Dow Theory

In the field of Financial Technical Analysis, Dow Theory is considered to be one of the oldest yet widely-
appreciated theories.

According to Dow Theory,- the Trend is split into three parts: primary, secondary, and minor.

The Dow Theory proposes that the market is divided into three phases: accumulation phase, panic phase,
and public participation phase.

Volume should go proportionately with the Trend.

History of Dow Theory

Let’s introduce first with the founder of Dow Theory- Charles Dow; he has also been a founder of Dow and
Jones company, and also, he has been recognized as the first Editor of Wall Steel Journal.

If we put light on the Dow Theory origin, so basically, this theory revolves around most of the editorials
written by Charles Dow in 1900-1902. But after Dow’s death, the work was continued by William
Hamilton.

Similarly, after the collective contribution of both Dow and Hamilton, Robert Rhea refined the theory and
published the book on it in 1932 named “The Dow Theory.”

Although the Dow Theory was proposed a century ago, the critical information that this ‘theory’ shares in
modern financial Technical Analysis is remarkable.

Although the theory was launched to analyze the DJIA and DJTA indices, experts reviewed it repeatedly
and found it applicable in other indices. Next, we’ll talk about the actual definition of Dow Theory.

About Dow Theory

Dow Theory is a part of technical analysis that helps the traders in identifying the market trends to generate
profits.

In the Dow Theory, traders come to know about the stock market. Such as how investors can get an idea
about the business environment through the stock market.
However, it’s the only single theory of its kind that explained the market trends movement very well.

Although the plethora of shifts taking place in the ‘stock market’ overtime, the Dow Theory’s basic tenets
are still holding a dominant position.

Basic principles of Dow Theory

The Dow Theory is largely based on the following significant tenets devised by Charles Dow. The major
principles are as follows.

The Stock Market Discounts Everything

The first principle of Dow Theory explains how price and indices can describe the market information
because before any significant change occurs in the market, it first impacts the stock price and indices.

For instance, this obtained data can include information related to earning announcements made by
‘companies, sentiments of investors, rise or fall in inflammation, etc.

It concludes that instead of taking an overview of a company’s balance sheets or study earning reports, the
analysis of price movements can provide you insightful information.

The Market Includes Three Trends

Dow Theory is supposed to be the first-ever theory that proposed the fact that market moves in Trend. Also,
these trends split up into three categories:

Primary Trend– It’s the most significant trend for the entire market. The primary Trend indicates the
market-moves, especially in the long-term.

Similarly, the duration of primary trends can last for many years.

Secondary Trends- These trends are a kind of corrections made to a primary trend. You can also recall it as
the primary Trend’s opposite movement.

For instance- the primary trend slopes upwards (creating a Bullish phase), the secondary Trend slopes
downward. But secondary trends last hardly for a few months or sometimes weeks.

Minor Trends-These trends are the fluctuations that occur daily in market movements. The minor trends
span for less than a few weeks.
However, minor trends go against the secondary Trend’s movements.

Primary Trend has Three phases of Each Trend

The Dow Theory also reveals another noteworthy point, which says that Primary Trend includes three
phases; named.

Accumulation Phase- When the primary trend beginning happens sloping upward (or downward) like
bullish (or bearish).

Panic Phase– This phase refers to the time when investors are likely to buy stocks in an extensive amount,
which results in significant speculation.

However, for investors, it becomes vital to book profits and exit as soon as possible.

Public Participation Phase- In this phase, more investors are likely to enter the market as the
improvements become visible across business conditions.

Similarly, this also triggers a rise (or decline) in prices in the market.

Market indices must confirm with each other

It is also mentioned in Dow’s Theory that a single index fails to verify a trend in the market. That’s why
market averages and indices much confirm each other.

However, it also implies that there should be no discrepancies between the index. Indeed they should be
reflecting the same opinion.

For instance- suppose a bullish trend occurs in India; the Sensex, Nifty, Nifty Midcap, Nifty Smallcap
alongside other indices are likely to slop upwards.

