Portfolio Theory - Is it wise to place all of your eggs in one basket?!

Portfolio theory has been the topic of debate for a number of years. First developed by Markowitz in 1952, the idea that investors can reduce risk by diversification and holding a portfolio of investments has been challenged by many investors; most notably Warren Buffett.

A prime example of Portfolio Theory being applied is in the pharmaceutical industry, which attract the question why has there been such a surge in mergers and acquisitions, with totals of $221 billion in the first half of 2015? (Fortune, 2015).

 The giants in the pharmaceutical industry, such as Teva, Mylan and Pfizer, are diversifying their risk by buying smaller research focused companies. This is a much cheaper strategy and is far more suited to their high growth business model as they don’t have to invest years into researching and developing new drugs. These companies believe that acquisitions are the only way to keep their revenues growing as fast as investors expect. The complexity of today’s breakthrough medicines mean that it is often cheaper for a company to acquire the next blockbuster drug than to develop it in-house.  

The pharmaceutical industry is an example of the application of portfolio theory being a success, as it is easy for a firm to just purchase a company to acquire new patents which can then be used to mass produce new drugs. When used in other contexts, for example as an investment technique, it is not always as efficient. It relies on past information to make future returns, which cannot give you an advantage as this information is and has already been available to the market. This is the fundamentals of the efficient market hypothesis.