Markowitz Theory

Introduction:
Markowitz theory was presented by harry Markowitz in 1952. Its also known as Modern
portfolio theory.
Modern Portfolio theory:
Modern portfolio theory is a theory of finance that attempts to maximize portfolio
expected return for a given amount of portfolio risk, or equivalently minimize risk for a given
level of expected return, by carefully choosing the proportions of various assets.
Assumptions of portfolio theory
Markowitz theory based on following assumptions
Investors are rational:
Investors are rational and behave in a manner as to maximize their utility with a given level of
income or money.
Free access to Information:
Investors have free access to fair and correct information on the returns and risk. It means that
there will be no hidden information which effects the portfolio selection of investor.
Efficient Market
The markets are efficient and absorb the information quickly and perfectly.

Risk Averse:
Investors are risk averse and try to minimize the risk and maximize return. A risk averse investor
is an investor who prefers lower returns with known risks rather than higher returns with
unknown risks. So Investors try to maximize return by minimizing risk.
Decision on expected return and Standard deviation:
Investors base decisions on expected returns and variance or standard deviation of these returns
from the mean. Investor decides for portfolio selection on basis of expected return and standard
deviation which is risk.
High return at given level of risk:
Investors prefer higher returns to lower returns for a given level of risk. So if for two portfolio
we have same level of risk then we will select the one with higher return and if we have same
return for two portfolio then we will selected the one with lower risk.
Mathematical Model:
Expected return:

Where

is the return on the portfolio,

is the return on asset i and

component asset (that is, the proportion of asset "i" in the portfolio).

is the weighting of

Portfolio returns variance:

Where

is the correlation coefficient between the returns on assets i and j. alternatively the

expression can be written as:

Where

for i=j.

Portfolio returns volatility (standard deviation):

For a two asset portfolio:

Portfolio
return:

Portfolio variance:
For a three asset portfolio:

Portfolio return:

Portfolio
variance:

Efficient Frontier:
Markowitz gave idea of efficient frontier which is a set of optimal portfolios that offers the
highest expected return for a defined level of risk or the lowest risk for a given level of expected
return. Portfolios that lie below the efficient frontier are sub-optimal, because they do not
provide enough return for the level of risk. Portfolios that cluster to the right of the efficient
frontier are also sub-optimal, because they have a higher level of risk for the defined rate of
return. According to Markowitz, for every point on the efficient frontier, there is at least one
portfolio that can be constructed from all available investments that has the expected risk and
return corresponding to that point.
The relationship securities have with each other is an important part of the efficient frontier.
Some securities' prices move in the same direction under similar circumstances, while others
move in opposite directions. The more out of sync the securities in the portfolio are (that is, the
lower their covariance), the smaller the risk (standard deviation) of the portfolio that combines
them. The efficient frontier is curved because there is a diminishing marginal return to risk. Each
unit of risk added to a portfolio gains a smaller and smaller amount of return.