What is Portfolio Separation Theorem?

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The portfolio separation theorem is an economic theory that tells that the investment decisions or choices of a firm are not related to the investment preferences of the firm’s owners. It postulates that a firm should try to maximize profit rather than trying to diversify the decisions of the firm’s owners. The separation theorem also states that irrespective of the preferences of a firm’s shareholders, the firm should choose optimal production measures that will bring more profits to the investment portfolio.

Note − The portfolio separation theorem states that the total number of portfolios that are required to create an optimum allocation equals the characteristics that investors are concerned about.

The significance of the theorem is that it shows why every investor needs to hold shares in “the market portfolio,” rather than the stocks that are somehow peculiar to that investor. The separation theorem paves the path to the Capital Asset Pricing Model (CAPM), the idea of passive investing, indexing, and measurement of the risk of a single stock by its correlation with the market portfolio, also known as beta.

Why is Fisher's Separation Theorem Important?

The Separation Theorem asks the organizations to make maximum profit the primary goal rather than trying to achieve the utility preferences of shareholders. The theorem tells that the productivity value of a firm should not be altered by the preferences of the owners. Also, the value should not affect the owner's or shareholders' preferences.

The Separation Theorem holds that the decisions of investment of a firm and the preferences of its owners or shareholders are two separate objectives. This theorem states that the shareholders of a firm have different investment ideas that are separate from the firm’s managers. Hence, managers should focus on how to maximize the value or profit of the firm and ignore the utility preferences of shareholders.

Modigliani-Miller Theorem

The Separation Theorem created the path for the development of the "Modigliani-Miller theorem". It postulates that in an efficient capital market, the exact value of a firm is not affected by the utility preferences of its owner. The Modigliani-Miller theorem states that how a company finances its investments or arranges dividend distributions does not affect its value. According to the theorem, a firm can finance investments through debt financing, equity financing, and internal revenue.

Note − The Separation Theorem emphasizes that there is no reward for taking an unsystematic risk. If one chooses a portfolio that is not the market portfolio, then there exists some combination of the market portfolio and the riskless asset that could generate a higher return at the same risk as the portfolio one has chosen.

Updated on 28-Sep-2021 07:00:59