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Optimal Portfolio Construction With Markowitz Model Among Large Cap's in India
Optimal Portfolio Construction With Markowitz Model Among Large Cap's in India
Optimal Portfolio
Construction With
Markowitz Model
Among Large Caps In
India
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NITHYA.J
Abstract
The aim of this project is to construct effective portfolio for the large cap companies. This study enables to
know the performance of some Nifty Fifty companies having larger market capitalization. The analysis given
on this project is on the basis of risk & return and on Sharpe index model. This project suggests best
investment decision in selected large cap industries. By closely watching the daily price changes the trend and
time of entry and exit in the market can be predicted. In short the decisions as which script has to make sell
decisions and the composition of funds of asset allocation for each script can be analyzed by the way of
modern approach using Single Index Model (Sharpe model).
1. Introduction
The risk of a portfolio comprises systematic risk, also known as un- diversifiable risk, and unsystematic risk
which is also known as idiosyncratic risk or diversifiable risk. Systematic risk refers to the risk common to all
securities, i.e. market risk. Unsystematic risk is the risk associated with individual assets. Unsystematic risk
can be diversified away to smaller levels by including a greater number of assets in the portfolio (specific
risks "average out"). The same is not possible for systematic risk within one market. Depending on the
market, a portfolio of approximately 30-40 securities in developed markets such as UK or US will render the
portfolio sufficiently diversified such that risk exposure is limited to systematic risk only. In developing
markets a larger number is required, due to the higher asset volatilities.
A rational investor should not take on any diversifiable risk, as only non-diversifiable risks are rewarded
within the scope of this model. Therefore, the required return on an asset, that is, the return that compensates
for risk taken, must be linked to its riskiness in a portfolio contexti.e. its contribution to overall portfolio
riskinessas opposed to its "stand alone risk." In the CAPM context, portfolio risk is represented by higher
variance i.e. less predictability. In other words the beta of the portfolio is the defining factor in rewarding the
systematic exposure taken by an investor.
A rational investor always attempts to minimize risk and maximize return on his investment. Investing in
more than one security is a strategy to attain this often-conflicting goal. In 1952, Harry M. Markowitz
developed a model that could be used to systematically operationalise the old adage dont put all eggs in
one basket. Markowitz's portfolio model is concerned with selecting optimal portfolio by risk adverse
investors. According to the model risk adverse investors should select efficient portfolios, the portfolio that
maximizes return at a given level of risk or minimize risk at a given level of return, which can be formed by
combining securities having less than perfect positive correlations in their returns. Markowitz model was
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theoretically elegant and conceptually sound. However, its serious limitation was the volume of work well
beyond the capacity of all except a few analysts.
To resolve the problem William F. Sharpe developed a simplified variant of the Markowitz model that
reduces substantially its data and computational requirements (Sharpe 1963). As per Sharpes model, the
construction of an optimal portfolio is simplified if a single number of measures the desirability of including a
stock in the optimal portfolio. If we accept his model, such a number exists. In this case, the desirability of
any stock is directly related to its excess return-to-beta ratio. If the stocks are ranked from highest to lowest
order by excess return to beta that represents, the desirability of any stock's inclusion in a portfolio. The
number of stocks selected depends on a unique cut off rate such that all stocks with higher ratios will be
included and all stocks with lower ratios excluded.
Markowitzs original work still defines the main analytical tool for choosing optimal portfolios. In practice,
however, most of the work of the portfolio manager is done in preparing the inputs for the Markowitz model
(the forecasts for portfolio return and portfolio variance), and in interpreting the outputs of the model. The
most recent advances in portfolio management have focused on ways to analyze in more detail the different
sources contributing to the total risk in a portfolio.
Assuming that the rational investor seeks to maximize the expected return for a given level of volatility, or
equivalently seeks to minimize portfolios ex- ante risk for any given expected return, Markowitz [1952, 1959]
triggered the development of modern portfolio theory with the introduction of the mean-variance framework.
The concept of portfolio efficiency quantifies existing link between risk and return of a portfolio and the
complete set of optimal (or efficient) portfolios consequently forms the mean-variance frontier. Built upon the
mean-variance framework, the Capital Asset Pricing Model (CAPM) as developed by Sharpe [1964], Lintner
[1965] and Mossin [1966] states that under some certain conditions and taking different levels of investors'
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risk tolerance into account, the portfolio that provides the highest reward per unit of risk, better known as
Maximum Sharpe Ratio (MSR) portfolio should be held by all market participants.
