrigued investors would be something along the lines of ‘how exactly does one create a portfolio that would give the optimal results?’ Well as return is strongly linked with risk, it is important to understand what types of risk there are. In modern portfolio theory, there are two types: Systematic risk and Unsystematic risk. The former refers to risks that cannot be helped or avoided i.e. cannot be diversified away, for example interest rates and recessions, whereas the latter, also known as specific risk, refers to risk which can be diversified away through diversification. Understanding and knowing the risks is important as to be able to mitigate them when choosing securities, helping the investor to choose the optimal portfolio. 

The efficient frontier is then used to identify the combination of securities which will produce the best outcome. Below is an illustration of the efficient frontier curve, where the less risk is taken, the lower the expected return would be and in contrast the higher the risk taken, the higher the expected return would be. The dots nearest to the curve show the optimal combinations of securities, so these are the ones which investors will be interested in, whereas the dots furthest away represent portfolios which will either offer the same returns with more risk or less return for the same risk.

One problem with modern portfolio theory is that it uses past information to help predict future trends, which is not necessarily an accurate or reliable method. Whilst past information may be used as a guide for some investors, the end results could be entirely different. For those investors who have had successful portfolios, it could just be seen as luck rather than strategy, because otherwise they would all be consistently successful and the drawbacks wouldn’t be so apparent.

Another major issue of this theory is that during financial crisis, the use of modern portfolio theory has not been able to withstand such stock-market changing events. The correlations amongst asset classes were inconsistent and unsymmetrical, so in other words the theory failed to deliver in such circumstances and from these experiences, it has called to question the usefulness of portfolio theory.

At the end of the day, modern portfolio theory is exactly that-a theory, which may sound promising to investors. However, in reality, there are many limitations of using this theory, one reason being it is difficult to predict stock market movements from past information. It also causes problems when there is no actual answer to the question ‘how much is enough?’ in relation to how many stocks you should have in your portfolio, as research and answers have been given by various people, but they are not the same. This is just other issue of using portfolio theory, but it would also bring to question, if not portfolio theory, then what? No doubt, investors are looking for a solution which will fix the problems of portfolio theory, or perhaps researching new methods and strategies altogether.

Blog 2

Shareholder Wealth Maximisation vs Profit Maximisation

As shareholders are the business owners, it is understandable that business managers should try to optimise shareholder wealth rather than profit maximisation.

So what exactly is shareholder wealth maximisation? Well according to Arnold, maximising wealth can be defined as maximising purchasing power. To maximise purchasing power, companies pay a flow of dividends to investors, who are interested in the long-term sustainability of the company rather than a quick payback. The idea of wealth maximisation is that business managers are trying to increase the stock price, which in turn increases the wealth for the holder of the stock. As stock prices rise, the value of the firm increases which also increases the worth of the shareholder. 

On the other hand, profit maximisation is said to be a short-term benefit, which will benefit managers not shareholers. One difference between profit maximisation and shareholder wealth is that, according to Arnold, “profit is a concept developed by accountants to aid decision making, one decision being to judge the quality of stewardship shown over the owner’s funds.” 

Also, profit maximisation is viewed as a get rich quick scheme which does not allow for long-term success of the company. On the other hand wealth creation is created in the long-term, which is what investors are looking for as it indicates business stability hence why business managers often use this as their objective.

 There are some extreme cases however, where bad decisions are made and behind closed doors, shareholders don't really know what is going on. The reliability of the figures shown in company accounts are not always accurate, and in some cases purposely manipulated. 

One recent example being Tesco’s overstated profit of £250million, which is currently under investigation by Deloitte and law firm Freshfields. This news has understandably caused a huge impact on Tesco’s share prices which plunged 11.06% lower at 203p effectively causing £2.2 billion wiped from Tesco’s value on the stock market. As such a large company on the FTSE 100, it is extraordinary for something like this to happen on such a large scale. Many shareholders have walked away from the company and the major shareholders have a lot of unanswered questions and frustration is building up as they judge and put down Tesco’s managers. According to The Sunday Telegraph, One of Tesco's largest shareholders, Harris Associates, has sold around two thirds of its stake, saying the retailer lacks a clear strategy. David Herro, the Chief Investment Officer of Harris’s international division said the risk factors relating to the investment were too high to justify the U.S. investment firm holding a big position in Tesco shares. This is just one of many examples of account manipulation and why accounting profit is not a good proxy for shareholder wealth. 

The value of shareholders will vary in different companies, where maximising shareholder wealth is a primary objective for some companies, for example Citigroup in their mission statement:

 "Our goal for Citigroup is to be the most respected global financial services company. Like any other public company, we're obligated to deliver profits and growth to our shareholders. Of equal importance is to deliver those profits and generate growth responsibly."

 They clearly mention shareholders indicating their importance, whereas many other companies including Apple, who is to return $130 billion of cash to shareholders by the end of next year, according to The Telegraph, do not mention shareholders or their importance in their mission statement:

“Apple designs Macs, the best personal computers in the world, along with OS X, iLife, iWork and professional software. Apple leads the digital music revolution with its iPods and iTunes online store. Apple has reinvented the mobile phone with its revolutionary iPhone and App Store, and is defining the future of mobile media and computing devices with iPad.”

This however, is not to say shareholders are not important, but rather they are focusing more on the quality and evolution of technological goods, which can be a positive factor, as according to John Kay who states, 

“Firms going directly for ‘shareholder value’ may do worse for shareholders than those that focus on vision and excellence first and find themselves shareholder wealth maximisers in an oblique way." 

 This statement fits in well with Apple, a company who have focused on product creation and their mission statement is entirely product-orientated, yet they effectively have become so successful that shareholders are expecting a large return on their investment in the coming year.