Traditional Vs Modern Portfolio Analysis

Traditional Portfolio theory is one of the subjective analysis but it has provided positive results to many some people who have invested keeping in mind the individual securities. Through this traditional theory, investors have been getting the maximum return at the minimum risk.

On the other hand, modern portfolio theory emphasizes on maximizing of return through a combination of securities. It discusses the relationship between different securities and then draws inter-relationships of risks between them.  This theory states that by combining a low risk security with the one with higher risk will ultimately result in a success by investor in making choice of investment.

Traditional portfolio analysis has been of a very subjective nature but it has provided success to some persons who have made their investments by making analysis of individual securities through evaluation of return and risk conditions in each security.

In fact, the investor has been able to get the maximum return at the minimum risk or achieve his return position at that indifferent curve which states his risk condition. The normal method of calculating the return on an individual security was by finding out the amount of dividends that have been given by the company, the price earning ratios, the common holding period and by an estimation of the market value of the shares.

The modern portfolio theory believes in the maximization of return through a combination of securities. The modern portfolio theory discusses the relationship between different securities and then draws inter-relationships of risks between them.

It is not necessary to achieve success, only by trying to get all securities of minimum risk. The theory states that by combining a security of low risk with another security of high risk, success can be achieved by an investor in making a choice of investment outlets.

Traditional theory was based on the fact that risk could be measured on each individual security through the process of finding out the standard deviation and that security should be chosen where the deviation was the lowest. Greater variability and higher deviations showed more risk than those securities which had lower variation.

The modern theory is of the view that by diversification risk can be reduced. Diversification can be made by the investor either by having a large number of shares of companies in different regions, in different industries, or those producing different types of product lines.

Diversification is important but the modern theory states that there cannot be only diversification to achieve the maximum return. The securities have to be evaluated and thus diversified to some limited extent within which the maximum achievement can be sought by the investor. The theory of diversification was based on the research work by Harry Markowitz.

Markowitz is of the view that a portfolio should be analysed depending upon:

(a) The attitude of the investor towards risk and return; and

(b) The quantification of risk

Thus, traditional theory and modern theory are both framed under the constraints of risk and return, the former analysing individual securities and the latter believing in the perspective of combination of securities.

Traditional theory believes that the market is inefficient and the fundamental analyst can take advantage of the situation. By analysing internal financial statements of the company, he can make superior profits through higher returns. The technical analyst believed in the market behaviour and past trends to forecast the future of the securities. These analyses were mainly under the risk and return criteria of single security analysis.

Modern portfolio theory, as brought out by Markowitz and Sharpe, is the combination of the securities to get the most efficient portfolio. Combination of securities can be made in many ways. Markowitz developed the theory of diversification through scientific reasoning and method.