Modern Portfolio Theory

Prof Mahesh Kumar

Amity Business School
 Modern Portfolio Theory
Modern portfolio theory was introduced by Harry
Markowitz in 1952. Markowitz, Sharpe & Miller were co-
recipients of the Nobel Prize in Economics in 1990 for
their pioneering work in portfolio theory

Harry Markowitz William F. Sharpe Merton Miller

 Expected Return
The expected return on a portfolio is the weighted average
of the returns of each asset within the portfolio
Example: A portfolio is comprised of three securities with
the following returns:

Security Return % of Portfolio

A 5% 30%
B 10% 45%
C 15% 25%
Expected Return
 The expected return of the portfolio is the
weighted average:
n
r̂  r w
j 1
j j

  5%   .30    10%   .45    15%   .25 

 9.75%

rj = return at time period j

r̂ = expected return
wj = proportion of the portfolio comprised of asset j
Portfolio Risk: Two Risky Assets
 Standard deviation of a two-asset portfolio is
calculated as follows:

2 2 2 2
σ = w σ + w σ + 2wAwBρ A,Bσ Aσ B
A A B B

σ = standard deviation
wA = the proportion of the portfolio comprised of A
ρA,B= the correlation coefficient between A & B
Portfolio Risk: Two Risky Assets

σ= w2A σ 2A + wB2 σ B2 + 2wA wBρA,Bσ A σ B

Portfolio risk is driven mainly by

the correlation between the
assets!!
 Correlation
 Correlation is a measure of the linear relationship
between two assets
 Correlation varies between perfect negative (-1) to
perfect positive (+1)
 Perfect negative correlation: when the return on
asset A rises, the return on Asset B falls and vice
versa
 Perfect positive correlation: the returns on asset A
and Asset B move in perfect unison
Correlation & Risk Reduction
B
RB
Perfect
Negative Correlation

Perfect
Positive Correlation
RA A
Less than
Perfect Correlation

σA σB
To minimize portfolio risk, choose assets that have
very low correlations with each other.
 Moving Toward Many Risky Assets
 When the portfolio consists of many risky assets,
they form a plot similar to a broken egg shell shape
 Each dot within the broken egg shell shape
represents the risk/return profile for a single risky
asset or portfolio of risky assets
 To maximize return per unit of risk assumed, an
investor would always choose an asset or portfolio
that plots along the efficient frontier
 Portfolios: Many Risky Assets
Return

RA A

Standard Deviation
σA
You would never choose Asset A, as you can earn a higher return
with similar risk by choosing the asset that plots along the Efficient
Frontier.
Choosing a Portfolio: So Far

 The investor first decides how much risk to

assume
 The investor then chooses the portfolio that
plots along the efficient frontier with that
amount of risk
Introducing the Risk Free Security

 When a risk-free asset (Treasury Bill) is

introduced into the set of risky assets, a new
efficient frontier emerges
 This new efficient frontier is known as the
Capital Market Line (CML)
 The CML represents all possible portfolios
comprised of Treasury Bills and the Market
Portfolio
Adding the Risk-Free Asset

Return Capital Market Line

RM

A
Rf

Standard Deviation
σM
Capital Market Line (CML)
σ Portfolio
R Well-diversified = rf +  rMarket - rf 
Portfolio σ Market

 To maximize return for an amount of risk, investors should

hold a portion of their assets in T-bills and a portion in the
market portfolio.
 Linear relationship between risk and return
 To earn an expected return greater than the return on the
market portfolio, invest more than 100% of one’s own wealth
in the market portfolio.
What are we Missing?

 We know:
 Investors should split their assets between
Treasury bills and the market portfolio
 To reduce risk, invest a greater proportion of
assets in Treasury bills
 To enhance expected return, invest a greater
proportion of assets in the market portfolio