Harry Markowitzs Portfolio Theory Model

Presented by:
NAME ROLL NO.

Tushar Joshi Pratiksha Pandya Komal Fulekar Mandar Panchal

14 30 09 28

Introduction To Portfolio Theory

Modern portfolio theory was introduced by Harry Markowitz with his paper "Portfolio Selection," which appeared in the 1952. Prior to Markowitz's work, investors focused on assessing the risks and rewards of individual securities in constructing their portfolios. Markowitz proposed that with the help of std.deviation, correlation, covariance, investors should focus on selecting portfolios based on their overall risk-reward characteristics. In a nutshell, investors should select portfolios not individual securities.

Assumptions while developing the HM model

Risk of a portfolio is based on the variability of returns from the said portfolio. An investor is risk averse. An investor prefers to increase consumption. If investors will purchase no. of shares of different companies, the risk may be reduced. An investor is rational in nature.

Return On Portfolio
Stock ABC
Return % Probability Expected Return 11 or 17 0.5 each return 14

Stock XYZ
20 or 8 0.5 each return 14

Variance

36
6

Standard deviation 3

ABC expected return: .5 x 11+ .5x17= 14 XYZ expected return: .5 x 20+ .5x8= 14 ABC variance = .5(11-14) + .5(17-14) = 9 XYZ variance= .5(20-14) + .5(8-14) = 36 ABC standard deviation= 3 XYZ standard deviation= 6

Now ABC and XYZ have same expected return of 14 % but XYZ stock is much more risky as compared to ABC because the standard deviation is much more high. Suppose the investor holds 2/3 of ABC and 1/3 of XYZ the return can be calculated as follows: Rp=X R Rp= return form portfolio X= proportion of total security invested in security 1. R= expected return of security 1.

Let us calculate the expected return for both possibilities

possibility 1 : 2/3 x 11 + 1/3 x 20 = 14 possibility 2: 2/3 x 17 + 1/3 x 8 = 14

In both the cases the investor stands to gain if the worst occurs, than by holding either of security individually Holding two securities may reduce portfolio risk too.

Risk on Portfolio according to Markowitz model

p=[(X1)(1) ] + [(X2)(2) ] + 2X1X2(r12 . 1. 2)
where,
X1 = proportion of total portfolio in stock 1,
X2 = proportion of total portfolio in stock 2,

1 = standard deviation of stock 1,

2 = standard deviation of stock 1,

r12 = correlation co-variance of X1 and X2.

12

= covariance of X12

1 2
n

covariance of X12 = 1 (R1 R1) . (R2 R2) 2 i=1

where ,

R1 , R1 = Return percentage on stock 1 , R2 , R2 = Return percentage on stock 1 .

Example :
Return % Probability Stock ABC 11 or 17 0.5 each return Stock XYZ 20 or 8 0.5 each return

Expected return Variance Standard deviation

14 9 3

14 36 6

Solution :
n

covariance of X12 = 1 (R1 R1) . (R2 R2) 2 i=1 = 1 [(11-14)(20-14) + (17-14)(18-14)] 2 = -18

12

= covariance of X12

1 2
= -18/ (3 X 6) = -1

 p = [(X1)(1) ] + [(X2)(2) ] + 2X1X2(r12 . 1. 2)

= [(2/3) x 9] + [(1/3) x 36] + [2 x (2/3) x (1/3) x (-1 x 3 x 6)]
= 4 + 4 + (-8) =0

LIMITATIONS

CONCLUSION