In the same manner, such as in Bearish Trend, the indices are likely to slop downwards.

Volume Confirmation in Dow Theory

Trading Volume is the deciding element in which direction the market trend is likely to move.

For example- in an Upward Trend, analysts can observe a rise in volume and price proportionately (or
decrease).

On the other hand, in a downtrend, analysts can watch the ‘rise in volume with a drop in price and vice
versa.’
The Market Trends continue until Clear Signal
According to Dow’s Theory, despite significant noise in the market, the Trend exists.

However, this happens during the instances when there’s an upward trend, the likelihood of temporary trend
reversal is high, but in addition to this situation, the market is likely to stay in an upward direction.

Altogether, an analyst shouldn’t come across the end conclusion until a reversal starts becoming visible in
the market.

Significance of Closing Price

Out of the 4 major price levels, open high, low, and close, the closing price is very important as it provides
the final state of the overall stocks on a particular day.

The role of Sideways Market

The sideways market trend can effectively take the place of secondary market trends.

Phases of Market according to Dow Theory

According to this the Dow theory the market trends comprise 3 different phases, the accumulation phase, the
markup phase, and the distribution phase.

Accumulation Phase
It is one of the most basic phases usually observed after a huge sell-off when traders would not buy new
shares due to the fear of further sell-off situations.

It is the institutional, long-term investors who would buy maximum shares in such a situation, accumulating
as many shares as possible.

This phase marks the baseline of the market since these institutional buyers support further price drops by
buying shares from all interested sellers.

These institutional investors are sometimes referred to as ‘smart money’ and this phase may last for months.

Mark Up Phase
We can identify the markup phase with an upward trend in the stock price. The price is quick and sharp and
once the price reaches its highest value the market starts attracting the public to invest.

This phase attracts public investments and is therefore also referred to as the public participation phase.

Distribution Phase
It is the phase when institutional investors begin to distribute their acquired market shares.

The distribution of shares by the astute investors at regular intervals controls the price from going further
higher.

However, selling all the shares further creates a period of a huge sell-off. Therefore, this phase often
happens by a new accumulation phase, beginning the cycle once again.

This cycle of phases is often different for different markets and can last for months or even years.

Patterns in Dow Theory

The Dow Theory is a form of technical analysis and various patterns help the analyst and the trader in
identifying the possibilities in trading.

The popular Dow Theory patterns include the Double bottom and Double top formation, the triple bottom
and top, trading range, and the flag formation.

Each of these patterns is discussed further in the following sections.

The Reverse Patterns

The double and triple patterns are two types of reverse patterns since the stock price recovers and bounces
back to the particular levels within a limited time frame.

Double Bottom
Consider a situation when the stock price is at one of its lowest levels, the price may show some significant
recovery for a short period of two weeks or more and then drop down again.

This situation creates a double drop pattern in the chart and is referred to as the double bottom pattern. This
pattern indicates a bullish trend and traders can profit from buying shares.
Double Top
It happens in a situation when the stock price trends up to a particular level, comes down, and then again
bounces back to the top-level within two weeks or more.

The double top pattern indicates a bearish trend and the traders can look for opportunities to sell.

Triple Bottom and Triple Top

These patterns are in the way the double bottom and double top patterns are formed.

The only difference is that in this case, the price level bounces back twice, that is the price hits a particular
point thrice.

Range Formation
The market trends may continue to depict the bouncing pattern more than thrice as a result of which the
price seems to show a sideways trend.

The sideways trend in the market creates a range within which the price fluctuates and usually this situation
is difficult for trading.

However, there are opportunities in this range to generate profits, for which the upper range limit acts as the
resistance level and the lower limit the support level.

The range pattern may continue for months or a few years and the width of the range comes by the duration
of the pattern.

Stocks exhibit this range pattern or sideways trending market either due to the lack of some basic factors like
new announcements, product launches, etc. or during the waiting period of new changes.