Although mean-variance analysis and the CAPM are two pillars of modern finance, these models have been
scrutinized since their introduction. Especially simplified assumptions, namely the aim of rational and risk
averse investors to maximize economic utilities without influencing prices, having homogeneous investment
views based on all information to be available at the same time to all investors, trading without any costs and
holding a well diversified portfolio, have been strongly criticized. While Roll [1977] passed criticism on the
observability of the tangential portfolio, Merton [1980] found that already small changes in return estimates
can lead to completely different optimal weights in a portfolio construction process. In a nutshell, due to the
CAPM general assumptions and the question about availability of risk and return estimates, the meanvariance framework is known to have difficulties in its practical implementation.
Extending the work from Merton [1987], Malkiel and Xu [2006] found that if investors do not hold the
market portfolio, unsystematic risk is positively related to stock returns. According to Martellini [2008], taken
together with the fact that asset pricing theory implies a positive premium for systematic risk, these findings
suggest a positive relationship between total volatility and expected returns. However, Haugen and Baker
[1991] were the first to provide empirical evidence for the inefficiency of market capitalization-weighted
indices and exclusively focused on risk in their alternative portfolio construction process. Repeatedly
investing into a stock portfolio constructed to expose investors to minimum risk as measured by variance
provided a higher Sharpe Ratio (SR) than the Wilshire 5000 index in the period 1972-1989 and therewith
inspired further risk-based investing approaches. This paper adopts the question of how to construct an
optimal portfolio regarding different risk objectives and contributes to existing literature by examining using
Sharpes single index method.
2. Statement Of Problem
The report has been prepared for the basis of studying the various avenues or sectors where investors can
invest their savings in a group of securities or portfolios. Creation of portfolios helps to reduce risk, without
sacrificing returns. Portfolio management deals with the analysis of individual securities as well as with the
theory and practice of optimally combining securities into good portfolios. Portfolio is constructed to
diversify the risks and maintain perfect negative correlation between the securities held together. Framing
portfolio by selecting securities based on brand identity and recent performance does not turn up anticipated
return in long term. This paper is built around cooking up the portfolio by balancing the positive and negative
correlation existing between the securities and in turn getting returns closer to the anticipated results.
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2.1 Objectives
The main objective of this study is to create an optimum portfolio using Sharpes single index model.
We also consider the movement of share prices, expected returns, standard deviation and beta values.
The stock price movements, closing index points of the companies and beta values for the past four years
are collected for analysis.
All the values obtained above are interpreted and analysed using Sharpes single index model.
Of the fifty company of the index, the companies are chosen and analysed based on their performance in
the past four fiscal years.
No other factors other than the Share price movements, index movements, rate of return on government
securities and beta values for the securities for the past four years are taken for analysis.
2.3 Limitations
1. Only four years data has been considered for the construction of optimal portfolio.
2. Due to time constraint we are doing for only randomly selected fifteen scrips.
3. The portfolio is constructed purely on the basis of Sharpes model which basically considers the stock
price movements and does not take into consideration company specific factors, industry specific factors
and economic specific factors.
3. Review Of Literature
TANJA MAGO_C, M.S.(2009), the techniques that are used to solve the problem of optimal portfolio
selection all have their drawbacks. To solve these problems, we propose a new approach driven by utilitybased multi-criteria decision making setting, which utilizes fuzzy measures and integration over intervals. The
novel approach for an optimal portfolio selection has shown significant impact on the improvements of the
existing techniques both theoretically and experimentally. A common criterion for this assessment is the
expected return-to-risk trade-off as measured by the Sharpe ratio. Given that the ideal, maximized Sharpe
ratio must be estimated, we develop, in this paper, an approach that enables us to assess ex ante how close a
given portfolio is to this ideal. For this purpose, we derive the large-sample distribution of the maximized
Sharpe ratio, as obtained from sample estimates, under very general assumptions. This distribution then
represents the spectrum of possible optimal return-risk trade-offs that can be constructed from data.
