Financial Markets and Investments

Module Modern Portfolio Theory

Session No. I

Version 1.0
 Financial Markets and Investments

Material from the published or unpublished work of others which is referred to in the Class
Notes is credited to the author in question in the text. The Class Notes prepared is of 912
words in length. Research ethics issues have been considered and handled appropriately
within the Globsyn Business School guidelines and procedures.

FM&I/M5S1/v1.0/270120 Modern Portfolio Theory | Session No. I

 Financial Markets and Investments

Table of Contents

1. Introduction ............................................................................................................... 4

2. Efficient Set of Portfolio from the Feasible Set of Portfolios ................................ 4

3. Application of Markowitz on Efficient Set of Portfolios ......................................... 6

4. The Complication of Markowitz Theory ................................................................... 6

References ..................................................................................................................... 7

List of Figures
Figure 2.1: Feasible Set of Portfolios ......................................................................................... 5

FM&I/M5S1/v1.0/270120 Modern Portfolio Theory | Session No. I

 Financial Markets and Investments

1. Introduction
A large number of portfolios can be made from the limited number of securities registered in the
respective stock exchange. These portfolios are made through different proportions of such
securities. The formation of such numerous portfolios is considered as a feasible set of
portfolios. The investors search these kinds of feasible portfolios for investment. The feasible
set of portfolios is termed as the portfolio opportunity set. The investors like to earn the
maximum return from the invested money and at the same time, they want to bear the minimum
risk related to such investment. However, the nature of risk-taking capacity of the investors is
varied. Few investors are there who really want to take up higher risk to earn the return
according to the proportion of the higher risk. It means they are speculative and eager to earn
higher returns by taking up a risky venture of investment towards investing in risky securities.
But most of the investors want risk aversion. They prefer those funds where returns come
maximum with a lower degree of risks (Guided Choice, 2019). Generally, investors invest in the
shares to earn a better return from the risk free assets like bank fixed deposits etc.

2. Efficient Set of Portfolio from the Feasible Set of Portfolios

The feasible set of portfolios here refers to the opportunity set of portfolios that are
characterised by an expected return and a measure of risk. All the portfolios are shown in the
following figure which is called portfolio opportunity set. It is assumed that this portfolio set is a
mixture of different securities in a suitable proportion in comparison to other portfolios that are
not presented here. However, all these portfolios are not an efficient set of portfolios (Elton &
Gruber, 2011). Thefollowing data are shown in a table form relating tothe portfolio opportunity
set. The expected return and standard deviation of each portfolio are exhibited. Standard
deviation is the extent of variability of possible returns from the expected return.

FM&I/M5S1/v1.0/270120 Modern Portfolio Theory | Session No. I

 Financial Markets and Investments

Figure 2.1: Feasible Set of Portfolios

(Guided Choice, 2019)

In finding out the efficient portfolio among the given data of expected returns and standard
deviations it is important to consider the dominance rule. This rule is related to the efficient set
of portfolios. But before explaining this rule let us look at certain guidance of portfolio selection.

Rule 1:
Given two portfolios with the same expected return, the investor would prefer theonewith the
lower risk.

Rule 2:
Given two portfolios with the same risk, the investor would prefer the one with the
higherexpected return.

The dominance rule follows any of the following of the above rules. Accordingly, a portfolio will
dominate another if it has either a lower standard deviation possessingthe same returns with
others or a portfolio having better return over other securities bearingthe same level of risks as
other portfolios.

In the given set of theportfolio, we observe that portfolio 7 and 8 carry the same expected return
i.e. 13.5%. However, in terms of risk, these two portfolios differ with each other. The standard
deviation of portfolio 7 and 8 are 9.5 and 11.3 respectively. In this case, Portfolio 7 is regarded
as an efficient portfolio and Portfolio 8 is an inefficient portfolio. Again we can measure the

FM&I/M5S1/v1.0/270120 Modern Portfolio Theory | Session No. I

 Financial Markets and Investments

difference of two portfolios in terms of higher expected return. If we observe portfolio 4 and 5 we
can see that both these portfolios bear the same level of risk. However, portfolio 5 is superior to
portfolio 4 in terms of return. Therefore, portfolio 5 is regarded as an efficient portfolio as it
dominates over portfolio 4.

3. Application of Markowitz on Efficient Set of Portfolios

By applying rules 1 and 2 the efficient set of portfolios can be developed from a feasible set of
portfolios. Assume that all the other feasible portfolios are efficient. As per Markowitz, father of
Modern Portfolio Theory, the north-west boundary of all the possible portfolios is considered as
the efficient frontier which is a set of portfolios holding the global minimum variance portfolio and
the maximum return portfolio. This efficient frontier takes a concave shape is considered as
more efficient than all the possible portfolios. The rational and risk-averse investors are
interested in the portfolios lying on the curve (Fabozzi, 2015). They are the investors who seek
maximum return against minimum risk relating to the investment.

4. The Complication of Markowitz Theory

The principal limitation of the Markowitz Model is that countless numbers of data are required to
develop a possible set of portfolios. From these portfolios, the efficient set of portfolios is
constructed by applying a complex mathematical calculation called quadratic programming.
However, in choosing numerous sets of portfolios the following data are required. These are
estimates of return and variance of returns of all securities along with covariance of returns for
each pair of securities held by the portfolio. Suppose, if there are N securities in the portfolio,
the requirement of inputs are N return estimates, N variance estimates and N(N-1)/2 covariance
estimates. Total estimates include 2N with covariance estimates. Computation of such a large
number of data leads to having little use of this model in the application of portfolio analysis
(Guerard, 2016).

FM&I/M5S1/v1.0/270120 Modern Portfolio Theory | Session No. I

 Financial Markets and Investments

References

Elton, E. J. & Gruber, J. M., 2011. Investmets and Portfolio Performance. s.l.:World Scientific.

Fabozzi, J. F., 2015. Capital Markets: Institutions, Instruments, and Risk Management. s.l.:MIT
Press.

Guerard, J. B., 2016. Portfolio Construction, Measurement and efficiency. s.l.:Springer.

Guided Choice, 2019. Harry Markowitz’s Modern Portfolio Theory: The Efficient Frontier.
[Online]
Available at: https://www.guidedchoice.com/video/dr-harry-markowitz-father-of-modern-portfolio-
theory/
[Accessed 30 01 2020].

FM&I/M5S1/v1.0/270120 Modern Portfolio Theory | Session No. I