Assignment

on
PORTFOLIO SELECTION
by
HARRY MARKOWITZ
Name Prashanth premchand banu
Student ID A4018183
RISK MANAGEMENT ASSIGNMENT --MODERN PORTFOLIO THEORY

Modern portfolio theory, or MPT, is a popular investment theory which suggests that
investors can maximise returns and minimise risk by carefully selecting different
types of assets in their portfolio. The theory is considered as a mathematical
formulation of the concept of diversification in investing.

Modern portfolio theory was introduced in 1952 by Harry Markowitz, then a student
in the University of Chicago. The theory became very popular because at that time
there was no mathematical method to quantify risk and MPT offered a solution. For
his contribution to the finance, Markowitz received a Nobel prize in 1990.

In its simplest form MPT provides a framework to construct efficient portfolios by

selection of the investment assets, considering risk appetite of the investor. MPT
employs statistical measures such as correlation and co variation to quantify the effect
of the diversification on the performance of portfolio.

For most investors, the risk they take when they buy a stock is that the return will be
lower than expected. In other words, it is the deviation from the average return. Each
stock has its own standard deviation from the mean, which MPT calls "risk".

The risk in a portfolio of diverse individual stocks will be less than the risk inherent in
holding any one of the individual stocks (provided the risks of the various stocks are
not directly related).

Consider a portfolio that holds two risky stocks:

 One that pays off when it rains

 Another that pays off when it doesn't rain.

A portfolio that contains both assets will always pay off, regardless of whether it rains
or shines. Adding one risky asset to another can reduce the overall risk of an all-
weather portfolio.

Modern Portfolio Theory proposes that it’s possible to construct a portfolio of

investments that maximizes returns and minimizes risk by diversifying investments
among uncorrelated assets.

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RISK MANAGEMENT ASSIGNMENT --MODERN PORTFOLIO THEORY

There are two key assumptions inherent in MPT:

1. Investors Are Rational: This means that investors, collectively, will be correct
in their economic and financial assumptions on average. In other words,
market moves are always rational and based on the fundamental economic and
corporate realities of the moment.

2. Efficient Market Hypothesis: Those who subscribe to this view believe that all
information relevant to a stock is priced into it at a given point in time. In
other words, the stock price is reality.

MPT models an asset’s return as a normally distributed random variable, defines risk
as the standard deviation of return, and models a portfolio as a weighted combination
of assets so that the return of a portfolio is the weighted combination of the assets’
returns. By combining different assets whose returns are not correlated, MPT seeks to
reduce the total variance of the portfolio. MPT also assumes that investors are rational
and markets are efficient.

Although MPT is widely used in practice in the financial industry and several of its
creators won a Nobel Prize for the theory, in recent years the basic assumptions of
MPT have been widely challenged by fields such as behavioural economics, and
many companies using variants of MPT have gone bankrupt in various financial
crises. MPT is a mathematical formulation of the concept of diversification in
investing, with the aim of selecting a collection of investment assets that has
collectively lower risk than any individual asset. This is possible, in theory, because
different types of assets often change in value in opposite ways. For example, when
the prices in the stock market fall, the prices in the bond market often increase, and
vice versa. A collection of both types of assets can therefore have lower overall risk
than either individually.

It often requires investors to rethink notions of risk. Sometimes it demands that the
investor take on a perceived risky investment in order to reduce overall risk. That can
be a tough sell to an investor not familiar with the benefits of sophisticated portfolio
management techniques. Furthermore, MPT assumes that it is possible to select stocks
whose individual performance is independent of other investments in the portfolio.

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RISK MANAGEMENT ASSIGNMENT --MODERN PORTFOLIO THEORY

But market historians have shown that there are no such instruments; in times of
market stress, seemingly independent investments do, in fact, act as though they are
related.

Likewise, it is logical to borrow to hold a risk-free asset and increase your portfolio
returns, but finding a truly risk-free is very complicated. Government-backed bonds
are presumed to be risk free, but, in reality, they are not. Securities such as gilts and
U.S. Treasury bonds are free of default risk, but expectations of higher inflation and
interest rate changes can both affect their value.

The conventional interpretation of MPT is based on finance research through the mid-
1960s. By that standard, buying and holding the market portfolio and letting it ride is
the embedded wisdom. But research over the last several decades tell us that risk and
return are more complicated, which implies doing something other than holding the
unmanaged market portfolio. In the long run, the broad market portfolio is still likely
to perform as theory predicts and generate middling to slightly above middling returns
for relatively little risk compared with the various efforts to beat this index.

Another assumption of MPT is that investors accurately understand what returns are
possible. This is often not the case and is why many investors often need help from
money managers. Professionals are more likely to understand real-world limitations
of Modern Portfolio Theory.

Conclusion
Even though MPT has evolved into a major theory in finance and it is commonly used
by research analysts and portfolio managers as a tool to monitor risk and return
characteristics of a portfolio, some serious criticisms have also evolved to challenge
the very basic assumptions of MPT, especially after the findings in the field of
behavioural economics. For example, the theories that markets are efficient and all
investors are rational have been proved wrong by behavioural economists as well as
the success of outstanding investors. Also other assumptions such as the correlations
between asset classes are constant and all investors have access all available
information are also wrong in many cases. Further, MPT does not take into account
the impact of taxes and trading costs on portfolio returns. Moreover, the reliance of
MPT on past performance to project expected returns is not always reliable since as
everyone knows past performance is no guarantee of future results. A portfolio's

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RISK MANAGEMENT ASSIGNMENT --MODERN PORTFOLIO THEORY

success rests on the investor's skills and the time he or she devotes to it. Sometimes it
is better to pick a small number of out-of-favour investments and wait for the market
to turn in your favour than to rely on market averages alone.

Reference
1. Markowitz, Harry M. (1952). Portfolio selection, Journal of Finance, 7 (1), 77-
91.

2. Gupta, Francis, Markowitz, Harry M.Fabozzi, Frank J. (2002) The Legacy of

Modern Portfolio Theory THE JOURNAL OF INVESTING Fall 2002

3. Risk glossary (2006) "Modern portfolio theory", Available from

http://www.riskglossary.com/link/portfolio_theory.htm [19/06/2006]

4. Andrei Shleifer: Inefficient Markets: An Introduction to Behavioral Finance.

Clarendon Lectures in Economics (2000)

External links

1. http://www.investopedia.com/articles/06/MPT.asp

2. http://www.capital-flow-watch.net/tag/modern-portfolio-theory/

3. http://www.articlesbase.com/investing-articles/modern-portfolio-theory-an-
introduction-2105870.html#ixzz0t5RMm3Fp

4. http:/en.wikipedia.org/wiki/Modern_portfolio_theory

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