Seegopaul, Hamish; Gupta, Francis; Prestbo, John (2005), For many plan sponsors, the greatest allocation to a
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single asset class is generally to domesticlarge-cap equities, so even a marginal difference in the performance
of this asset class over a long period can result in significant differences in the value of overall plan.Gotoh,
Jun-ya; Takeda, Akiko(2011), the reformulations of the robust counterparts of the value-at-risk (VaR) and
conditional value-at-risk (CVaR) minimizations contain norm terms and are shown to be highly related to the
-support vector machine (-SVM), a powerful statistical learning method. For the norm-constrained VaR and
CVaR minimizations, a nonparametric theoretical validation is posed on the basis of the generalization error
bound for the -SVM.Dale, Garry (2009), The adviser's job, often with the help of a computerized modeling
tool, is to balance the asset weighted portfolio against the client's assessed risk profile. Admittedly, this
sounds complex, but, in simple terms, a client's risk profile is a measure of how much capital they are
prepared to lose over a given period of time. Not, as many understand it, where the client fits on a scale of one
to ten. Jacobson, Brian J (2006), one of the challenges of using downside risk measures as an alternative
constructor of portfolios and diagnostic device is in their computational complexity, intensity, and
opaqueness. The question investors, especially high-net-worth investors who are concerned about tax
efficiency, must ask is whether downside risk measures offer enough benefits to offset their implementation
costs in use. A final insight is an outline of how to forecast risk using distributional scaling. Marketing
business weekly (2008), Calibration procedure proved superior to existing methods of averaging two or more
separate optimizations made with one or more risk models. First, optimality is guaranteed since there is no ad
hoc averaging done after optimization. Second, overly conservative solutions are explicitly avoided as the
primary tracking error constraint is always binding. Third, there often is a substantial synergistic benefit when
both risk models affect the solution. Bilbao, A; Arenas, M; M Jimnez; B Perez Gladish; M V Rodrguez
(2006), Expert estimations about future Betas of each financial asset have been included in the portfolio
selection model denoted as `Expert Betas' and modeled as trapezoidal fuzzy numbers. Value, ambiguity and
fuzziness are three basic concepts involved in the model which provide enough information about fuzzy
numbers representing `Expert Betas' and that are simple to handle. Clarke, Roger (2002),The ex-ante
relationship is a generalized version of a previously developed "fundamental law of active management" and
provides an important strategic perspective on the potential for active management to add value. The ex post
correlation relationship represents a practical decomposition of performance into the success of the returnprediction process and the "noise" associated with portfolio constraints.Rudin, Alexander M; Morgan,
Jonathan S,(2006), Despite the importance of diversification in portfolio construction, our current methods of
measuring it are inefficient. Implementation in hedge fund strategies reveals that various hedge funds offer
less diversification than may have been thought, and that there has been reduced diversification in the past
several years,Kangari, R, Riggs, L S,(1988)Two major obstacles are risk evaluation associated with each
project and the correlation coefficient between projects, which describes the efficiency of the diversification.
The probabilistic approach that is suggested is a more realistic approach to the evaluation of correlation. It is
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not possible for a contractor to completely diversify a portfolio, so industry risk cannot be
eliminated.Borkovec, Milan; Domowitz, Ian(2010)Accounting for trading costs ex ante delivers superior net
returns, broader diversification, lower turnover, and a portfolio robust to noisy alpha signals, relative to
standard mean-variance stock selection and portfolio construction. Mitigation of transaction costs, leading to
improvement in realized returns and better alignment of return with risk, begins at the portfolio construction
stage and therefore should not be controlled only at the level of trading desks.
4. Research Methodology
This is a descriptive study on the construction of portfolio of stocks. The data taken for the study is Secondary
in nature. The data has been collected from various websites like National Stock Exchange (NSE) and also
from the databases of Ebsco and Proquest. The study is conducted with the financial data for the past four
years from 1 April 2008 to 31 March 2012. The sample size of the study is limited to 15 large cap companies.
They are a combination of stocks from various sectors namely Banking, Information Technology, Energy,
FMCG, Infra, Pharma, etc.. The sampling technique adopted is Random Sampling.
Return
The total gain or loss experienced on an investment over a given period of time, calculated by dividing the
assets cash distributions during the period, plus change in value, by its beginning-of-period investment value
is termed as return.
Return = ((Todays market price Yesterdays market price)/Yesterdays market price)*100
Efficient Portfolio
A portfolio that maximizes return for a given level of risk or minimizes risk for a given level of return is
termed as an efficient portfolio.
