Portfolio Return & Risk and

Markowitz Model
Contents
• Markowitz Theory of Optimal Portfolio Selection
Model
▫ Portfolio Return
▫ Portfolio Risk (For two, three and more securities)
▫ Markowitz Efficient Frontier
▫ Markowitz Optimal Portfolio Selection
▫ Diversification and Portfolio Risk
Portfolio Return & Risk
• An investor prefers to hold a portfolio of securities with
the rational of spreading & minimizing risk through
diversification.

• For a given set of securities any number of portfolios can

be constructed.

• A rational investor will attempt to find out the most

efficient of all these portfolios.

• To select the most efficient portfolio each portfolio needs

to be analyzed from its return and risk perspective.
Portfolio Return & Risk
• An efficient/optimal portfolio will be the one for which….
▫ The return is maximum given the amount of risk; or
▫ The risk is minimum given the amount of return.

• The conceptual framework & analytical tools for

determining this optimal portfolio in a objective manner is
provided by Harry Markowitz.

• He described his work first in 1952 in Journal of Finance

article and then in his own book in 1959.
Portfolio Return & Risk
• His method of portfolio analysis & selection is
known as Markowitz model.

• Markowitz model laid the foundation of what is

today known as modern portfolio theory.
Markowitz Theory of Optimal
Portfolio Selection
1. Creation of different portfolios for a given set
of securities.
2. Calculation of Portfolio Return and Portfolio
risk (for each portfolio).
3. Plotting all the portfolios on a graph with
return of portfolios on Y axis and risk of
portfolios on X axis.
4. Finding the Efficient Frontier of portfolios.
5. Selecting the Optimal Portfolio.
Step-1:Portfolio Creation and
Analysis
• According to Markowitz model, for a given n
number of securities any number of portfolios are
created by using different weights.

• Each portfolio is then evaluated on the basis of

portfolio return and risk.

• From among all these portfolios, the most

optimal or efficient portfolio is selected.
Step-2 Portfolio Return & Risk
• Each portfolio needs to be analyzed on basis of
return and risk.

• Thus, firstly it is important to calculated an

estimated return and estimated risk of each
portfolio.

• Now, a portfolio can consist of two, three or

more securities.
Portfolio Return
• The expected return of a portfolio is the weighted average of return
of each individual security held in the portfolio.

• The weight applied to each security is the proportion of funds

invested in it.

_ _
rp= Σ Xi ri
Where,
_
rp=Expected return of portfolio

Xi =Proportion of funds invested in each security

_
ri =Expected return of each security
Portfolio risk
• Risk of individual securities is measured in terms of
variance and standard deviation.

• But measuring portfolio risk is not as simple.

• A portfolio consists of a group of individual securities.

• And hence the risk of portfolio would depend not only on

the risk of each security but also on the interactive risk
between securities.

• Interactive risk means how returns of one security moves

with returns of other securities in the portfolio.
Portfolio risk
• This interactive risk is measured in terms of
covariance and co-relation.

• Covariance is the absolute measure of interactive

risk where as correlation is the relative or
standardized measure of interactive risk.

• Thus in order to calculate portfolio risk, we need

measures of variance of each security,
covariance and co-relation.
Portfolio risk – For Two Security
Portfolio
• Suppose we have two securities A & B in a portfolio.

• Covariance
_ _
CovAB = Σ [RA-RA] [RB-RB] / N
Where,
CovAB= Covariance between A & B
RA = Return on security A
_
RA = Expected return to security A
RB = Return on Security B
_
RB = Expected return to security B
N = Number of observation
Portfolio risk – For Two Security
Portfolio
• Covariance is the measure of how securities move
together.

• If returns of two securities move in the same direction

consistently, the covariance will be positive.

• If returns of two securities move in the opposite

direction consistently, the covariance will be negative.

• If the movements are independent of each other, the

covariance will be close to zero.
Portfolio risk – For Two Security
Portfolio
• Correlation

rAB= CovAB / σ A σ B

Where,
rAB= Coefficient of correlation of A & B
CovAB = Covariance between A & B
σ A = Standard deviation of A
σ B = Standard deviation of B
Portfolio risk – For Two Security
Portfolio
• Correlation is a more standardized measure of
interactive risk.

• Its value may range from -1 to +1

Portfolio risk – For Two Security
Portfolio
• Portfolio Variance
▫ Portfolio variance is not simply the weighted
average of variance of individual securities.

▫ But the covariance i.e. the relationship between

securities of the portfolio is also considered.
Portfolio risk – For Two Security
Portfolio
• Portfolio Variance

σ2p = X2A σ2A + X2B σ 2B + 2 X A XB rAB σ A σ B

Where,

σ2p = Portfolio Variance

XA = Percentage of total portfolio value in stock A
σA = Standard deviation of A
XB = Percentage of total portfolio value in stock B
σ B= Standard deviation of B
rAB = Correlation coefficient of A and B
Portfolio risk – For Two Security
Portfolio
• Now,

rAB = CovAB
______
σAσ B
• Thus, CovAB = rAB σ A σ B

• Thus, σ2p = X2A σ2A + X2B σ 2B + 2 X A XB rAB σ A σ B

can be written as

σ2p = X2A σ2A + X2B σ 2B + 2 X A XB CovAB

Portfolio risk – For Two Security
Portfolio
• Thus, risk of the portfolio will be minimized
when the value of portfolio variance can be
minimum.

• The portfolio variance will be surely less in case

of a negative correlation or covariance.

• Thus, the real aim of diversification that is

minimizing the risk will be achieved only when
the selected securities have negative correlation
Portfolio Risk – For 3 security or
more
• Suppose that a portfolio has three securities A, B and C.

