What is the Modern Portfolio Theory (MPT)?

Efficient Frontier: this was introduced by Nobel Laureate Harry Markowitz and is a
cornerstone of MPT (Modern portfolio theory).

• High degree of risk means a higher potential return, conversely, investors who take
on a low degree of risk have low potential return.
• There is an optimal portfolio that could be designed with a perfect balance between
risk and return. This optimal portfolio does not simply include securities with the
highest potential returns or low risk securities. It aims to balance securities with the
greatest potential returns with an acceptable degree of risk or securities with lowest
degree of risk for a given level of potential return. This is because of an investor
chooses to invest only in low risk securities, he would be limiting himself only to low
return thus, in order to build an optimum portfolio, low and high risk securities need to
be combined in such way that the investors gets a high return for a relatively low risk
level.
• The points on the plot of risk versus expected returns where optimal portfolios lie are
known as efficient frontier.
• The efficient frontier, is a set of ideal or optimal portfolios expected to give the
highest return for a minimal return. This frontier is formed by plotting the expected
return on the y-axis and the standard deviation as a measure of risk on the x-axis.

Using the efficient frontier theory, investments are highly diversified, that is there is a mix of
investments that offer the highest returns and those that offer the lowest risks in the portfolio.
hence, diversification is an attribute of optimal portfolios that use the efficient frontier
principle. Here are some important things you should know about efficient frontier;

• Investment portfolios and securities that offer the maximum expected return for a
clearly defined level of risk make up the efficient frontier.
• The nature of investments that make up the optima porfilio determine the returns and
risks of the investment.
• An investment portfolio is placed at the efficient frontier line based on the return and
the risk.
• The compound annual growth rate (CAGR) is the metric for measuring investment
return while the standard deviation is the metric that measures the risk of the
investment.
• Diversification is an attribute of optimal portfolios that make up the efficient frontier.
Optimal Portfolio

In the investment market, there is always a belief or an assumption that the higher the
benefit of an investment, the higher the risk that it entails. Also, the lower the risk, the lower
the return. However, Harry Markowitz developed a theory that creates a balance between
risk and return and that is the efficient frontier theory. The efficient theory uses a set of
optimal portfolios in creating a balance between the expected returns of investment and their
defined level of risk. This set of optimal portfolio offer the highest rate of return for a defined
level of risk, aloco, they offer the lowest level of risk for a maximum potential return.
Selecting Investments

It is important to know that the types of investments that an investor selected in a portfolio
will determine whether the portfolio will be an efficient frontier. Basically, securities that have
a high level of risk as well as high expected returns occupy the right end of the efficient
frontier. Also, on the left side of the efficient frontier are securities or investment instruments
that have low risks as well as low potential returns. Investors that have risk-tolerance those
that are interested in using the efficient frontier theory, usually, select from the right side of
the efficient frontier. For investors that want to avert investment risks, selecting from the left
side of the efficient frontier is the best choice.

Limitations

There are many setbacks or limitations on the efficient frontier theory. One of the limitations
of this theory is that it is best as a theory and not in practice. The fact that investments
making up the optimal portfolio in the efficient frontier are selected based on the assumption
that returns on assets usually follow normal distribution is another limitation of this theory. In
reality, returns on assets are said to follow a heavy-tailed distribution and not the normal
distribution. Aside from the above limitations, some underlying assumptions in the efficient
theory such as the rationality of investors and their tendency to avoid risk is debatable. This
is because the market generally witness irrational investors and risk-daring investors who
can influence certain decisions in the market.

The Principle of Diminishing Marginal Utility

Marginal utility refers to the utility gained from the consumption of an additional unit of a
good or service.

The principle of diminishing marginal utility is illustrated here as the total utility increases at a
diminishing rate with additional consumption. It is evidenced by figures D, E, and F having
decreased marginal utility. Therefore, the principle of diminishing marginal utility indicates
that each additional unit of consumption adds less to the cumulative utility than the previous
unit.

indifference curves are infinite

Sample pictures of indifference curves may show you one or two indifference curves.
However, the fact is that you can draw an infinite number of indifference curves between two
indifference curves. A set of indifference curves is called an indifference map.

An indifference curve to the right represents higher level of satisfaction

The first property tells you that there are infinite indifference curves. All these indifference
curves represent different levels of satisfaction. A higher indifference curve represents a
higher level of satisfaction.

indifference curves are not influenced by market or economic circumstances.

 An indifference curve is purely a subjective phenomenon and it has nothing to do with the
external economic forces.

Indifference curves do not intersect

Indifference curves cannot intersect each other. Suppose there are two indifference curves –
‘A’ and ‘B’. These two indifference curves represent two different levels of satisfaction. If
these indifference curves intersect each other, the intersection will represent the same level
of satisfaction, which is impossible.

Indifference curves do not touch either axes

An indifference curve represents various combinations of two commodities. If an indifference

curve touches horizontal axis or vertical axis, it implies that the customer prefers only one
commodity because when it touches axes, one of the commodities becomes zero quantity.
This violates the basic definition of an indifference curve. Hence, an indifference curve does
not touch either horizontal axis or vertical axis.

