The Role of Mean-Variance Efficiency
We began the Chapter with an idealized picture of investors (including management) who are rational and risk-averse and formally analyses one course of action in relation to another. What concerns them is not only profitability but also the likelihood of it arising; a risk-return trade-off with which they feel comfortable and that may also be unique.
Thus, in a sophisticated mixed market economy where ownership is divorced from control, it follows that the
objective of strategic financial management should be to implement optimum investment-financing decisions using risk-adjusted wealth maximizing criteria, which satisfy a multiplicity of shareholders (who may already hold a diverse portfolio of investments) by placing them all in an equal, optimum financial position.
No easy task!
But remember, we have not only assumed that investors are rational but that capital markets are also reasonably efficient at processing information. And this greatly simplifies matters for management. Because today’s price is independent of yesterday’s price, efficient markets have no memory and individual security price movements are random. Moreover, investors who comprise the market are so large in number that no one individual has a comparative advantage. In the short run, “you win some, you lose some” but long term, investment is a fair game for all, what is termed a “martingale”. As a consequence, management can now afford to take a linear view of investor behavior (as new information replaces old information) and model its own plans accordingly.
Like Fisher’s Separation Theorem, the concept of linearity offers management a lifeline because in efficient capital markets, rational investors (including management) can now assess anticipated investment returns (ri) by reference to their probability of occurrence, (pi) using classical statistical theory. What rational market participants require from companies is a diversified investment portfolio that delivers a maximum return at minimum risk.
What management need to satisfy this objective are investment-financing strategies that maximize corporate wealth, validated by simple linear models that statistically quantify the market’s risk-return trade-off .
If the returns from investments are assumed to be random, it follows that their expected return (R) is the expected monetary value (EMV) of a symmetrical, normal distribution (the familiar “bell shaped curve” sketched overleaf). Risk is defined as the variance (or dispersion) of individual returns: the greater the variability, the greater the risk.
We began the Chapter with an idealized picture of investors (including management) who are rational and risk-averse and formally analyses one course of action in relation to another. What concerns them is not only profitability but also the likelihood of it arising; a risk-return trade-off with which they feel comfortable and that may also be unique.
Thus, in a sophisticated mixed market economy where ownership is divorced from control, it follows that the
objective of strategic financial management should be to implement optimum investment-financing decisions using risk-adjusted wealth maximizing criteria, which satisfy a multiplicity of shareholders (who may already hold a diverse portfolio of investments) by placing them all in an equal, optimum financial position.
No easy task!
But remember, we have not only assumed that investors are rational but that capital markets are also reasonably efficient at processing information. And this greatly simplifies matters for management. Because today’s price is independent of yesterday’s price, efficient markets have no memory and individual security price movements are random. Moreover, investors who comprise the market are so large in number that no one individual has a comparative advantage. In the short run, “you win some, you lose some” but long term, investment is a fair game for all, what is termed a “martingale”. As a consequence, management can now afford to take a linear view of investor behavior (as new information replaces old information) and model its own plans accordingly.
Like Fisher’s Separation Theorem, the concept of linearity offers management a lifeline because in efficient capital markets, rational investors (including management) can now assess anticipated investment returns (ri) by reference to their probability of occurrence, (pi) using classical statistical theory. What rational market participants require from companies is a diversified investment portfolio that delivers a maximum return at minimum risk.
What management need to satisfy this objective are investment-financing strategies that maximize corporate wealth, validated by simple linear models that statistically quantify the market’s risk-return trade-off .
If the returns from investments are assumed to be random, it follows that their expected return (R) is the expected monetary value (EMV) of a symmetrical, normal distribution (the familiar “bell shaped curve” sketched overleaf). Risk is defined as the variance (or dispersion) of individual returns: the greater the variability, the greater the risk.
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