TRADITIONAL & MODERN

THEORY APPROACH
Presented By:
Harshal Kadam (18)
Alex George (20)
Yash Shah (37)
Omkar Sonawane ()

Traditional Theory Approach

It believes that the market is inefficient & the fundamental
analyst can take advantage of the situation.
It is very subjective in nature.
It is to estimate the return to find out the amount of dividends,
price earning ratios, common holding period & market value of
shares.
It recognises specific types of risk & non risk factors.
Interest Rate Risk.
Purchasing Power Risk.
Financial Risk.
Non Risk Variables Taxation & Liquidity.

Traditional Theory Approach

It can be measured on each individual security through the
process of finding out of standard deviation.
Greater variability & higher standard deviation shows high risk
and vice versa.
Investors prefers larger to smaller returns from securities, to
achieve higher returs that depends on the investors judgement
of risk.
Investors can get higher return by analysing internal financial
statements of the company.

Traditional Theory Approach

The following steps needed in traditional portfolio
theory:
1. Background Information
2. Investment Goals
3. Investment Policies
4. Security Selections

Modern Theory Approach

Modern portfolio theory quantifies the relationship between the
risk and return and assumes that an investor must be
compensated for assuming risk.
It believes in the maximisation of return through a combination
of securities
The theory states that by combining securities of low risk with
securities of high risk success can be achieve in making a
choice of investors
There can be various combination of securities, the modern
theory points out that the risk of portfolio can be reduced by
diversification.

Modern Theory Approach

Modern portfolio theory (MPT) is a theory of finance that attempts to
maximize portfolio expected return for a given amount of portfolio risk, or
equivalently minimize risk for a given level of expected return, by carefully
choosing the proportions of various assets. Although MPT is widely used in
practice in the financial industry and several of its creators won a Nobel
memorial prize for the theory, in recent years the basic assumptions of MPT
have been widely challenged by fields such as behavioral economics.

Modern Theroy Approach

MPT is a mathematical formulation of the concept of diversification in
investing, with the aim of selecting a collection of investment assets that has
lower overall risk than any other combination of assets with the same
expected return.
This is possible, intuitively speaking, because different types of assets
sometimes change in value in opposite directions.For example, to the extent
prices in the stock market move differently from prices in the bond market, a
combination of both types of assets can in theory generate lower overall risk
than either individually. Diversification can lower risk even if assets' returns
are positively correlated.
MPT was developed in the 1950s through the early 1970s and was
considered an important advance in the mathematical modeling of finance.
A study conducted by Myron Scholes, Michael Jensen, and Fischer Black in
1972 suggests that the relationship between return and beta might be flat or
even negatively correlated

Mathematical Model

Risk and expected return

Risk Averse Investors
An investor who wants higher expected returns
must accept more risk. The exact trade-off
(situatiion)will be the same for all investors, but
different investors will evaluate the tradeoff(situation) differently based on individual
risk aversion characteristics.
The implication is that a rational investor will
not invest in a portfolio if a second portfolio

Mathematical Model
An investor can reduce portfolio risk simply by
holding combinations of instruments that are not
perfectly positively correlated (correlation
coefficient).
An investors can reduce their exposure to
individual asset risk by holding a diversified
portfolio of assets.
Diversification may allow for the same portfolio
expected return with reduced risk.
These ideas have been started with Markowitz
and then reinforced by other economists and
mathematicians
If all the asset pairs have correlations of 0they
are perfectly uncorrelatedthe portfolio's
return variance is the sum over all assets of the
square of the fraction held in the asset times the
asset's return variance (and the portfolio
standard deviation is the square root of this
sum).

Diversification

Advantages of Modern Portfolio Theory

The Efficient Market Frontier Markowitz formulated that there is a line at which a portfolio produces the ideal amount of
return for a given level of risk: This is known as the efficient market frontier. It shows whether a
portfolio is taking on too much risk for a given a level of return. It can also reveal whether or
not a portfolio is achieving a high enough return for the amount of risk it is taking.
Putting Theory Into Action The goal for investors is to build a portfolio out of uncorrelated assets and securitiesthis holds
true regardless of your risk tolerance. I will give you two examples.
First, investors who are risk-averse will want to allocate the majority of their portfolios to bonds
or bond mutual funds. The types of bonds included in the portfolio should have differing
maturity dates, varying issuers and various credit ratings.
Second, investors with a higher tolerance for risk will want to allocate the majority of their
portfolios to stocks.
Other Consideraation
A truly diversified portfolio should include other asset classes as well, such
as real estate and commodities.
.

Criticism of Modern Portfolio Theory

Modern Portfolio Theory still has been subjected to various criticisms. The assumptions made
by Markowitz have been criticized due to research findings in other fields of study, particularly
within behavioral economics. The behavioral economists have proven that the assumption on
"investors' acting rationally" is wrong.
The opinion that investors do not need to pay any taxes or transaction costs does not hold true.
The assumption that investors can buy securities of any sizes is claimed not to be practical,
since some securities have the minimum order sizes, and securities cannot be bought or sold in
fractions.
Investors have a credit limit which does not allow them to lend or borrow unlimited amounts of
shares.
Besides, the correlations between assets are never stable and fixed; they tend to change
together with the changes in the universal relations, existing between fundamental assets.
Furthermore, the theory does mathematical calculations on expected values, based on past
performance to measure the correlations between risk and return.
Experienced investors consider past performance not to be a guarantee of future performance.

Thank You