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Correlation
A statistical measure of the relationship between any two series of numbers representing data of any kind is
known as correlation.
Cut-Off Point
Ci = (MV*(Ri-Rf) /NRV)/ (1+MV*^2/NRV)
Where MV=variance of the market index
NRV = variance of a stocks movement that is not associated with the
movement of market index that is stocks unsystematic risk.
Table 1: Return, Standard Deviation, Beta and Residual Variance of Individual Stock
Portfolio Scrips
Individual Return
Unsystematic Risk
ITC
45.15630781
2.48941059
0.561263549
6.197165084
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HDFC
-8.034497417
3.792903111
1.148901333
14.38611401
INFOSYS
2.956756271
1.923710021
0.692962931
3.700660244
ICICI
72.82353214
3.39112593
1.549568331
11.49973507
ONGC
-39.13308354
3.322595538
0.825152399
11.03964111
SBI
62.29244616
2.734717596
1.143667091
7.478680331
TATA MOTORS
60.63047122
4.300381038
1.30728804
18.49327707
M&M
69.60074429
3.386513204
1.074686915
11.46847168
NTPC
0.866573602
1.964663737
0.722779541
3.859903601
BHEL
-85.35497731
3.593234935
1.032742164
12.9113373
CIPLA
51.13273521
1.938771035
0.498426256
3.758833127
WIPRO
49.03034737
2.803540103
0.886436543
7.85983711
DLF
-36.97339488
3.937281052
1.572556532
15.50218208
RANBAXY
49.53198033
2.989680009
0.745920128
8.938186558
SAIL
-10.1237203
3.231801617
1.296612145
10.44454169
(Ri-Rf)/
Rank
New Ranking
ITC
65.77357
CIPLA
HDFC
-14.1653
12
ITC
INFOSYS
-7.62414
M&M
ICICI
41.6784
RANBAXY
ONGC
-57.4113
14
SBI
SBI
47.2624
WIPRO
TATA MOTORS
40.07569
ICICI
M&M
57.09639
TATA MOTORS
NTPC
-10.2015
10
INFOSYS
BHEL
-90.6276
15
NTPC
CIPLA
86.05633
SAIL
WIPRO
46.01609
HDFC
DLF
-28.7515
13
DLF
RANBAXY
55.35711
ONGC
SAIL
-14.1628
11
BHEL
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10
CIPLA yielded the maximum return among the companies selected and Bharat Heavy Electricals Limited
yielded lower return following that ONGC and DLF yielded lower return. Pharma and FMCG have shown a
higher return in all the companies chosen for the analysis. It shows that Pharma is the growing sector and it is
most preferred investable securities in India. Beta is greater than 1 in Mahindra and Mahindra, State Bank of
India, ICICI, Tata Motors, SAIL, HDFC, DLF and BHEL, which shows that these securities have more risk
and at the same time the reward per unit of risks is also more. But in case of other companies with regards to
beta it is less than 1 which shows it is less risky when compared to market risk.
Sharpe has provided a model for the selection of appropriate securities in a portfolio. The excess return of any
stock is directly related to its excess return to beta ratio. It measures the additional return on a security (excess
of the risk less asset return) per unit of systematic risk. The ratio provides a relationship between potential
risk and reward. Ranking of the stocks are done on the basis of their excess return to beta. Based on the excess
return to beta ratio the scrips are ranked from 1 to 15, with Cipla being in the first rank and BHEL being in
the last. The excess return to beta ratio was calculated using 8.24% as risk free rate of return.