However, a change in both these factors can produce a range breakout with high volumes and a higher rate
of price change.

A stop loss is essential while trading using range breakouts. An example of trading in range breakout with
the use of stop-loss is as follows,

 Consider the stock in a sideways market, with the price oscillating between Rs.150 and Rs.300.
 Consider the range breakout to be at Rs.300, with the stock trading at Rs.350. In this case, the trader
has to keep Rs.300 as the stop loss.
 The minimum price would be Stop loss + range width.
In this case it is, Rs.300 + 150 = Rs.450
Flag Pattern in Dow Theory
A flag pattern happens when the stock price rises sharply follows by a small decline of around 10%
(correction). The pattern is what we call a flag formation since it creates a look of the flag on the leg.

The largest benefit of the flag formation is that, it provides the trader an additional opportunity to buy the
shares that they might have left out.

This kind of pattern forms as a result of selling too many shares to gain profit, which further leads to a drop
in price.

Reward to Risk Ratio (RRR) in Dow Theory

The Reward to Risk Ratio is a general concept in the trading system. Its general relation to the trading makes
it important to mention here.

The fundamental benefit of RRR is that it calculates the possible returns during any particular period.
Consider the following hypothetical example for better understanding.

 A stock trade enters at Rs.200 with Rs.180 as the stop loss and Rs.230 as the expected target.
 The risk involved is Rs.200 – Rs.180 = Rs.20
 The expected profit is Rs.230 – Rs.200 = Rs.30
 RRR = expected reward/ risk value, therefore RRR, in this case, would be 30/20 = 1.5
 That is, for every Rs.1 risk the trader can expect the benefit of Rs.1.4
The trader analyzes minimum RRR for adjustment analyzing the risks.

Important things to note in Dow Theory

Here are some important things to keep in mind –

Closing Prices and Line Ranges

Charles Dow pays special attention solely to the closing prices irrespective of the index’s intraday
movements.

To get a vital insight into the Trend, the closing price first unleashes Trend’s probabilities, irrespective of
intraday price movement.
On the other hand, you get another feature describing in Dow Theory, ‘the idea of line ranges’ also known
as trading ranges used in technical analysis for further approaches.

These are actually a period of sideways price movements that analysts often view as a consolidation period.

Similarly, a smart trader always waits for price movements that are likely to break the trend line, so coming
across the final ‘decision’ appears straightforward.

In short, if the price exceeds the line, the probabilities of a hike in market trends are likely to come.

Signals and Identification of Trends

In the entire Dow’s Theory, the most challenging aspect that most of the traders find hard to implement is
trend reversals’ accurate identification.

Bear one thing in mind, an analyst who follows Dow Theory is likely to trade with the market’s direction.
Still, it’s crucial that before coming across the final judgment, they identify directional shifts’ points.

Although, the crucial technique that most of the traders use in Dow Theory to get an idea about the trend
reversals is peak-through analysis.

So what is it? A ‘peak’ refers to the highest price during the market move; on the other hand, ‘through’
refers to the lowest price during the market move.

However, Dow’s Theory proposes that the market keeps fluctuating every time and never moves in a
straight line.

But the theory believes that from highs to lows, the overall market trend moves in the same direction.

In a nutshell, you can find in Dow Theory; the upward Trend is a series of higher peaks along with higher
through moving consecutively.

Meanwhile, the Dow Theory’s sixth tenet shares an opinion that the Trend is likely to stay effective until a
clear sign of trend reversal occurs, which is somewhat similar to Newton’s First law of motion ‘an object
will continue to move in the same direction until the outer force obstruct that motion.’

Similarly, the market moves continuously in a direction and waits for the change to disturb its position. It
can be anything from business conditions to economic changes.

Reversals
If a reversal occurs in the primary Trend, it means that the market has failed to build another consecutive
peak and through in the primary Trend’s direction.

