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Published by Prashanth Banu

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Published by: Prashanth Banu on Jul 20, 2010
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PORTFOLIO SELECTION byHARRY MARKOWITZ Name Prashanth premchand banuStudent ID A4018183
Modern portfolio theory, or MPT, is a popular investment theory which suggests thatinvestors can maximise returns and minimise risk by carefully selecting differenttypes of assets in their portfolio. The theory is considered as a mathematicalformulation of the concept of diversification in investing.Modern portfolio theory was introduced in 1952 by Harry Markowitz, then a studentin the University of Chicago. The theory became very popular because at that timethere 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 byselection of the investment assets, considering risk appetite of the investor. MPTemploys statistical measures such as correlation and co variation to quantify the effectof the diversification on the performance of portfolio.For most investors, the risk they take when they buy a stock is that the return will belower than expected. In other words, it is the deviation from the average return. Eachstock 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 inholding any one of the individual stocks (provided the risks of the various stocks arenot 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 rainsor 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 investmentsamong uncorrelated assets.LSBF Risk Management assignment 2
There are two key assumptions inherent in MPT:1.Investors Are Rational: This means that investors, collectively, will be correctin their economic and financial assumptions on average. In other words,market moves are always rational and based on the fundamental economic andcorporate realities of the moment.2.Efficient Market Hypothesis: Those who subscribe to this view believe that allinformation relevant to a stock is priced into it at a given point in time. Inother 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 combinationof 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 toreduce the total variance of the portfolio. MPT also assumes that investors are rationaland markets are efficient.Although MPT is widely used in practice in the financial industry and several of itscreators 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, andmany companies using variants of MPT have gone bankrupt in various financialcrises. MPT is a mathematical formulation of the concept of diversification ininvesting, with the aim of selecting a collection of investment assets that hascollectively lower risk than any individual asset. This is possible, in theory, becausedifferent types of assets often change in value in opposite ways. For example, whenthe prices in the stock market fall, the prices in the bond market often increase, andvice 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 theinvestor 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 portfoliomanagement techniques. Furthermore, MPT assumes that it is possible to select stockswhose individual performance is independent of other investments in the portfolio.LSBF Risk Management assignment 3

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