MPT & Efficient Frontier

Diversification
• An investor can reduce portfolio risk simply by
holding combinations of instruments that are
not perfectly positively correlated (correlation
coefficient ).
• In other words, investors can reduce their
exposure to individual asset risk by holding a
diversified portfolio of assets. Diversification
may allow for the same portfolio expected
return with reduced risk.
 Diversification
• These ideas have been started with Markowitz
and then reinforced by other economists and
mathematicians such as Andrew Brennan who
have expressed ideas in the limitation of
variance through portfolio theory.
 Diversification Contd.
If all the asset pairs have correlations of 0—
they are perfectly uncorrelated—the portfolio's
return variance is the sum over all assets of the
square of the fraction held in the asset times the
asset's return variance (and the portfolio
standard deviation is the square root of this
sum).
 Illustration of Diversification Intro.
• A company that sells wool products like sweaters and
blankets is more profitable when the price of wool is
lower.
• A company that is a wool wholesaler is generally less
profitable when the price of wool is lower, unless they
are able to sell a lot more wool.
• Though the companies work together, their profits
have a low correlation.
• In other words, the profitability of one company does
not follow the same lines as the profitability of the
other company. And sometimes they are even inversely
related
 MPT Discussion
• One important thing to understand about
Markowitz’s calculations is that he
treats volatility and risk as the same thing.
• In layman’s terms, Markowitz uses risk as a
measurement of the likelihood that an
investment will go up and down in value – and
how often and by how much.
 MPT theory discussion
• The theory assumes that investors prefer to
minimize risk. The theory assumes that given
the choice of two portfolios with equal
returns, investors will choose the one with the
least risk.
• If investors take on additional risk, they will
expect to be compensated with additional
return.
 MPT discussion
• According to MPT, risk comes in two major
categories:
• systematic risk – the possibility that the entire
market and economy will show losses negatively
affecting nearly every investment; also
called market risk
• unsystematic risk – the possibility that an
investment or a category of investments will
decline in value without having a major impact
upon the entire market
 Diversification & Risk
• Diversification generally does not protect against
systematic risk because a drop in the entire market
and economy typically affects all investments.
• However, diversification is designed to decrease
unsystematic risk.
• Since unsystematic risk is the possibility that one single
thing will decline in value, having a portfolio invested in
a variety of stocks, a variety of asset classes and a
variety of sectors will lower the risk of losing much
money when one investment type declines in value.
 The Efficient Frontier

• In order to compare investment options,

Markowitz developed a system to describe each
investment or each asset class with math, using
unsystematic risk statistics.
• Then he further applied that to the portfolios that
contain the investment options.
• He looked at the expected rate-of-return and the
expected volatility for each investment.
• He named his risk-reward equation The Efficient
Frontier.
 Illustration
• Following are the data regarding six securities

A B C D E F

Return (%) 8 8 12 4 9 8

Risk (%) Std. 4 5 12 4 5 6

Deviation

• Which of the securities would be selected?

 Illustration Solution
• Using Risk and Return trade off, an investor
prefer highest return of 12% , would prefer
security C.
• A person wiling to take a low risk would prefer
Sec A to Sec D, as the former gives a higher
return for the risk taken.
• Similarly a person willing to take a moderate
risk would prefer security E to Sec B or Sec F.
 The Efficient Frontier