However, if we talk about uptrend, the signal of reversal would be a sign of failure of the market that isn’t
able to reach a new high or higher low.

However, in such situations, an analyst should know that the market is going through a primary downward
trend.

On the other hand, if the market is able to establish a strong peak and as compared to the previous peak, it is
much higher, so it indicates the situation of upward Trend.

Role of Dow Theory in the checklist

The Dow Theory has a prominent place in the trading checklist. It helps the trader is looking at the trade
from the perspective of the theory.

Moreover, it provides an additional confirmation to begin any trade.

Dow Theory – Conclusion

The Dow Theory is one of the most important theories of technical analysis. It was developed in the late
19th century by Charles Dow and is prominent even today.

The theory has had supporters as well as critics equally over these years. It is completely on the fundamental
principles which we have described in this section.

Traders can benefit from the trade by following the trade and interpreting all the distinct patterns involved in
it.

Therefore, traders can analyze the trades and the related profits using the Dow Theory.
What is the Random Walk Theory?

The Random Walk Theory, or the Random Walk Hypothesis, is a mathematical

model of the stock market. Proponents of the theory believe that the prices
of securities in the stock market evolve according to a random walk.

A “random walk” is a statistical phenomenon where a variable follows no

discernible trend and moves seemingly at random. The random walk theory,
as applied to trading, most clearly laid out by Burton Malkiel, an economics
professor at Princeton University, posits that the price of securities moves
randomly (hence the name of the theory) and that, therefore, any attempt
to predict future price movement, either through fundamental or technical
analysis, is futile.
The implication for traders is that it is impossible to outperform the overall
market average other than by sheer chance. Those who subscribe to the
random walk theory recommend using a “buy and hold” strategy, investing
in a selection of stocks that represent the overall market – for example, an
index mutual fund or ETF based on one of the broad stock market indexes,
such as the S&P 500 Index.

Basic Assumptions of the Random Walk Theory

1. The Random Walk Theory assumes that the price of each security in
the stock market follows a random walk.
2. The Random Walk Theory also assumes that the movement in the price
of one security is independent of the movement in the price of another
security.
Brief History of the Random Walk Theory

In 1863, a French mathematician turned stock broker named Jules Regnault

published a book titled “Calcul des Chances et Philosophie de la Bourse” or
“The Study of Chance and the Philosophy of Exchange.” Regnault’s work is
considered one of the first attempts at the use of advanced mathematics in
the analysis of the stock market.

Influenced by Regnault’s work, Louis Bachelier, another French

mathematician, published a paper titled “Théorie de a Spéculation” or the
“Theory of Speculation.” This paper is credited with establishing the ground
rules that would be key to the use of mathematics and statistics in the stock
market.

In 1964, American financial economist Paul Cootner published a book

entitled “The Random Character of Stock Market Prices.” Considered a
classic text in the field of financial economics, it inspired other works such as
“A Random Walk Down Wall Street” by Burton Malkiel (another classic) and
“Random Walks in Stock Market Prices” by Eugene Farma.

Implications of the Random Walk Theory

Since the Random Walk Theory posits that it is impossible to predict the
movement of stock prices, it is also impossible for a stock market investor to
outperform or “beat” the market in the long run. It implies that it is
impossible for an investor to outperform the market without taking on large
amounts of additional risk.

As such, the best strategy available to an investor is to invest in the market

portfolio, i.e., a portfolio that bears a resemblance to the total stock market
and whose price reflects perfectly the movement of the prices of every
security in the market.

A flurry of recent performance studies reiterating the failure of most money

managers to consistently outperform the overall market has indeed led to
the creation of an ever-increasing number of passive index funds.

Also, it appears that an increasing number of investors are firm believers in

the wisdom of index investing. According to data from Vanguard and
Morningstar, 2016 saw an unprecedented inflow of more than $235 billion
into index funds.

