Portfolio Management in New Drug Development - Innovation and Marketing in the Pharmaceutical Industry - page 97

The classical measures of portfolio risk include Beta from the CAPM, which
originates from the financial economics literature (Black 1972 ; Lintner 1965 ;
Markowitz 1952 ; Sharpe 1964 ) and mean-variance. 5 These are widely used firm-
level and portfolio-level measurements in the strategic management literature
(Ruefli et al. 1999 ).
The key equation of CAPM (from Black 1972 ) states that under certain
assumptions the expected return on an asset R i for a given period will satisfy
ER R

() =+ ( ) -

b[ ] , where R f is the return on a riskless asset for the
same time period, R m is the return on the market portfolio of assets, and bi i is the
slope indicating the covariance of R i with R m . It essentially values an asset (e.g., a
portfolio) against a set of chosen assets (e.g., a set of portfolios), and bi i is widely
used as a measure of the risk of R i .
However, the CAPM's fit to the product development setting is questioned since
its assumptions are based on financial markets (Devinney et al. 1985 ; Ruefli et al.
1999 ; Wernerfelt 1985 ). Devinney and Stewart ( 1988 ) suggest that managers have
more control over product development than financial assets, risk and return of new
products may be less related than in financial assets, and that CAPM does not cap-
ture interactions among projects in a portfolio. In addition, financial economics
assumes that firm-specific risk can be diversified away (Fama and Miller 1972 )
whereas for a pharmaceutical firm undertaking product development, the firm-
specific risk component is not as easily diversifiable (acquisitions and licensing can
help to some extent). Devinney and Stewart ( 1988 ) propose a generalized model
that addresses these shortcomings.
Taggart and Blaxter ( 1992 ) introduce a methodology of assessing the risk associ-
ated with a firm's research portfolio by separating the technical risk and market risk
components, and suggest this can be used for tracking a firm's risk profile over time.
An alternative approach to yield ex ante measures of risk is to survey top executives
(Singh 1986 ) or conduct market research on stakeholder risk perceptions as dis-
cussed earlier (Ofek and Srinivasan 2002 ).
We join Ruefli et al. ( 1999 ) in calling for further investigation of risk measures,
especially tailored to the pharmaceutical drug development context.

E RR

i f i m f

3.2.4 Impact of Information Presentation on Decision Making

Assuming that portfolio valuation and risk are defined and measured, there remains
the challenge of distilling the vast amount of information that exists about a port-
folio such that managers can make decisions. This information can be summarized
in multiple ways to support decision making (Ahn et al. 2010 ; Day 2007 ; Dvir
et al. 2006 ). Decision making can be influenced both by heuristics managers use to

5 The mean-variance approach to evaluate projects or portfolios is popular due to its ease of com-
putation and interpretation (Ruefli et al. 1999 ).