USING MODERN PORTFOLIO THEORY TO IDENTIFY INCREASED INVESTMENT RISKS IN PRIVATE BANKS A Project Presented to the Faculty of California State Polytechnic University, Pomona In Partial Fulfillment Of the Requirements for the Degree Master of Science In Economics By Roberto Martinez Suarez 2015 SIGNATURE PAGE PROJECT: USING MODERN PORTFOLIO THEORY TO IDENTIFY INCREASED INVESTMENT RISKS IN PRIVATE BANKS AUTHOR: Roberto Martinez Suarez DATE SUBMITTED: Fall 2015 Economics Department Dr. Bruce Brown Project Committee Chair Professor of Economics Dr. Carsten Lange _____________________________________________ Graduate Coordinator Professor of Economics ii ACKNOWLEDGEMENTS Foremost, I would like to express my sincere gratitude to my advisor Prof. Bruce Brown for his continuous support of my graduate studies and research, and for his patience, motivation, enthusiasm, and immense knowledge. His guidance has helped me in all the time of research and writing of this project. I cannot imagine having a better advisor and mentor. Besides my advisor, I would like to thank my other project committee member Prof. Carsten Lange. His encouragement, insightful comments, and hard questions have been truly appreciated. My sincere thanks also goes to Dr. Mohammad Safarzadeh for making economics at Cal Poly Pomona so difficult. This forced me to bring my “A” game. I thank my classmates Justin Niakamal and David Raymundo. They have offered me their guidance, assistance, and friendship throughout the previous two years. Last, but not the least, I would like to thank my family. I thank my parents Roberto Martinez and Emma Victoria Martinez for giving birth to me in the first place and for supporting me spiritually throughout my life. I thank my younger siblings Erika, Bayron, Alfred, and Denise who have been instrumental in my success as well. A shout-out to my girlfriend Erica Picazo for being very supportive and understanding. iii ABSTRACT In the wake of the Great Recession of 2009, it is little wonder that there has been growing interest in identifying optimal investment strategies that can avoid unnecessary risks while maximizing returns on investment. Despite its constraints, modern portfolio theory has emerged as a viable strategy for this purpose. This paper applies modern portfolio theory to identify indications of increased investment risks in private banks. This paper also explores how those investment risks can in turn affect private markets, particularly in view of potential penalty risks that private investors sometimes incur. An examination of portfolio returns for various levels of risk through an evaluation of a firm’s beta is followed by an analysis concerning the perspective of Warren Buffett on this issue. Finally, in the conclusion, the paper provides a summary of the research and important findings concerning the application of modern portfolio theory. iv TABLE OF CONTENTS Signature Page…………………………………………………………………………. ii Acknowledgements……………………………………………………………………. iii Abstract………………………………………………………………………………... iv List of Tables…………………………………………………………………………… vi List of Figures………………………………………………………………………….. vii Chapter1: Introduction………………………………………………………………… 1 Chapter 2: Review and Analysis……………………………………………………….. 2 Overview of Modern Portfolio Theory………………………………………… 2 Identifying Signs of Increased Investment Risks in Private Banks……………. 6 How Increased Investment Risk Affects Private Markets……………………... 23 Applicability of Beta to Increased Investment Risk in Private Banks…………. 25 Chapter 3: Conclusion………………………………………………………………….. 29 References……………………………………………………………………………… 31 Appendix: Due Diligence Required for Investments in Private Enterprises…………… 34 v LIST OF TABLES Table 1 Variables That Signal Potential Investment Crises……………………... 20 Table 2 Stock Selection Using Beta……………………………………………... 26 vi LIST OF FIGURES Figure 1 Share of the investment portfolio dedicated to credit investments: 2007-2011………………………………………………………………. 12 Figure 2 Portion of the securities portfolio classified as credit or spread investments in 2011…………………………………………………….. 14 Figure 3 Increase in credit portfolio assets and liquidity portfolio asset exposures……………………………………………………………….. 15 Figure 4 Minimizing unsystematic risk through portfolio diversification……….. 18 Figure 5 Efficient frontier for Google and Coca Cola stocks……………………. 