Random Walk Theory in Practice

In 1988, the Random Walk Theory was put to the test in the famous Dart
Throwing Investment Contest. Devised by the Wall Street Journal, this
contest pitted professional investors working out of the New York Stock
Exchange against dummy investors. The dummy investors consisted of the
Wall Street Journal staff who chose stocks by throwing darts at a board.

The experiment, titled “The Wall Street Journal Dartboard Contest,” gained
much fanfare and media attention. Out of 100 contests, the professional
investors won 61, whereas the dart-throwing dummies won 39. However, the
professional investors only beat the market (as represented by the
performance of the Dow Jones Industrial Average) 51 times out of 100.

Criticism of the Random Walk Theory

One of the main criticisms of the Random Walk Theory is that the stock
market consists of a large number of investors, and the amount of time each
investor spends in the market is different. Thus, it is possible for trends to
emerge in the prices of securities in the short run, and a savvy investor can
outperform the market by strategically buying stocks when the price is low
and selling stocks when the price is high within a short time span.

Other critics argue that the entire basis of the Random Walk Theory is
flawed and that stock prices do follow patterns or trends, even over the long
run. They argue that because the price of a security is affected by an
extremely large number of factors, it may be impossible to discern the
pattern or trend followed by the price of that security. However, just
because a pattern cannot be clearly identified, that doesn’t mean that a
pattern does not exist.

Portfolio Investment Process

The ultimate aim of the portfolio manager is to reduce the risk and increase the
return to the investor in order to reach the investment objectives of an investor. The
manager must be aware of the portfolio investment process. The process of
portfolio management involves many logical steps like portfolio planning, portfolio
implementation and monitoring. The portfolio investment process applies to
different situation. Portfolio is owned by different individuals and organizations with
different requirements. Investors should buy when prices are very low and sell when
prices rise to levels higher that their normal fluctuation.

Portfolio Investment Process

Portfolio investment process is an important step to meet the needs and
convenience of investors. The portfolio investment process involves the following
steps:
1. Planning of portfolio.
2. Implementation of portfolio plan.
3. Monitoring the performance of portfolio.

1. Planning of Portfolio
Planning is the most important element in a proper portfolio management. The
success of the portfolio management will depend upon the careful planning. While
making the plan, due consideration will be given to the investor’s financial capability
and current capital market situation. After taking into consideration a set of
investment and speculative policies will be prepared in the written form. It is called as
statement of investment policy. The document must contain (1) The portfolio
objective (2) Applicable strategies (3) Investment and speculative constraints. The
planning document must clearly define the asset allocation. It means an optimal
combination of various assets in an efficient market. The portfolio manager must keep
in mind about the difference between basic pure investment portfolio and actual
portfolio returns. The statement of investment policy may contain these elements.
The portfolio planning comprises the following situation for its better performance:

(A) Investor Conditions: – The first question which must be answered is this —
“What is the purpose of the security portfolio?” While this question might seem
obvious, it is too often overlooked, giving way instead to the excitement of selecting
the securities which are to be held. Understanding the purpose for trading in financial
securities will help to: (1) define the expected portfolio liquidation, (2) aid in
determining an acceptable level or risk, and (3) indicate whether future consumption
(liability needs) are to be paid in nominal or real money, etc. For example: a 60 year
old woman with small to moderate saving probably (1) has a short investment
horizon, (2) can accept little investment risk, and (3) needs protection against short
term inflation. In contrast, a young couple investing couple investing for retirement in
30 years has (1) a very long investment horizon, (2) an ability to accept moderate to
large investment risk because they can diversify over time, and (3) a need for
protection against long-term inflation. This suggests that the 60 year old woman
should invest solely in low-default risk money market securities. The young couple
could invest in many other asset classes for investment diversification and accept
greater investment risks. In short, knowing the eventual purpose of the portfolio
investment makes it possible to begin sketching out appropriate investment /
speculative policies.