Indifference curves are convex to the origin

Indifference curves are always convex to the origin. The convexity of the indifference curves
indicates diminishing marginal rate of substitution (MRS). As you go down the curve of an
indifference curve, the curve becomes flatter as one good is substituted for the other. It is the
individual’s marginal rate of substitution, which is defined as the more an individual
consumes good A in proportion to good B, the less of good B the individual will substitute for
another unit of good A.

• An indifference curve is a graphical representation of various combinations or consumption

bundles of two commodities. It provides equivalent satisfaction and utility levels for the
consumer.
• It makes the consumer indifferent to any of the combinations of goods shown as points on
the curve. Also, it means the consumer cannot prefer one bundle over another on the same
graph.
• The marginal rate of substitution (MRS) indicates if a consumer is willing to sacrifice one
good for another commodity while maintaining the same level of utility.

MPT
MPT is an investment theory coined by Harry Markowitz based on a idea that risk-averse
investors can construct portfolios to optimize or maximize expected return based on a given
level of market risk, emphasizing that risk is an inherent part of higher reward.
Markowitz created a formula that allows an investr to mathematically trade off risk tolerance
and reward expectations resulting in the ideal portfolio.

• This theory is based on two concepts :

1. Every investor’s goal is to maximize return for any level of risk.
2. Risk can be reduced by diversifying a portfolio through individual , unrelated
securities. With a well-balanced and calculated portfolio, if some of the assets fall
 due to market conditions, others should rise an equal amount in
compensation, according to MPT.
• MPT works under the assumption that investors are risk-averse, that means they are
more comfortable with less risk and usually preferring a portfolio with less for a given
level of Return. So, given a choice between a higher return possibility with
unknown risk, and a lower return possibility with known risk, most people will
naturally prefer the latter portfolio with the known risk, even if it means a lower
return. Also, investors would only prefer high-risk investments of they can expect a
larger reward, given that the risk is known.
• While the benefits of diversification are clear, investors must determine the level of
diversification that best suits them. This can be determined through what is called the
efficient frontier, a graphical representation of all possible combinations of risky
securities for an optimal level of return given a particular level of risk.
1. At every level of return, investors can create a portfolio that offers the lowest
possible risk.
2. For every level of risk, investors can create a portfolio that offers the highest
return.
Advantages:

• Traders don’t rely on only one investment for their financial stability; rather, they
diversify their portfolio in order to get the maximum return with minimum risk.
• It helps in evaluating and managing risks and returns associated with the
investments.
Disadvantages:

• MPT doesn't deal with the real world, because all the measures used by MPT are
based on projected values, or mathematical statements about what is expected
rather than real or existing. Investors have to use predictions based on historical
measurements of asset returns and volatility in the equations, which means they are
subject to be changed by variables currently not known or considered at the time of
the equation.

• In this theory, there is an assumption that securities of any of the sizes can be
bought and sold, which doesn’t hold true as some of the securities have minimum
order sizes, which cannot be dealt with in the fraction.

SHARPE SINGLE INDEX MODEL

Implementation of Markowitz Portfolio Selection Model, however, requires large number of

input data for calculations. Suppose, if there are n securities in a portfolio, the Markowitz
Model requires n expected returns, n variance terms, and n(n-1)/2 covariance terms and to
calculate covariances for large portfolios requires large amounts of computing power.
In an attempt to simplify the Markowitz model with respect to reducing the covariance
estimates, William Sharpe developed a simple and elegant model called as Single Index
Model or Market Model. . in Sahrpe’s SIM, if an investor is calculating for n securities, the
model need 3n+2 estimates. Therefore, in case of 50 securities SIM model will require only
152 estimates as compared to the Markoqitz model requiring 1325 estimates.
• Sharpe model favors that an individual security has relationship with one common
parameter of the market ,i.e., index of market. To simplify analysis, the single-index
model assumes that there is only 1 macroeconomic factor that causes the systemic
risk affecting all stock returns and this factor can be represented by the rate of return
on a market index, such as the S&P 500.
• Sharpe justified that portfolio risk is to be identified with respect to their return co-
movement with the market and not necessarily with respect to within the security co-
movement in a portfolio. In short, Don’t only look at the movement of the price of the
portfolio but also the overall price of the portfolio moving along with the market
prices.
• This model is based on 4 concepts:
1. Market Portfolio: market indexes like Sensex. Every security is related to the
market.
2. Systematic Risk: macro factors that affect the return of all the stocks such as
cost of labor.
3. Unsystematic factors: these are micro factors relating to a firm-specific events
such as change in management, low credit rating, etc.
4. Residual error Return: it means return that arise on account of any
extraordinary events that may be favourable or unfavourable to the firm.
Sharpe’s SIM expressed the return from an individual security as a function of
the return of the overall market index.
Ri = a + bRm + e, where, Ri refers to the return on security I, Rm =refers to
the return on market index, a= risk free return, e= residual error
• It offers a single value to be used for performance ranking of different funds or
portfolios.
• Measures the risk premium of the portfolio in terms of its total risk. Risk premium is
the difference between the portfolio average rate of return and the risk free rate of
return.
• The standard deviation of the portfolio indicates risk.
• The index assigns high value to the assets that supports the risk adjusted average
rate of return.