MPT 1

MODERN PORTFOLIO THEORY

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BUSI 1002 Introduction to Management and Leadership

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Managing the portfolio of activities for the corporations has been the center of focus

since the 1970s. Concepts in this domain have however focused more on profitability and

effective allocation of resources. With this in mind, managing risk in the corporation has gained

attention recently with organizations focusing on various forms of risk management such as

financial and operational. Most organizations have disregarded much concerning strategic

decision making and its role in taking care of risks leading to a gap between it and the

accompanying risks. As a way of bridging the gap, modern portfolio theory (MPT) has become a

point of consideration as it encapsulates risk into the process of strategic decision-making to

manage the corporate portfolio. Incorporating risk may be relevant to a corporation or be a

crackdown as it will be showed in this paper. Also, the rest of the discussions will focus on MPT

from the various perspectives involving transferability, its consequences due to the relationship

and possible limitations of MPT in a managerial context of a corporate.

Relevance of incorporating risk in strategic financial management

The MPT affiliated with finance and the capital asset pricing model state that there is no

need for corporate managers to show concern with reducing the risk in the firm to a specific level

due to theoretical reasoning. Corporation owners are always considered as the main stakeholders

of an organization. Thus, managing the organization should follow their interests. The theoretical

arguments of MPT articulate that stakeholders should possess portfolios that exhibit a higher

degree of diversification. In line with this scenario, the investors should urge the organizations

where they invest to take higher risk in in investment under favorable conditions of combined

expected return and systematic risk. In the stockholder’s portfolio, some of the corporations may

go bankrupt while others may exhibit a reputable level of prosperity. The stakeholder should

ensure that despite all the prevailing circumstances there is some return that seems satisfactory as
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supported by Hull (2012: 8). Although argued from such a theoretical perspective most scholars

tend to concur with the notion that this is not a sound behavior in the contemporary world (Hull,

2012: 147). Furthermore, as the later presentations will show, corporate risk forms an important

parameter as far as strategic management is concerned and from the perspectives of the corporate

leaders although the level of application may differ. In the early studies Amit and Wernerfelt,

(1990: 524) pointed out that the conflict that may rise between how the theory of finance and the

approaches regarded for strategic management of risks can be elucidated from the perspectives

of two controversial positions. Firstly, there is the question of efficacy, from the position of

theoretical finance affiliated with the capital markets. Nevertheless, for this to occur, the capital

markets must adopt a high level of efficacy and the diversify all the nonsystematic risk as much

as possible. For this position, the risk never seems to be a matter worth considering. Secondly, is

about the managers maximizing all the issues affiliated with corporate. The financial theory

proposes that value maximization for the stockholders should be one of the managerial goals.

Nevertheless, the need for managers to fulfill the needs of various stakeholders like employees,

the community, and the suppliers does not show any consistency with the financial theory (Amit

and Wernerfelt, 1990: 525).

Hitherto, these two conflicts have remained largely unattended to. Nevertheless,

incorporating risks in the strategic management may bore fruits for the stakeholders despite the

presence of efficacy in the capital markets and the maximization value for the stockholders. Amit

and Wernerfelt, (1990: 527) found evidence to support the premise that low risk permits

corporations to heighten the flow of cash through the acquisition of production factors at reduced

costs or operating and efficient levels. The benefits accrued from lowering the risks have also

been explored by Damodaran who identified five ways by which lowering risk in corporations
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through hedging can be of significance (Damodaran, 2008: 329). He deduced the following 1)

the smoothing of earnings can contribute to tax benefits particularly from the presence of convex

tax rating or from the asymmetric treatment of the tax affiliated with hedging benefits and

expenses; 2) Providing protection against extremities of risk of any catastrophe may mitigate the

likelihood of distress that would incur extra financial costs. This would encompass not only the

cost affiliated with bankruptcy but also the intermediate costs pertinent to the perceived trouble

that could be beyond substantial; 3) The problem of underinvestment may be reduced through

risk hedging as it can be tracked back to averse risk pertinent to managerial and frictions in the

capital market; 4) Reducing being exposed to particular forms of risk may enable the

corporations to gain more autonomy regarding the optimization of the capital structure and

reduce their capital costs; and 5) Corporations may obtain rewards from the investors that hedge

against the risks unrelated to the cores of their business since the financial statements of such

firms seem more lucrative with robust information.

On the basis of both interdisciplinary empirical evidence and theoretical conflicts,

considering risks in strategic management seems to have benevolence for the corporation

Criticisms and the limitations of Transferability of MPT

Proposal affiliated with the application of MPT in the management of portfolio came

from Cardozo & Wind (1985) to cement the study that Cardozo & Smith in 1983 had

already conducted. The portfolio theory pertinent to finance or MPT displays potential as a

planning and analytical tool for the decision-making process. As a form of commenting on

the study of Cardozo and Smith Devinney, Stewart & Shocker (1985: 107) gave out their

thoughts regarding the shortcomings of transferability of MPT to strategic decision making.

In their critique, they articulated that product investment or activities affiliated with
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business are different from the perspectives of structure and in relation to investments in

the financial markets. Such differences contribute to technical limitations through the

application of the techniques affiliated with the financial portfolio and in particular the

CAPM. To begin with, financial markets view risk as a form of a deviation of returns. One

fundamental assumption of efficacy in strategies regarding investment is the arbitrage that

occurs in the unsystematic risks within the financial markets. However, it is not possible to

directly apply the various metric returns of accounting such as ROI or ROA. Another

limitation worth mentioning is that variation occurs in the product cycle when it comes to

investment in the corporation and this is not exhibited in the available financial portfolio

techniques. Therefore, applying MPT to corporate would only be beneficial if the business

is mature and has some position stability in the market accompanied by some degree of

clarity in the allocation of cost and revenues.

