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PORTFOLIO SELECTION by HARRY MARKOWITZ Name Prashanth premchand banu Student ID A4018183

RISK MANAGEMENT ASSIGNMENT --MODERN PORTFOLIO THEORY

Modern portfolio theory, or MPT, is a popular investment theory which suggests that investors can maximise returns and minimise risk by carefully selecting different types of assets in their portfolio. The theory is considered as a mathematical formulation of the concept of diversification in investing. Modern portfolio theory was introduced in 1952 by Harry Markowitz, then a student in the University of Chicago. The theory became very popular because at that time there 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 by selection of the investment assets, considering risk appetite of the investor. MPT employs statistical measures such as correlation and co variation to quantify the effect of the diversification on the performance of portfolio. For most investors, the risk they take when they buy a stock is that the return will be lower than expected. In other words, it is the deviation from the average return. Each stock 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 in holding any one of the individual stocks (provided the risks of the various stocks are not 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 rains or shines. Adding one risky asset to another can reduce the overall risk of an allweather portfolio. Modern Portfolio Theory proposes that it’s possible to construct a portfolio of investments that maximizes returns and minimizes risk by diversifying investments among uncorrelated assets.

LSBF Risk Management assignment

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RISK MANAGEMENT ASSIGNMENT --MODERN PORTFOLIO THEORY

There are two key assumptions inherent in MPT: 1. Investors Are Rational: This means that investors, collectively, will be correct in their economic and financial assumptions on average. In other words, market moves are always rational and based on the fundamental economic and corporate realities of the moment. 2. Efficient Market Hypothesis: Those who subscribe to this view believe that all information relevant to a stock is priced into it at a given point in time. In other 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 combination of 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 to reduce the total variance of the portfolio. MPT also assumes that investors are rational and markets are efficient. Although MPT is widely used in practice in the financial industry and several of its creators 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, and many companies using variants of MPT have gone bankrupt in various financial crises. MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection of investment assets that has collectively lower risk than any individual asset. This is possible, in theory, because different types of assets often change in value in opposite ways. For example, when the prices in the stock market fall, the prices in the bond market often increase, and vice 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 the investor 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 portfolio management techniques. Furthermore, MPT assumes that it is possible to select stocks whose individual performance is independent of other investments in the portfolio. LSBF Risk Management assignment 3

RISK MANAGEMENT ASSIGNMENT --MODERN PORTFOLIO THEORY

But market historians have shown that there are no such instruments; in times of market stress, seemingly independent investments do, in fact, act as though they are related. Likewise, it is logical to borrow to hold a risk-free asset and increase your portfolio returns, but finding a truly risk-free is very complicated. Government-backed bonds are presumed to be risk free, but, in reality, they are not. Securities such as gilts and U.S. Treasury bonds are free of default risk, but expectations of higher inflation and interest rate changes can both affect their value. The conventional interpretation of MPT is based on finance research through the mid1960s. By that standard, buying and holding the market portfolio and letting it ride is the embedded wisdom. But research over the last several decades tell us that risk and return are more complicated, which implies doing something other than holding the unmanaged market portfolio. In the long run, the broad market portfolio is still likely to perform as theory predicts and generate middling to slightly above middling returns for relatively little risk compared with the various efforts to beat this index. Another assumption of MPT is that investors accurately understand what returns are possible. This is often not the case and is why many investors often need help from money managers. Professionals are more likely to understand real-world limitations of Modern Portfolio Theory.

Conclusion
Even though MPT has evolved into a major theory in finance and it is commonly used by research analysts and portfolio managers as a tool to monitor risk and return characteristics of a portfolio, some serious criticisms have also evolved to challenge the very basic assumptions of MPT, especially after the findings in the field of behavioural economics. For example, the theories that markets are efficient and all investors are rational have been proved wrong by behavioural economists as well as the success of outstanding investors. Also other assumptions such as the correlations between asset classes are constant and all investors have access all available information are also wrong in many cases. Further, MPT does not take into account the impact of taxes and trading costs on portfolio returns. Moreover, the reliance of MPT on past performance to project expected returns is not always reliable since as everyone knows past performance is no guarantee of future results. A portfolio's LSBF Risk Management assignment 4

RISK MANAGEMENT ASSIGNMENT --MODERN PORTFOLIO THEORY

success rests on the investor's skills and the time he or she devotes to it. Sometimes it is better to pick a small number of out-of-favour investments and wait for the market to turn in your favour than to rely on market averages alone.

Reference
1. Markowitz, Harry M. (1952). Portfolio selection, Journal of Finance, 7 (1), 7791. 2. Gupta, Francis, Markowitz, Harry M.Fabozzi, Frank J. (2002) The Legacy of Modern Portfolio Theory THE JOURNAL OF INVESTING Fall 2002 3. Risk glossary (2006) "Modern portfolio theory", Available http://www.riskglossary.com/link/portfolio_theory.htm [19/06/2006] from

4. Andrei Shleifer: Inefficient Markets: An Introduction to Behavioral Finance. Clarendon Lectures in Economics (2000) External links 1. http://www.investopedia.com/articles/06/MPT.asp 2. http://www.capital-flow-watch.net/tag/modern-portfolio-theory/ 3. http://www.articlesbase.com/investing-articles/modern-portfolio-theory-anintroduction-2105870.html#ixzz0t5RMm3Fp 4. http:/en.wikipedia.org/wiki/Modern_portfolio_theory

LSBF Risk Management assignment

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