New(Ri-Rf)/
(Ri-Rf)/New
(Ri-Rf)/New
MarketVar*(Ri-
USR
USR
Rf)/New USR
CIPLA
86.0533
5.687379398
5.687379398
19.32693481
ITC
65.7735
3.341892869
9.029272267
30.68340342
M&M
57.096
5.749556017
14.77882828
50.22162771
RANBAXY
55.357
3.445805809
18.22463409
61.93121477
SBI
47.262
8.265778228
26.49041232
90.02010172
WIPRO
46.016
4.600165897
31.09057822
105.6524519
ICICI
41.678
8.699877204
39.79045542
135.2165003
TATA MOTORS
40.075
3.703284478
43.4937399
147.8010551
INFOSYS
-7.624
-0.989405019
42.50433488
144.4388446
NTPC
-10.201
-1.380681883
41.123653
139.7469915
SAIL
-14.162
-2.279726714
38.84392628
131.9999913
HDFC
-14.165
-1.318923544
37.52500274
127.5180062
DLF
-28.7515
-4.586181493
32.93882125
111.9331781
ONGC
-57.411
-3.541066306
29.39775494
99.8998754
BHEL
-90.627
-7.48621515
21.91153979
74.46011096
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Scrip's
^2/New
11
^2/New USR
1+MV*^2/New USR
USR
CIPLA
0.066085602
0.066085602
1.224573046
15.7825904
ITC
0.050785206
0.116870808
1.397152067
21.96139142
M&M
0.100691043
0.217561851
1.739321824
28.87425835
RANBAXY
0.062246653
0.279808504
1.9508493
31.74577082
SBI
0.174891585
0.454700089
2.545168408
35.36901583
WIPRO
0.099964625
0.554664714
2.884869641
36.6229553
ICICI
0.20866171
0.763326424
3.593946876
37.62339982
TATA MOTORS
0.092387723
0.855714147
3.907900171
37.82109281
INFOSYS
0.12975957
0.985473717
4.348851017
33.21310481
NTPC
0.13533938
1.120813097
4.808763253
29.06090073
SAIL
0.160970084
1.281783181
5.355774118
24.64629545
HDFC
0.093039463
1.374822645
5.671942166
22.48224726
DLF
0.159522223
1.534344868
6.214032888
18.0129684
ONGC
0.061678823
1.59602369
6.423630754
15.55193305
BHEL
0.082601603
1.678625293
6.704328713
11.10627389
Cut Off
37.82109281
Cut Off
CIPLA
15.78259
ITC
21.96139
M&M
28.87426
RANBAXY
31.74577
SBI
35.36902
WIPRO
36.62296
ICICI
37.6234
TATA MOTORS
37.82109
CIPLA
6.395374073
41.96%
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12
ITC
2.530425592
16.60%
M&M
1.806077157
11.85%
RANBAXY
1.463401973
9.60%
SBI
1.443729097
9.47%
WIPRO
0.924188657
6.06%
ICICI
0.519553808
3.41%
TATA MOTORS
0.159321617
1.05%
Proportion Of Investment
CIPLA
41.96%
ITC
16.60%
M&M
11.85%
RANBAXY
9.60%
SBI
9.47%
WIPRO
6.06%
ICICI
3.41%
TATA MOTORS
1.05%
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13
6. Findings
The Pharma and FMCG sectors are the major contributors for the portfolio. Among the selected 15 stocks,
pharmaceutical sector is performing well. The beta values for those stocks are lesser than 1 which indicates,
minimal risk is involved in those stocks. So we consider 2 stocks from Pharma, two stocks from Banking
sector and two from manufacturing according to the cut-off value calculated. The CIPLA forms the major
contribution with 42% followed by ITC with 17%.
7. Recommendations
The recommended proportion investments to the companies according to constructed portfolio are Cipla
42%, ITC 17%, M&M 12%, Ranbaxy 10%, SBI 9%, Wipro 6%, ICICI 3%, and Tata Motors 1%.
Investors expecting high return for the minimal risk can go for Cipla (<1).
To investors who are risk lovers can go for M&M.
Investors better not to think about BHEL, ONGC, DLF, and HDFC.
CIPLA
41.96%
9.60%
ITC
M&M
11.85%
RANBAXY
16.60%
SBI
WIPRO
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14
8. Conclusion
Though there are 15 stocks that meet the criteria for being included in the Portfolio, the portfolio is
constructed with the top 8 stocks that meet the criteria to be included in the portfolio according to the Sharpe
Index Model. Those stocks are: CIPLA, ITC, Mahindra & Mahindra, Ranbaxy, State Bank of India, Wipro,
ICICI and Tata Motors. The portfolio predominantly consists of stocks from the pharmaceutical sector. The
share market is more challenging, fulfilling and rewarding to resourceful investors willing to learn the trade
for having effective returns with minimum risk involved. The optimal portfolio analysis and risk, return trade
off are determined by the challenging attitudes of investors towards a variety of economic, monetary, political
and psychological forces prevailing in the stock market. Thus the portfolio construction table would help an
investor in investment decisions. And the investor would select any company among the fifteen companies
from the above portfolio table. I also hope this dissertation will help the investors as a guiding record in future
and help them to make appropriate investment decisions.
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