Companies make capital investments to exploit opportunities and create value, so any opportunity to save money and create value is clear and sensible. However, using only the net present value approach to make investment selections is not sufficient or plausible for portfolio-level decisions. This understanding leads us to modern portfolio economics and the adaptation of a powerful investment theory tool, the Efficient Frontier.
Every field has its own language and its own way of thinking. While physicists talk about motion, forces, and energy, they learn and analyze nature using the language of mathematics. Portfolio management is no different. When the ideas of portfolio management are expressed in economic and mathematical terms, they are easier to understand and verify. Most economic models are built using the tools of mathematics. Efficient Frontiers, alignment, resource scarcity, capacity, waste: these terms are part of the portfolio management language.
The Efficient Frontier is a fundamental scientific method that is extremely effective in visually summarizing the information required to understand all of the portfolio possibilities, the cost trade-offs, and the factors that affect the efficiency of the portfolio. Furthermore, this method allows stakeholders to organize, explore, search, and select the optimum portfolio.
The Efficient Frontier answers three key portfolio management questions:
• What are the best possibilities of projects that an organization can implement given the available budget and organizational capabilities?
• Are we getting the best from our potential portfolio of projects? If not, why are we not getting the most from our investment portfolios?
• Are we overinvesting in IT?
These are the same questions usually asked by chief executive officers, chief operating officers, and chief financial officers. With analysts and the board increasingly challenging the CEO to translate investments into bottom-line results, it is natural that he or she may question the value of IT and the soundness of the decision making involved in selecting where to invest. This leaves the chief information officer and his team under scrutiny, challenged to justify the value and method of IT investment decisions.
The Efficient Frontier helps managers and executives from the IT and the business sides of an organization understand the tradeoffs between portfolio value and cost. It is an applied economics method that shows how companies manage their scarce resources. Specifically it will help in understanding the following:
• The concepts of scarcity and its consequences
• The concept of value and cost and its graphical presentation
• The concepts of and relationships between value, cost, and current operating practices
• Breaking the constraints and its influence on the Efficient Frontier
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