Conventional finance

What Is Conventional Finance?

Conventional finance refers to the established body of theories, models, and practices that underpin traditional investment and financial decision-making. It operates on core assumptions such as investor rationality, efficient markets, and the pursuit of maximizing returns while minimizing risk. As a fundamental component of Investment Principles, conventional finance provides the framework for understanding how financial markets operate, how assets are valued, and how individuals and institutions make financial choices. It is deeply rooted in neoclassical economics and focuses on quantifiable metrics and statistical analysis to guide portfolio management and financial planning. Conventional finance emphasizes concepts like the risk-return tradeoff and the benefits of diversification to achieve optimal investment outcomes.

History and Origin

The foundations of conventional finance were largely laid in the mid-20th century, marking a significant shift from more anecdotal or qualitative approaches to a rigorous, quantitative discipline. A pivotal moment came with Harry Markowitz's groundbreaking work on Modern Portfolio Theory (MPT). His 1952 paper, "Portfolio Selection," introduced a mathematical framework for optimizing investment portfolios based on the expected returns and risks of various assets, crucially considering their correlations.⁷ This innovation, further developed in his 1959 book Portfolio Selection: Efficient Diversification of Investments, moved portfolio management beyond merely selecting individual securities to constructing portfolios that balance risk and reward efficiently.⁶ This theoretical underpinning paved the way for subsequent developments, including the Capital Asset Pricing Model (CAPM) and the Efficient Market Hypothesis, solidifying the analytical approach central to conventional finance.

Key Takeaways

• Conventional finance is built upon assumptions of rational investors and efficient markets.
• It utilizes quantitative models and statistical analysis for investment decisions.
• Key concepts include risk-return optimization, diversification, and asset valuation.
• It forms the bedrock of modern portfolio management and financial planning.
• Conventional finance provides a systematic approach to understanding and navigating financial markets.

Formula and Calculation

While "conventional finance" itself doesn't have a single overarching formula, it encompasses numerous mathematical models and calculations central to its principles. For instance, the expected return of a portfolio ((E[R_p])) is a weighted average of the expected returns of its individual assets:

$E[R_p] = \sum_{i=1}^{n} w_i \cdot E[R_i]$

Where:

• (E[R_p]) = Expected return of the portfolio
• (w_i) = Weight (proportion) of asset (i) in the portfolio
• (E[R_i]) = Expected return of asset (i)
• (n) = Number of assets in the portfolio

A more complex, but equally fundamental, calculation in conventional finance is the portfolio variance ((\sigma_p^2)), which measures the overall risk of a portfolio by considering not just individual asset variances but also their covariances:

$\sigma_p^2 = \sum_{i=1}^{n} w_i^2 \sigma_i^2 + \sum_{i=1}^{n} \sum_{j=1, i \neq j}^{n} w_i w_j \text{Cov}(R_i, R_j)$

Where:

• (\sigma_p^2) = Variance of the portfolio
• (w_i), (w_j) = Weights of assets (i) and (j) in the portfolio
• (\sigma_i^2) = Variance of asset (i)
• (\text{Cov}(R_i, R_j)) = Covariance between the returns of asset (i) and asset (j)

These formulas are critical for understanding the risk and return characteristics of a portfolio, guiding decisions related to asset allocation and optimization.

Interpreting Conventional Finance

Interpreting conventional finance involves understanding its underlying assumptions and how they translate into practical investment strategies. It posits that asset prices reflect all available information, implying that consistently "beating the market" through active management is difficult due to market efficiency. Investors are presumed to be rational, acting in their self-interest to¹², ³⁴⁵