(B) Market Condition: – The portfolio owner must known the latest developments in
the market. He may be in a position to assess the potential of future return on various
capital market instruments. The investors’ expectation may be two types, long term
expectations and short term expectations. The most important investment decision in
portfolio construction is asset allocation. Asset allocation means the investment in
different financial instruments at a percentage in portfolio. Some investment
strategies are static. The portfolio requires changes according to investor’s needs and
knowledge. A continues changes in portfolio leads to higher operating cost. Generally
the potential volatility of equity and debt market is 2 to 3 years. The another type of
re-balancing strategy focuses on the level of prices of a given financial asset.

(C) Speculative Policies: – The portfolio owner may accept the speculative
strategies in order to reach his goals of earning to maximum extant. If no speculative
strategies are used the management of the portfolio is relatively easy. Speculative
strategies may be categorized as asset allocation timing decision or security selection
decision. Small investors can do by purchasing mutual funds which are indexed to a
stock. Organization with large capital can employ investment management firms to
make their speculative trading decisions.

(D) Strategic Asset Allocation: – The most important investment decision which
the owner of a portfolio must make is the portfolio’s asset allocation. Asset allocation
refers to the percentage invested in various security classes. Security classes are
simply the type of securities: (1) Money Market Investment; (2) Fixed Income
obligations; (3) Equity Shares; (4) Real Estate Investment; (5) International securities.

Strategic asset allocation represents the asset allocation which would be optimal for
the investor if all security prices trade at their long-term equilibrium values that is, if
the markets are efficiency priced.

2. Implementation of Portfolio Plan

In the implementation stage, three decisions to be made, if the percentage holdings
of various assets classes are currently different from the desired holdings as in the
SIP, the portfolio should be re-balances to the desired SAA (Strategic Asset Allocation).
If the statement of investment policy requires a pure investment strategy, this is the
only thing, which is done in the implementation stage. However, many portfolio
owners engage in speculative transaction in the belief that such transactions will
generate excess risk-adjusted returns. Such speculative transactions are usually
classified as “timing” or “selection” decisions. Timing decisions over or under weight
various assets classes, industries, or economic sectors from the strategic asset
allocation. Such timing decision deal with securities within a given asset class,
industry group, or economic sector and attempt to determine which securities should
be over or under-weighted.

(A) Tactical Asset Allocation: – If one believes that the price levels of certain asset
classes, industry, or economic sectors are temporarily too high or too low, actual
portfolio holdings should depart from the asset mix called for in the strategic asset
allocation. Such timing decision is preferred to as tactical asset allocation. As noted,
SAA decisions could be made across aggregate asset classes, industry classifications
(steel, food), or various broad economic sectors (basic manufacturing, interest-
sensitive, consumer durables).

Traditionally, most tactical assets allocation has involved timing across aggregate
asset classes. For example, if equity prices are believes to be too high, one would
reduce the portfolio’s equity allocation and increase allocation to, say, risk-free
securities. If one is indeed successful at tactical asset allocation, the abnormal
returns, which would be earned, are certainly entering.

(B) Security Selection: – The second type of active speculation involves the
selection of securities within a given assets class, industry, or economic sector. The
strategic asset allocation policy would call for broad diversification through an indexed
holding of virtually all securities in the asset in the class. For example, if the total
market value of HPS Corporation share currently represents 1% of all issued equity
capital, than 1% of the investor’s portfolio allocated to equity would be held in HPS
corporation shares. The only reason to overweight or underweight particular securities
in the strategic asset allocation would be to off set risks the investors’ faces in other
assets and liabilities outside the marketable security portfolio. Security selection,
 however, actively overweight and underweight holding of particular securities in the
belief that they are temporarily mispriced.

