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A class act

I have heard talk of modern portfolio
theory and asset class investment funds. Can you explain how these
funds work?The foundation of modern portfolio theory was a 1952
paper, Portfolio Selection, in which Dr Harry Markowitz established a
theory explaining the best way for an investor to choose a portfolio.
His basic theory was that investors should choose a portfolio that
offers the best return for a given level of risk – the efficient
portfolio.

Later work by contributors such as Dr William Sharpe added to our
understanding of how to choose the best portfolio from a set of
securities. Modern portfolio theory is of such importance in
investing that the economists who formulated the theory received the
Nobel Prize in economic science in 1990. It has four basic premises:l
Investors are inherently risk averse and unwilling to accept risk
except where the returns will compensate them for that risk.
Investors are often more concerned with risk than reward.

l The securities markets are efficient. In fact, advancing IT and
increased sophistication of investors are causing markets to become
even more efficient.

l The focus of attention should shift away from individual securities
analysis to consideration of a portfolio as a whole based on explicit
risk/reward parameters and total portfolio objectives. Efficient
allocation of capital to specific asset classes will be far more
important than selecting individual investments.

l For every risk level, there is an optimal combination of asset
classes that will maximise returns. Quantitative methods can be used
to measure risk and diversify effectively among asset classes.
Portfolio diversification is not so much a function of how many
stocks or bonds are involved as it is of the relationship of assets
to each other. The percentage and proportionality of these assets in
the portfolio are of paramount importance.

Many investors are reluctant to invest much in the stockmarket
because they know many stories of companies that have come on hard
times. Some imagine that just when a stock has gone high, it may be
about to fall sharply. They forget that while a stock may rise or
fall dramatically, movements in the overall market are more subdued.

Modern portfolio theory explains that two effects govern the
movements of every stockmarket and stock-specific event. It is
primarily stock-specific events that cause individual stocks to move
up or down wildly. You may think your best protection against
stock-specific risk is to have portfolio managers who know the
companies in your portfolio well but the events that cause most
damage usually come as a surprise. A company may have a sudden
product liability problem or the chairman may die. It may make a
surprise product announcement or land a major contract. These events
are often unanticipated so cause movements that not even the best
portfolio managers expect.

In fact, modern portfolio theory tells us that if the market can
anticipate an event, the effect is already evident in the stock’s
price and no further profit from knowledge of the event is possible.
This is known as the efficient market theory.

If it is surprises that portfolio managers cannot anticipate events
that move stocks, how can an investor protect a portfolio against
them? The answer is diversification. The stock-specific movements of
specific stocks may not be predictable but over a diversified
portfolio they tend to cancel each other out. Modern portfolio theory
says we can build diversified portfolios to reduce stock-specific
risk but that market events, which affect all stocks, are not
diversifiable. Even a diversified portfolio of stocks is subject to
the overall movements of the market. Fortunately, the theory predicts
that the market rewards us for taking this risk by giving generous
long-term growth potential. Asset allocation is where we decide how
aggressively to pursue this growth.

An asset class is a group of investments whose risk factor and
expected returns are similar. Originally, institutional asset class
funds were not available to investors. The minimum investment was
often millions of pounds, effectively removing them from the reach of
all but the wealthiest investors.

An asset class fund is a fund designed to broadly represent the
market or a significant segment of the market such as big companies
or the stocks of a particular country. These funds invest in a large
number of the stocks of their defined segment of the market to
provide returns approximating the returns offered by that market
segment.

By using asset class funds, it is hoped to be able to lower risk by
increasing diversification, achieve market segment returns and
minimise costs. By choosing asset classes that have the most impact
on the market, you should be able to approximate total market
performance.

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