CH 9 Modern Port Folio theorymARKOWITZ MODEL

Ch 9
Modern Portfolio
Theory
Harry Markowitz
Model
Modern Portfolio Theory
(MPT)
 Modern portfolio theory (MPT) was
introduced by Harry Markowitz with
his paper "Portfolio Selection," which
appeared in the 1952 Journal of Finance.
 .
The Markowitz Model, also
known as Modern Portfolio
Theory (MPT), was developed by
Harry Markowitz in 1952 and
has since become a cornerstone
of portfolio management. It
provides a quantitative
framework for constructing
an optimal portfolio that
maximizes returns for a given
level of risk or minimizes risk for
Consideration should be
given on
1. Risk and Return
2. Diversification
3. Co -relation
Modern Portfolio Theory
(MPT)
 It emphasizes the trade off between the
risk and return.
 If the investor wants higher return, he has
to take higher risk. But he prefers a high
return but a low risk and hence the need
for a trade off.
 MPT emphasizes the need for
maximization of returns through a
combination of securities, whose total
variability is lower.
 A portfolio is said to be efficient, if it is
expected to yield the highest return
possible for the lowest risk.
Assumptions of Markowitz
Theory
 Investors are rational and behave in a
manner as to maximize their utility with a
given level of income.
 Investors have free access to fair and
correct information on returns and risk.
 The markets are efficient and absorb the
information quickly and perfectly.
 Investors are risk averse and try to
minimise the risk and maximise return
 Investors prefer higher returns to lower
returns for a given level of risk.
Markowitz
Diversification
 Markowitz postulated that diversification
should not only aim at reducing the risk of
a security by reducing its variability or
standard deviation, but by reducing the
covariance or interactive risk of two or
more securities in a portfolio.
 It attaches importance to standard
deviation, to reduce it to zero, if possible,
covariance to have as much as possible
negative interactive effect among the
securities within the portfolio and
coefficient of correlation to have negative
so that the overall risk of the portfolio as a
whole is nil or negligible.
Criteria for Dominance
 Dominance refers to the superiority of one
portfolio over the other.
 A set can dominate over the other , if with
the same return, the risk is lower or with
the same risk, the return is higher.
 Dominance principal involves trade off
between the risk and return.
Portfolio Optimization Process:
Asset Selection: Investors choose a set
of assets in which to invest. These assets
can be individual stocks, bonds, mutual
funds, or any other investment vehicles.
Expected Returns and Risks: For each
asset, investors estimate the expected
return and risk. This could be historical
data or forecasts based on various
factors.
Correlation Analysis: Investors
analyze the correlation between the
returns of different assets.
Diversification benefits are maximized
Efficient Frontier: The efficient
frontier represents a set of optimal
portfolios that offer the highest
expected return for a given level of risk,
or the lowest risk for a given level of
expected return. These portfolios are
efficient in the sense that they
maximize returns while minimizing
risks.
Portfolio Construction: Investors
construct portfolios along the efficient
frontier based on their risk tolerance
and investment objectives. The optimal
Markowitz Model
 Coefficient of correlation (r) is measure
designed to indicate the similarity or
dissimilarity.
 If the ‘r’ is -1.0, it is perfect negative
correlation
 If the ‘r’ is +1.0, it is perfect positive
correlation
 If the ‘r’ is 0, returns are independent.
 Therefore, correlation between two
securities depend on:
 Covariance between them
 Standard deviation of each
 In Markowitz Model, We need to have
inputs of expected returns, risk measured
Covariance shows that how two
securities moves together
Standard deviation shows that

how much the returns of a single
security varies over time
Corelation is a standardized
version of covariance the remove
the influence of unit and provides a
clearer indication of strength and
direction of the relationship
Markowitz Model
 Holding 2 securities in a portfolio can
reduce risk
 According to Markowitz,
 the securities with covariance which is either
negative or low amongst themselves, is the best
manner to reduce risk
 Investing in a large no of securities is not the
right method of investment
 It is the right kind of security which brings the
maximum results
Markowitz Model:
Change in Portfolio
Proportions
 If the amount of proportion of funds
invested in different stocks is changed, it
will change the portfolio risk.
 Therefore by changing the investment
proportions in different securities, the
portfolio risk can be brought down to zero.
 For availing the advantage of diversification,
coefficient of correlation has to be taken into
consideration .
Markowitz Efficient
 Frontier
Some portfolios are more attractive than others.
 ‘B’ is more attractive than ‘F’ and ‘H’; ‘C’ than ‘E’
 Among all the portfolios, the portfolios which
offer the highest return at particular risk are
called efficient portfolios. Here these are ABCD.
.
B .A  Now the question is which
portfolio the investor should
C choose.
. .H  He would choose a
.G portfolio that maximizes his
D .E .F
. . I
utility.
Utility Analysis
 Utility is the satisfaction the investor
enjoys from the portfolio return.
 An ordinary investor is assumed to receive
greater utility from the higher return and
vice versa.
 If he is allowed to choose between two
certain investments, he would always like
to take the one with larger outcome.
The end

CH 9 Modern Port Folio theorymARKOWITZ MODEL

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Ch 9

1. Risk and Return

Standard deviation shows that

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