3. Monitoring the Performance of Portfolio

Portfolio performance monitoring is a continuous and on going assessment of present
investment portfolio and the portfolio manger shall incorporate the latest
development which occurred in capital market. The portfolio manager should take into
consideration of investor’s preferences, capital market condition and
expectations. Monitoring the portfolio performance is up-grading activity in asset
composition to take the advantage of economic, industry and market conditions. The
market conditions are depending upon the Government policy. Any change in
Government policy would reflect the stock market, which in turn affects the
portfolio. The continues revision of a portfolio depends upon the following factors:

1. Change in Government policy.

2. Shifting from one industry to other
3. Shifting from one company scrip to another company scrip.
4. Shifting from one financial instrument to another.
5. The half yearly / yearly results of the corporate sector

Risk reduction is an important factor in portfolio. It will be achieved by a diversification

of the portfolio, changes in market prices may have necessitated in asset
composition. The composition has to be changed to maximize the returns to reach the
goals of investor.

Markowitz Theory: Subject

Matter, Assumptions and Models
Before the development of Markowitz theory, combination of
securities was made through “simple diversification”. The layman
could make superior returns on his investments by making a
random diversification in his investments.

A portfolio consisting of securities of a large number will always

bring a superior return than a portfolio consisting of ten securities
because the portfolio is ten times more diversified.
The simple diversification would be able to reduce unsystematic or
diversifiable risk. In securities, both diversifiable and un-
diversifiable risks are present and an investor can expect 75% risk
to be diversifiable and 25% to be un-diversifiable.

Simple diversification at random would be able to bring down the

diversifiable risk if about 10 to 15 securities are purchased.
Unsystematic risk was supposed to be independent in each security.
Many research studies were made on diversification of securities. It
was found that 10 to 15 securities in a portfolio would bring
adequate returns. Too much diversification would also not yield the
expected return.

Some experts have suggested that diversification at random does

not bring the expected return results. Diversification should,
therefore, be related to industries which are not related to each
other. Many industries are correlated with each other in such a way
that if the stock of ‘X’ increases in price the stock of ‘Y’ also
increases and vice versa.

By looking at the trends, industries should be selected in such a way

that they are unrelated to each other. A person having on his
portfolio about 8 to 10 securities will reduce his risk but if he has
too many securities as described above it would not lead to any
gain.

If systematic risk is reduced by simple diversification, research

studies have shown that an investor should spread his investments
but he should not spread himself in so many investments that it
leads to “superfluous diversification”. When an investor has too
many assets on his portfolio he will have many problems. These
problems relate to inadequate return.

It is very difficult for the investor to measure the return on each of

the investments that he has purchased. Consequently, he will find
that the return he expects on the investments will not be up to his
expectations by over- diversifying.

The investor will also find it impossible to manage the assets on his
portfolio because the management of a larger number of assets
requires knowledge of the liquidity of each investment, return; the
tax liability and this will become impossible without specialized
knowledge.

An investor will also find it both difficult and expensive to look after
a large number of investments. This will also have the effect of
cutting into the profits or the return factor on the investments.

If the investor plans to switch over investments by selling those

which are unprofitable and purchasing those which will be offering
him a high rate of return, he will involve himself in high transaction
costs and more money will be spent in managing superfluous
diversification.

The research studies have shown that random diversification will

not lead to superior returns unless it is scientifically predicted.
Markowitz theory is also based on diversification. He believes in
asset correlation and in combining assets in a manner to lower risk.

Assumption of the Markowitz Theory:

Markowitz theory is based on the modern portfolio theory under
several assumptions.

The assumptions are:

Assumption under Markowitz Theory:
(1) The market is efficient and all investors have in their knowledge
all the facts about the stock market and so an investor can
continuously make superior returns either by predicting past
behaviour of stocks through technical analysis or by fundamental
analysis of internal company management or by finding out the
intrinsic value of shares. Thus, all investors are in equal category.

(2) All investors before making any investments have a common

goal. This is the avoidance of risk because they are risk averse.

(3) All investors would like to earn the maximum rate of return that
they can achieve from their investments.

(4) The investors base their decisions on the expected rate of return
of an investment. The expected rate of return can be found out by
finding out the purchase price of a security dividend by the income
per year and by adding annual capital gains.