Consequences of this inconclusive relationship

It is worth taking note of the apparent lack of any conclusive definition showing the

relationship in a risk-return for corporate investments. This implies that concepts affiliated with

MPT are difficult to apply in a managerial setting affiliated with the corporate portfolio. If there

cannot be a standard definition to exhibit the relationship between return and risk, the trade-off,

and the integration between the two, then it is difficult to enforce the terminologies in a model.

Having the ability to carry out risk and return comparison for individual investments and the

contributions they make is a significant attribute as it allows for investment comparison from the

perspectives of risk. Nevertheless, the applying models affiliated with risk-returns tradeoffs such

as efficient frontier and CAPM would not seem a viable alternative. With this in mind it also

important to take note of the mathematical equations that would have been used. They are not
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applicable to this circumstance since the relationship is unclear. Using them, therefore, would

only result in inconsistency. Thus, MPT cannot give the rightful model to use based on the

combination of the combined portfolio that optimizes returns following a particular level of risk

or reduces the risk following a particular return. Additionally, divisibility of investments hinders

the development of the optimization model for the corporate portfolios. The theory of financial

portfolio makes an assumption that financial investments possess infinite divisibility and as such,

it is possible to determine their weights in a given portfolio in the form of a continuous decimal.

The assumption regarding perfect divisibility may be perfect for some industries that are

frictionless or when the macro level is used to consider the corporate investments. Single

corporate investment mostly uses a decision of 0-1 on a scale i.e. it either invests or not. The

corporation may, therefore, lack decision regarding the investment weight in relation to that

portfolio, the investment capital weight, return of investment or any other parameter associated.

So, any MPT framework with the aim of optimizing the investments of a corporation would be

restricted to the weight parameters already mentioned. However, MPT tools can lead to

incorporate risk as far as management of portfolios is concerned. The contribution would involve

focusing on individual contributions to the framework rather than weighing all the tradeoffs

between risk and return. This implies that the framework may not be significant as a standalone

in managing a corporation although it can be used as a tool to manage risk in the product lines or

units of business encapsulated in the portfolio.

The theoretical possibilities and limitations of MPT in a corporate management context

The concerns regarding the use of MPT to integrate strategic management and risk have

caused severe limitations with the most comprehensive being the decline in the usage of the

model that encapsulates the risk-return relationship. This is attributable to two issues. Firstly, is
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the complex characteristic of corporate investment leading to incorporation of a second issue

which is the risk-return relationship which makes it harder for the indivisibility of investments.

These are only solved by the motivating contributors. Various reasons have hindered corporate

trading as compared to trading in the financial markets. Additionally, the managerial criterion of

the corporate portfolios is more complex compared to that of financial. All of these complexities

lead to the risk-return relationship already discussed.

Also, the nature of the corporate markets contributes to more fundamental assumptions

that behind the lack of satisfaction in MPT because the corporates are incapable of action as risk

takers when it comes to pricing. When the corporations fear such a risk, they end up affecting the

market through the models of MPT as these models become endogenous to the actions of the

market leading to risk-return. This can create alterations to the risks and returns of the market as

well as the investments that encompass it. The problem herein is identical to the models that

Cumova and Nawrocki, (2011) addressed in his optimization for the downside risk required to

approach the problem. The higher degree of indivisibility in the investments of the corporate is

always beyond the control of the corporation. Corporate investments often base their decisions

on 2 options as already mentioned and that is do or not. These decisions can never be divided

into fragments. Optimization process affiliated with the MPT via the determination of the

weights of investments is somehow hard to enforce in the context of managerial corporation

thereby leaving behind one conclusion that there can never be any static or general form of

relations affiliated with risk and return as corporate investments are concerned.

Conclusively, MPT is applicable to the connections that previously exhibited

disconnected responsibilities attached to corporate management, strategic and risk management

too. Existing literature has shown tan analysis of the key concepts and the MPT relationship
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under the context of corporate management. The importance of these steps is to find the actual

implementation affiliated with MPT and the connections to strategic and risk management of a

corporation via the management of the portfolio. Also, there is need to take note of the key

limitations hindering the relationship of MPT in corporate management. From a critical

perception, it turns out that the models of MPT for the risk-return should be dismissed as they

make it impossible for the corporate portfolios to optimize risk and return. Thus, there is a need

for further research to look for effective options that can incorporate strategic and risk

management through the selected concepts of MPT.

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References

Amit, R. and Wernerfelt, B. (1990). WHY DO FIRMS REDUCE BUSINESS RISK? Academy

of Management Journal, 33(3), pp.520-533.

Cardozo, R. and Smith, D. (1983). Applying Financial Portfolio Theory to Product Portfolio

Decisions: An Empirical Study. Journal of Marketing, 47(2), p.110.

Cardozo, R. and Wind, J. (1985). Risk-return approach to product portfolio strategy. Long Range

Planning, 18(2), pp.77-85.

Cumova, D. and Nawrocki, D. (2011). Asymmetric LPM model for heuristic mean–semivariance

analysis. Journal of Economics and Business, 63(3), pp.217-236.

Damodaran, A. (2008). Strategic risk taking. 1st ed. Upper Saddle River, N.J.: Wharton School

Pub.

Devinney, T., Stewart, D., and Shocker, A. (1985). A Note on the Application of Portfolio

Theory: A Comment on Cardozo and Smith. Journal of Marketing, 49(4), p.107.

Hull, J. (2012). Risk management and financial institutions + website. 1st ed. Hoboken, New

Jersey: John Wiley & Sons, Inc.