19 vii CHAPTER 1 INTRODUCTION Today, there is a growing consensus among practitioners that it is possible to identify salient risks and improve returns on investment by applying modern portfolio theory. There is less agreement, though, concerning the optimal approaches to applying modern portfolio theory to identify increased investment risks in private banks and how those investment risks can affect private markets. To determine the facts, this paper uses modern portfolio theory to reveal signs of increased investment risks in private banks. This paper then explores how those investment risks effect private markets, especially in light of potential penalty risks that private investors sometimes incur. In addition, by appraising a firm’s beta, there can be an examination of portfolio returns for various levels of risk. Beta views risk solely from the perspective of market prices. Warren Buffett’s opinion on this matter is that some investors shun beta because it implies that a stock that has fallen sharply in value is more risky than it was before it fell. Finally, a summary of the research and important findings concerning the application of modern portfolio theory in this context are provided in the conclusion. 1 CHAPTER 2 REVIEW AND ANALYSIS Overview of Modern Portfolio Theory The recipient of the 1990 Nobel Prize winner in economics, Harry Markowitz, was responsible for developing modern portfolio theory as well as for participating in additional collaboration with other economists to fine-tune its tenets (Bai, Dow, & Newsom, 2008). A useful definition of modern portfolio theory is provided by Mangram (2013) who advises, “[Markowitz’s] innovative work established the underpinnings for Modern Portfolio Theory -- an investment framework for the selection and construction of investment portfolios based on the maximization of expected portfolio returns and simultaneous minimization of investment risk” (p. 59). The work by Markowitz was expanded upon in 1964 by William Sharpe whose research into financial asset price formation became known as the Capital Asset Pricing Model, or CAPM (Mangram, 2013). This expanded conceptualization of modern portfolio theory provides a useful framework for investment analysis that allows practitioners to select and develop investment portfolios that are founded on the optimization of expected returns of the portfolio and the simultaneous minimization of the associated risks of investment (Fabozzi, Gupta, & Markowitz, 2002). The expanded version of modern portfolio theory is frequently referred to as the mean-variance analysis in which the “mean” is used interchangeably with the average expected return and the “variance” applies to the indicated risk (Mangram, 2013). The mean-variance analytical approach has since emerged as a fundamental approach to optimizing investment portfolios (Campbell, 2000). There are some 2 constraints to modern portfolio theory as conceptualized by Markowitz. For example, Goetzmann and Wachter (1999) note, “As originally conceived, mean-variance calculates a set of portfolio weights across assets that result in the highest expected return for each given level of investor risk. While useful, the procedure is not without drawbacks” (p. 271). The main drawbacks to modern portfolio theory depend on the viewpoints of the investors, with some viewing some aspects of the model as being suboptimal while others consider other variables more salient for their purposes (Viezer, 1999). Along this same line, Campbell (2000) points out, “This approach usefully emphasizes the ability of diversification to reduce risk, but it ignores several critically important factors. Most notably, the analysis is static; it assumes that investors care only about risks to wealth one period ahead” (para. 2). However, Campbell goes on to explain that a number of institutional and individual investors are more interested in developing a long-term system of consumption. Moreover, there are also constraints to the mean-variance analytical approach. These include the manner in which financial wealth and income are treated (Bielski, 2005). Along this line, Campbell (2000) adds, “Mean-variance analysis treats financial wealth in isolation from income. Long-term investors typically receive a stream of income and use it, along with financial wealth, to support their consumption” (para. 2). Currently, mean-variance analysis is the foundation of modern portfolio selection and optimization (Leung, 2009). Notwithstanding these constraints, the research to date suggests that the risk factors associated with modern portfolio theory can be determined through the 3 application of different mathematical formulas and can be analyzed using the concept of diversification. Diversification seeks to optimize a weighted collection of investment assets that, in the aggregate, demonstrate lower risk factors compared to investments in any individual asset or asset class (Mangram, 2013). This concept is derived directly from the earlier work by Markowitz. As Mangram (2013) points out, “Diversification is, in fact, the core concept of modern portfolio theory and directly relies on the conventional wisdom of ‘never putting all your eggs