ASSIGNMENT OF INVESTMENT AND PORTFOLIO ANALYSIS PORTFOLIO THEORY BY HERRY MARKOWITZ

SUBMITTED TO DR. NIAMAT KHAN SUBMITTED BY SSH SHAYKH

Portfolio theory Portfolio theory deals with the value and risk of portfolios rather than individual securities. It is often called modern portfolio theory or Markowitz portfolio theory. According to the theory, it is possible to construct an efficient front line of optimal portfolios that offers the maximum possible expected return for a exact level of risk. This theory was pioneered by Harry Markowitz in his paper Portfolio Selection, which was published in 1952 in the Journal of Finance. The four basic steps involved in portfolio construction are (1) Security valuation, (2) Asset allocation, (3) Portfolio optimization, and (4) Performance measurement. The key result in portfolio theory is that the unpredictability of a portfolio is less than the weighted average of the volatilities of the securities it contains. The standard deviation of the expected return on a portfolio is: (Wi2i2 + WiWjCovij) Where the sums are over all the securities in the portfolio, Wi is the proportion of the portfolio in security i, i is the standard deviation of expected returns of security i, and, Covij is the covariance of expected returns of securities of i and j. Assuming that the covariance is less than one (invariably true), this will be less than the weighted average of the standard deviation of the expected returns of the securities. This is why diversification reduces risk. The other important results in modern portfolio theory are those dealing with the construction of efficient portfolios. Modern portfolio theory is not universally accepted, despite being the standard textbook description of portfolio risk and return. Markowitz himself thought normally distributed variance an inadequate measure of risk. Models have been developed that use asymettric and fat tailed distributions (post-modern portfolio theory). There are also more radical objections, including an alternative behavioral portfolio theory. Any theory or strategy that suggests it is possible to outperform the market without taking extra risk contradicts Markowitz portfolio theory, as does the evidence for the value effect or the existence of persistent arbitrage opportunities. Note that only the last of

these is necessarily a failure of market efficiency the two are often confused (at least in the context of their failure).

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 assets 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 behavioral 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. However, 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. Like wise, 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. The Portfolio Theory is has so many assumptions, most of which damage the Theory to certain point. Some other key assumptions are: All investors aim to maximize profit and minimize risk. All investors act rationally and are risk averse. All investors have access to the same information at the same. Correlations between assets are fixed and constant forever. There are no taxes or transaction costs. Any investor can borrow unlimited amounts of shares with no credit limits and at therisk free rate of interest.

Limitations Firstly, the connections between risk and return are constructed by past performance, therefore it does not promise a good future for the investors. It is also mathematically calculated and the values are based on past performance. Secondly, the proposition of investors being able to buy securities of any sizes is not realistic because certain securities have minimum order sizes and securities cannot be bought or sold in portions. Furthermore, investor cannot borrow unlimited amounts of shares cause of their credit limit.

Reference 1. Markowitz, Harry M. (1952). Portfolio selection, Journal of Finance, 7 (1), 7791.2.Gupta, Francis, Markowitz, Harry M.Fabozzi, Frank J. (2002) The Legacy of Modern Portfolio Theory THE JOURNAL OF INVESTING Fall 20023.Risk glossary (2006) "Modern portfolio theory", Available fromhttp://www.ri skglossary.com/link/portfolio_theory.htm [19/06/2006]4.Andrei Shleifer: Inefficient Markets: An Introduction to Behavioral Finance.Clarendon Lectures in Economics (2000)External links1.http://www.investopedia.com/articles/06/MPT.asp2.http://www.capital-flowwatch.net/tag/modern-portfolio-theory/3.http://www.articlesbase.com/investingarticles/modern-portfolio-theory-an-introduction-2105870.html#ixzz0t5RMm3Fp 4 .http:/en.wikipedia.org/wiki/Modern_portfolio_theory