Portfolio Theory

Abstract

In the last 30 years a branch of applied microeconomics was developed and specialised into modern finance theory. It is important to understand some of the advances in this theory and how they underpin the principles of property investment. It is not within the range of this text to provide details of the theory or any extensive discussion and you are referred to one of the specialist texts. This summary, for instance, uses an approach from Financial Theory and Corporate Policy (Copeland and Weston 1988). The beginning of the separate development of modern finance theory was with Markowitz’s work in the 1950s when he was developing portfolio theory, which is now applied in the selection of investment portfolios (Markowitz 1952, 1959). In addition, Modigliani and Miller were working on capital structure and gearing at this time. Modern finance theory emphasises the analytical and quantitative skills of management rather than a descriptive approach to the understanding of finance. However, you should appreciate that, in a text of this nature, a descriptive approach is appropriate at this level and thus the application of theory is limited. Copeland and Weston (1988) suggest that there are six seminal and internally consistent theories on which modern finance theory and investment is founded. These are listed below together with brief explanations. All these theories attempt to answer the common problem related to economics: ‘How do individuals and society allocate scarce resources through a price system based on the valuation of risky assets’?