• Now in order to find out the portfolio risk, the

interactive risk i.e. covariance needs to be found out for
each pair of security.

• That is, the covariance between A & B, B & C and C & A.

• Thus, the calculations become more difficult and thus a

variance-covariance matrix is used to make it easy.
Portfolio Risk – For 3 security or
more
• For more than 2 security, the formula for
portfolio variance is…..
n n

σ2p= Σ Σ Xi Xj σij
i=1 j=1
Where,
Xi = proportion of investment made in first security
Xj = proportion of investment made in second
security
σij = covariance between first and second security
Portfolio Risk – For 3 security or
more
• Thus, the value of Xi Xj σij has to be found out for
each possible pair of securities and then all those
values have to be summed up.

• This is done conveniently through a variance-

covariance matrix.
Portfolio Risk – For 3 security or
more
• Example:

▫ If there are three securities A,B and C and the

proportion of investment is 0.20,0.30 and 0.50
respectively.

▫ The variance of each security and the covariance

of each pair of securities can be put in the matrix
Portfolio Risk – For 3 security or
more
Variance-covariance matrix

Weight (0.2) (0.3) (0.5)

A B C
(0.2) A 52 63 36
(0.3) B 63 38 74
(0.5) C 36 74 45
Portfolio Risk – For 3 security or
more
Portfolio Variance
σ2p =Σ Σ Xi Xj σij
=(0.2×0.2×52)+(0.2×0.3×63)+(0.2×0.5×36)
+(0.3×0.2×63)+(0.3×0.3×38)+(0.3×0.5×74)
+(0.5×0.2×36)+(0.5×0.3×74)+(0.5×0.5×45)
=53.71

Standard Deviation=sqrt (53.71)=7.3287

Portfolio Risk – For 3 security or
more
• Thus, if the number of given securities are more than
three then, the variance-covariance matrix will become
larger and larger.

• The required number of covariances to compute a

portfolio variance is (n2 – n)/2.

• Thus, if n tends to be very large, then the computation is

becomes massive and complex.
Varying Degrees of Correlation
• Since the model emphasizes on interactive risk
between securities, it is important to analyze the
value of correlation.

• Correlation between securities play an important

role in determining the risk of the portfolio.

• There can be extreme values of correlation(-1

or+1), no correlation(0) or intermediate
values(e.g. 0.50).
Rp r=+1 B
B Rp r=-1

A
A

σp σp

Rp r=0 B Rp r = 0.50
B

A A

σp σp
Two Security Portfolio with varying degrees of correlation

Rp

r=-1
r=+1

r=0

A
r=-1

σp
Varying Degrees of Correlation
• Thus, it can be observed from the graphs that
there is a grater chance of minimizing portfolio
risk if there is a negative relationship between
the two securities.

• Important Observation
▫ Whenever correlation coefficient < ratio of smaller
standard deviation to larger standard deviation,
the combination of those two securities gives a
lesser standard deviation than either of the
individual security
Step-3&4: Markowitz Efficient
Frontier
• Many portfolios can be created by combining the
selected securities in varying proportions.

• Each portfolio will have its return and risk.

• If we plot all the portfolios on a graph, with their

respective returns on Y axis and risk on X axis, we can
identify the efficient and inefficient portfolios.

• And from the graph we can find that some portfolios will
always dominate the other portfolios.
Markowitz Efficient Frontier
• A curve passing through all such efficient portfolios is known as
the efficient frontier.

• An efficient portfolio is the one for which,

▫ The risk is minimum given the amount of return; or
▫ The return is maximum given the amount of risk

• Thus, the efficient frontier extends from minimum variance

portfolio to maximum return portfolio.

• Thus, all portfolios lying between the minimum risk portfolio

and maximum return portfolio on the efficient frontier represent
the set of efficient portfolios.
Rp

E F

C A

σp
Markowitz Efficient Frontier
• It can be seen from the above graph that portfolio E is
efficient than portfolio A as it has less risk given the
same amount of return.

• Similarly, portfolio E is efficient than portfolio F.

• Portfolio B is more efficient than portfolio A as it gives

more return at the same amount of risk.

• Thus, the line passing from the minimum risk portfolio C

to maximum return portfolio B is the Markowitz efficient
frontier.
 Markowitz Efficient Frontier
Rp
B

σp
Step-5:Selection of Optimal
Portfolio
• From among all the efficient portfolios, an investor has to
select his optimal portfolio.

• This decision will depend upon his degree of aversion to risk.

• If he is more risk averse, he would select a portfolio lying in

the lower side of the efficient frontier.

• If he is moderate risk taker, he would select the one lying in

the middle of the frontier.

• And if he is a risk lover than, he would select the one lying on

the upper side of the frontier.
Selection of Optimal Portfolio
• An investor’s preference for return and risk can
be represented graphically by his risk-return
utility curves or indifference curves.

• Thus, theoretically the optimal portfolio is the

one at the point of tangency between the
indifference curve and efficient frontier.
 Selection of Optimal Portfolio
I1
I2
Rp
I3

Efficient frontier

σp
Revising the steps of Markowitz theory
• Select a set of securities on basis of their individual risk
and return.

• Construct different portfolios using these securities in

different proportions.

• Calculate return and risk of each portfolio and put them up

on a graph.

• Find out the set of efficient portfolios.

• Ultimately select the optimal portfolio based upon

individual risk-return preference of the investor.
 Diversification and portfolio risk
σp

Unsystematic risk

Systematic risk

5 10 15 20 No. of securities