Critically discuss the Harry Markowitz portfolio theory and its developments (Business & Marketing Essay)

THE HARRY MARKOWITZ PORTFOLIO THEORY AND ITS DEVELOPMENTS
Name
Course
Professor
Institution
Due Date
The Harry Markowitz Portfolio Theory and Its Developments
Introduction
Markowitz's portfolio theory presents one of the various pillars of theoretical finance developed by Markowitz in 1959. According to Markowitz's theory, investors have the capability of designing a portfolio that could maximize returns by quantifying the existing amount of risk. In this case, the investors can reduce the level of risk through diversification of assets alongside the allocation of assets concerning their investments through the quantitative methodology. Harry Markowitz's theory allows for investor analysis on the various risks relative to the expected returns. In this theory, there's an attempt to maximize the portfolio expected return for a certain amount of portfolio risk or rather equivalently minimizing risks for a given level of expected return. This is done by making careful choices on different assets' proportions (Wallengren and Sigurdson, 2017).
Critical Analysis of Markowitz's Portfolio Theory
The modern portfolio theory (MPT) is theoretically relevant from the perspective of other researchers. However, its nature of using simplistic assumptions provides a predominant bias. There is the question surrounding the viability of the theory as an investment strategy since its financial market model does not necessarily match the real-world experiences in numerous ways. The various basic assumptions that underlie the theory receive up-to-date challenges of equal measure from the relevant fields that include behavioral economics (Berk and Tutarli, 2020).
Notably, the various efforts that could translate such theoretical foundation as shown in theory into some viable portfolio construction algorithm encounter technical difficulties. This originates from the status of instability as per the original optimization issue as per the available data. Further, the theory cannot model the market. In this case, the risk, return, and correlation measures applicable by the theory follow the expected or instead forecast values. This means that they represent the various mathematical statements concerning the future. Practically, investors are required to be able to substitute predictions based on historical asset return measurement alongside value volatility within such equations. However, there's always some pattern of such expected values failing to account for existing new circumstances within the present environment that never existed at the point of historical data generation. Fundamentally, there is also the aspect of investors sticking to parameter estimation from previous market data since the theory attempts to model risk in terms of anticipated losses while not indicating the cause of such failures (Berk and Tutarli, 2020).
Simultaneously, the theory considers decision investments' personal, environmental, strategic, and social perspectives. In this case, the theory only considers maximization of risk-adjusted returns disregarding other consequent results. The theory's complete dependence on asset prices creates some vulnerability to various standard market failures. These entail those arising from information asymmetry, externalities as well as a public good. The aspect also seems responsible for rewarding corporate fraud alongside false accounting. Elaborately, a firm may seem to have strategic goals capable of shaping investment decisions while individual investors banks on their personal goals. In both situations, the relevant information besides historical returns seems appropriate as per the theory.
Further, the theory fails to take cognizance of its effect concerning asset pricing. In this case, the act of diversification tends to eliminate non-systematic risk at the cost of improving the systematic risk. The act of diversification pressurizes the portfolio management to make investments devoid of an analysis of the existing fundamentals for the benefit of eliminating the portfolios of non-systematic risk. In such a case, the artificial increase in demand increases the asset prices, whereby, when analyzed individually, it provides little fundamental value. The ultimate result is that the whole portfolio becomes more expensive, resulting in a decrease in positive return probability (Wallengren and Sigurdson, 2017).
The various frameworks that underlie this theory entail assumptions concerning markets as well as investors. Such assumptions as applicable in line with the theory either take an explicit or implicit perspective. The foundational assumptions under which the theory is built receives a vast challenge. For instance, concerning risk and returns, financial risk refers to the deviation from the anticipated historical returns within a defined period. However, the theory maintains that the essentiality that pertains to an asset's risk does not represent every asset's risk in isolation but various contributions towards each asset towards the risk of aggregate portfolio. Notably, the analysis of the risk of security takes place based on stand-alone and portfolio. In stand-alone, the asset is well considered within the point of isolation, while the portfolio basis considers assets to represent one of many assets (Grujić, 2016).
The modern portfolio theory is at times referred to as Markowitz portfolio theory. The theory assumes that most investors prefer approaching investment opportunities cautiously and always prefer the smallest possible risk to obtain the highest possible return, therefore, optimizing the aspect of the return to the risk ratio. The idea of an investor investing in multiple stocks provides the benefits of diversification, which entails a reduction within the entire portfolio's volatility (Grujić, 2016).
O'Neill (2000) points to the two aspects behind the theory, which entails the high probability of history repeating itself. The idea supports the fact that the application of historical data of securities is very crucial. The other thesis focuses on the fact that not all assets appreciate and depreciate in tandem. However, such aspects are essential for different investors since they assist in decision making. The theory has various critical practical applications, which entails reducing volatility in a portfolio of individual stocks. Before the invention of MPT, the input from the investors regarding portfolio management wa...