It is also necessary to know the standard deviation of the rate of

return expected by an investor and the rate of return which is being
offered on the investment. The rate of return and standard deviation
are important parameters for finding out whether the investment is
worthwhile for a person.

(5) Markowitz brought out the theory that it was a useful insight to
find out how the security returns are correlated to each other. By
combining the assets in such a way that they give the lowest risk
maximum returns could be brought out by the investor.

(6) From the above, it is clear that every investor assumes that
while making an investment he will combine his investments in such
a way that he gets a maximum return and is surrounded by
minimum risk.
(7) The investor assumes that greater or larger the return that he
achieves on his investments, the higher the risk factor surrounds
him. On the contrary, when risks are low the return can also be
expected to be low.

(8) The investor can reduce his risk if he adds investment to his
portfolio.

(9) An investor should be able to get higher return for each level of
risk “by determining the efficient set of securities”.

Markowitz Model:
Markowitz approach determines for the investor the efficient set of
portfolio through three important variables, i.e., return, standard
deviation and coefficient of correlation. Markowitz model is called
the “Full Covariance Model”.

Through this method the investor can, with the use of computer,
find out the efficient set of portfolio by finding out the trade-off
between risk and return, between the limits of zero and infinity.
According to this theory, the effects of one security purchase over
the effects of the other security purchase are taken into
consideration and then the results are evaluated.

The Effect of Combining Two Securities:

It is believed that holding two securities is less risky than having
only one investment in a person’s portfolio. When two stocks are
taken on a portfolio and if they have negative correlation, then risk
can be completely reduced because the gain on one can offset the
loss on the other.

The effect of two securities can also be studied when one security is
more risky when compared to the other security. The following
example shows a return of 13%. A combination of A and E will
produce superior results to an investor rather than if he was to
purchase only Stock-A and one-third of stock consists of Stock-B,
the average return of the portfolio is weighted average return of
each security in the portfolio.

Example 16.1:
Simple Situation:

The return on the portfolio on combining the two securities will be

Rp = R1X1 + R2X2
ADVERTISEMENTS:

RP = 0.10(0.25)+ 0.20(0.75)

= 17.5%

Example 16.2
Portfolio Analysis:
Markowitz two security Analysis:

Where, RP = the expected return to portfolio

X1 = proportion of total portfolio invested in security i
R1 = expected return to security i
N = total number of securities in portfolio

In the following situation:

(I) When Stock ‘A’ in a given investment is taken at 2/3 proportion
during prosperity

Rp = (2/3) x (7) + (1/3) x (5) = 6.33

(II) When Stock ‘A’ in a given investment is taken at 2/3 proportion

during depression

Rp = (2/3) x (7) + (1/3) x (13) = 9.0 (Higher return than expected).

Thus, by putting some part of the amount in stock which is riskier

stock, i.e., ‘B’, the risk can be reduced rather than if the investor
was to purchase only Stock ‘A’. If an investor was to purchase only
Stock ‘A’, his return would be according to his expectation an
average of 7.2% which becomes as low as 7% in depression periods
and rises to 11% in boom periods.

The standard deviation of this stock is as low as 2%. The investor

will make a return of higher than 7.2% by combining two-thirds of
Stock ‘A’ and one-third of Stock ‘B’. Thus, the investor is able to
achieve a return of 9% and bring the risk to the minimum level.

Thus, the effect of holding two securities in a portfolio does reduce

risk but research studies have shown that it is important to know
what proportion of the stock should be brought by the investor in
order to get a minimum risk, the portfolio returns can be achieved
at the higher point by setting of one variation against another.

The investor should be able to find out two investments in such a

way that one investment is giving a higher return, whereas the
other investment is not performing well even though one of the
securities is more risky, it will lead to a good combination.

This is a difficult task because the investor will have to continue to

find out two securities which are related to each other inversely,
like the example given for Stocks ‘A’ and ‘B’. But securities should
also be correlated to each other in such a way that maximum
returns can be achieved.