• The graph in the next slide is an example of

what the Efficient Frontier equation looks like
when plotted.
• The purpose of The Efficient Frontier is to
maximize returns while minimizing volatility
MPT
 The efficient frontier discussion
• Notice that The Efficient Frontier line starts with
lower expected risks and returns, and it moves
upward to higher expected risks and returns.
• So people with different Investor Profiles
(determined by investment time horizon,
tolerance for risk and personal preferences) can
find an appropriate portfolio anywhere along The
Efficient Frontier line.
• The Efficient Frontier flattens as it goes higher
because there is a limit to the returns investors
can expect.
Efficient Frontier
 Efficient Frontier
The hyperbola is sometimes referred to as the
'Markowitz Bullet', and is the efficient frontier if
no risk-free asset is available.
With a risk-free asset, the straight line is the
efficient frontier.
 Efficient Fort folio
The efficient frontier is a concept in modern
portfolio theory introduced by Harry Markowitz
and others in 1952.
It is the set of portfolios each with the feature
that no other portfolio exists with a higher
expected return but with the same standard
deviation of return.
 Concept overview
A combination of assets, i.e. a portfolio, is
referred to as "efficient" if it has the best
possible expected level of return for its level of
risk (which is represented by the standard
deviation of the portfolio's return).
 Concept overview
Here, every possible combination of risky assets can
be plotted in risk–expected return space, and the
collection of all such possible portfolios defines a
region in this space.
In the absence of the opportunity to hold a risk-free
asset, this region is the opportunity set (the feasible
set).
The positively sloped (upward-sloped) top
boundary of this region is a portion of a hyperbola
and is called the "efficient frontier."
 Modern Portfolio Theory
Modern portfolio theory (MPT) is a theory
of finance that attempts to maximize
portfolio expected return for a given
amount of portfolio risk, or equivalently
minimize risk for a given level of expected
return, by carefully choosing the
proportions of various assets.
.
 Modern Portfolio Theory
Although MPT is widely used in practice in the
financial industry and several of its creators won
a Nobel memorial prize for the theory, in recent
years the basic assumptions of MPT have been
widely challenged by fields such as behavioural
economics.
 MPT
MPT is a mathematical formulation of the
concept of diversification in investing, with the
aim of selecting a collection of investment
assets that has lower overall risk than any other
combination of assets with the same expected
return.
This is possible, intuitively speaking, because
different types of assets sometimes change in
value in opposite directions.
 MPT
For example, to the extent prices in the stock
market move differently from prices in the bond
market, a combination of both types of assets
can in theory generate lower overall risk than
either individually.
Diversification can lower risk even if assets'
returns are positively correlated.
More technically, MPT models an asset's return as a
normally or elliptically 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
perfectly positively correlated, MPT seeks to reduce
the total variance of the portfolio return.
MPT also assumes that investors are rational and
markets are efficient.
 MPT
• MPT was developed in the 1950s through the
early 1970s and was considered an important
advance in the mathematical modelling of
finance.
• Since then, some theoretical and practical
criticisms have been levelled against it.
 MPT
• These include evidence that financial returns
do not follow a normal distribution or indeed
any symmetric distribution, and that
correlations between asset classes are not
fixed but can vary depending on external
events (especially in crises).
• Further, there remains evidence that
investors are not rational and markets may
not be efficient.
 MPT
• Finally, the low volatility anomaly conflicts
with CAPM's trade-off assumption of higher
risk for higher return.
• It states that a portfolio consisting of low
volatility equities (like blue chip stocks) reaps
higher risk-adjusted returns than a portfolio
with high volatility equities (like illiquid penny
stocks).
 MPT
If a risk-free asset is also available, the
opportunity set is larger, and its upper
boundary, the efficient frontier, is a straight line
segment emanating from the vertical axis at the
value of the risk-free asset's return and tangent
to the risky-assets-only opportunity set.
• A study conducted by Myron Scholes, Michael
Jensen, and Fischer Black in 1972 suggests
that the relationship between return and beta
might be flat or even negatively correlated.
 Concept - MPT
• The fundamental concept behind MPT is that
the assets in an investment portfolio should
not be selected merely individually, each on
its own merits.
• Rather, it is important to consider how each
asset might change in price relative to how
every other asset in the portfolio might
change in price.
 Concept - MPT
• Investing is a tradeoff between risk and
expected return.
• In general, assets with higher expected
returns are riskier. The stocks in an efficient
portfolio are chosen depending on the
investor's risk tolerance: an efficient portfolio
is said to be having a combination of at least
two stocks above the minimum variance
portfolio.
 Concept - MPT
• For a given amount of risk, and on a lot of assumptions
about the probability distribution of returns on each
asset, MPT shows how to select a portfolio with the
highest possible expected return. Or, for a given
expected return, MPT explains how to select a portfolio
with the lowest possible risk (the targeted expected
return cannot be more than the highest-returning
available security, of course, unless negative holdings
of assets are possible.)
• Therefore, MPT is a theory of diversification. Under
certain assumptions and for specific quantitative
definitions of risk and return, MPT explains how to find
the best possible diversification strategy.