Financial Theory Of Investment

[Ceumar Pee]

Themodern portfolio theory (MPT) was a breakthrough in personal investing. It suggests that a conservative investor can do better by choosing a mix of low-risk and riskier investments than by going entirely with low-risk choices. More importantly, it suggests that the more rewarding option does not add additional overall risk. This is the key attribute of portfolio diversification.

The post-modern portfolio theory (PMPT) does not contradict these basic assumptions. However, it changes the formula for evaluating risk in an investment in order to correct what its developers perceived as flaws in the original.

Another benefit of the modern portfolio theory (and of diversification) is that it can reduce volatility. The best way to do that is to choose assets that have a negative correlation, such as U.S. treasuries and small-cap stocks.

The efficient frontier is a cornerstone of the modern portfolio theory. It is the line that indicates the combination of investments that will provide the highest level of return for the lowest level of risk.

When a portfolio falls to the right of the efficient frontier, it possesses greater risk relative to its predicted return. When it falls beneath the slope of the efficient frontier, it offers a lower level of return relative to risk.

Economists have had an enormous impact on trade policy, and they provide a strong rationale for free trade and for removal of trade barriers. Although the objective of a trade agreement is to liberalize trade, the actual provisions are heavily shaped by domestic and international political realities. The world has changed enormously from the time when David Ricardo proposed the law of comparative advantage, and in recent decades economists have modified their theories to account for trade in factors of production, such as capital and labor, the growth of supply chains that today dominate much of world trade, and the success of neomercantilist countries in achieving rapid growth.

Almost all Western economists today believe in the desirability of free trade, and this is the philosophy advocated by international institutions such as the World Bank, the International Monetary Fund, and the World Trade Organization (WTO). And this was the view after World War II, when Western leaders launched the General Agreement on Tariffs and Trade (GATT) in 1947.

However, economic theory has evolved substantially since the time of Adam Smith, and it has evolved rapidly since the GATT was founded. To understand U.S. trade agreements and how they should proceed in the future, it is important to review economic theory and see how it has evolved and where it is today.

Mercantilists believed that governments should promote exports and that governments should control economic activity and place restrictions on imports if needed to ensure an export surplus. Obviously, not all nations could have an export surplus, but mercantilists believed this was the goal and that successful nations would gain at the expense of those less successful. Ideally, a nation would export finished goods and import raw materials, under mercantilist theory, thereby maximizing domestic employment.

Then Adam Smith challenged this prevailing thinking in The Wealth of Nations published in 1776.[2] Smith argued that when one nation is more efficient than another country in producing a product, while the other nation is more efficient at producing another product, then both nations could benefit through trade. This would enable each nation to specialize in producing the product where it had an absolute advantage, and thereby increase total production over what it would be without trade. This insight implied very different policies than mercantilism. It implied less government involvement in the economy and a reduction of barriers to trade.

Thirty-one years after The Wealth of Nations was published, David Ricardo introduced an extremely important modification to the theory in his On the Principles of Political Economy and Taxation, published in 1817.[3] Ricardo observed that trade will occur between nations even where one country has an absolute advantage in producing all the products traded.

Ricardo showed that what was important was the comparative advantage of each nation in production. The theory of comparative advantage holds that even if one nation can produce all goods more cheaply than can another nation, both nations can still trade under conditions where each benefits. Under this theory, what matters is relative efficiency.

Economists sometimes compare this to the situation where even though a lawyer might be more proficient at both law and typing than the secretary, it would still pay the lawyer to have the secretary handle the typing to allow more time for the higher-paying legal work. Similarly, if each country specializes in the products where it is comparatively more efficient, total production will be higher and consumers will have more goods to utilize.

Furthermore, some products do not utilize the same factors of production over their life cycle.[6] For example, when computers were first introduced, they were incredibly capital intensive and required highly skilled labor. Over time, as volume increased, costs came down and computers could be mass produced. Initially, the United States had a comparative advantage in production; but today, when computers are mass produced by relatively unskilled labor, the comparative advantage has shifted to countries with abundant cheap labor. And still other products may use different factors of production in different countries. For example, cotton production is highly mechanized in the United States but is very labor intensive in Africa. The fact that factors of production may change does not nullify the theory of comparative advantage; it just means that the mix of products that a nation can produce relatively more efficiently than its trade partners may change.

Traditional economic theories expounded by Ricardo and Heckscher-Ohlin are based on a number of important assumptions, such as perfect competition with no artificial barriers imposed by governments. A second assumption is that production occurs under diminishing or constant returns to scale, that is, the costs of producing each additional unit are the same or higher as production increases. For example, to increase his wheat crop, a farmer may be forced to use less-fertile land or pay more for laborers to harvest the wheat, thereby increasing the cost of each additional unit produced.

Many economists, however, believe that the dynamic benefits of free trade may be greater than the static benefits. Dynamic benefits, for example, include the pressure on companies to be more efficient to meet foreign competition, the transfer of skills and knowledge, the introduction of new products, and the potential positive impact of the greater adoption of commercial law. Thus trade can affect both what is produced (static effects) and how it is produced (dynamic effects).

Assume that the United States exports aircraft to Japan and imports televisions, and that one airplane can purchase 1,000 televisions. If one airplane now can purchase 2,000 televisions, the United States will be better off; alternatively, its welfare is diminished if it can only purchase 500 televisions with a single airplane.

A country can also adopt a beggar-thy-neighbor stance by deliberately turning the terms of trade in its favor through the imposition of an optimum tariff or through currency manipulation. In his economics textbook, Dominick Salvatore defines an optimum tariff as

The firms gaining sales through this may well hire more workers and possibly increase dividends to stockholders. This money is distributed through the economy a number of times as a result of what economists call the money multiplier effect, which states that for every $1 an individual receives as income, a portion of it will be spent (i.e., consumption) and a portion will be saved. If individuals save 10 percent of their income, for every $1 earned as income, 90 cents will be spent and 10 cents will be saved. The 90 cents that is spent then becomes income for another individual, and once again 90 percent of this will be spent on consumption. This continues until there is nothing left from the original $1 amount.

The impact of trade on GDP, therefore, is the net amount that exports exceed or are less than imports. However, this is a static measure. As noted above, expanded exports also have a dynamic effect as companies become more efficient as sales increase.

The benefits of unilateral elimination of trade barriers are particularly obvious in those cases where the country does not produce the product; in these cases, eliminating trade barriers expands consumer choice. (As noted above, however, an exception to this occurs in situations where reducing a trade barrier on a raw material or component that is not produced by the country increases the effective rate of protection for the finished product.)

Increased import competition also has dynamic benefits by forcing domestic producers to become more efficient in order to compete in the lower price environment. Lower prices also may have a positive impact on monetary policy; because import competition reduces the threat of inflation, central banks can pursue a more liberal monetary policy of lower interest rates than otherwise would be the case. These lower rates benefit investment, housing, and other productive sectors.

Economists have developed a number of sophisticated models designed to simulate the changes in economic conditions that could be expected from a trade agreement. These models, which are based on modern economic theories of trade, are helpful where the barriers to trade are quantifiable, although the results are highly sensitive to the assumptions used in establishing the parameters of the model.

One type of model used extensively by economists to estimate the economy-wide effects of trade policy changes, such as the results of a multilateral trade round, is the Applied General Equilibrium Model, also called the Computable General Equilibrium (CGE) Model.[13] James

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