Portfolio Theories

Markowitz risk-return
analysis
Sharpe Portfolio
Optimization
Other theories
Markowitz Portfolio
Selection Model
Till 18th century – Bernoulli
and Cramer – Mean, Rule
of thumb, Intuition
Dr Harry M Markowitz –
Mean-Variance Model
(Rand Corporation, 1952)
Based on concept of
Efficient Market and
Portfolios.
Efficient market &
portfolios - implies

All investors have common

(homogeneous) expectations
regarding the expected returns,
variances and correlation of
returns among all securities;
All investors have the same
information about securities;
There are no restrictions on
investments;
There are no taxes;
There are no transaction costs;
and
No single investor can affect
the market price significantly.
Minimize Portfolio Risk /
Maximize Portfolio Return
Risk & Return for a 2-
asset portfolio
Efficient Frontier
Efficient Frontier with
Investor’s Indifference
Curve
Corner Portfolios

In which a new security is

added to a previous
efficient portfolio or in which
a security is dropped from a
previously efficient portfolio.
Investor’s Risk Frontier
Modifications to the
Efficient Frontier
A. Short Selling – 2 effects – a
security sold short produces a
positive return when a security
has a large decrease in price and
a negative return when its price
increases.
If it pays to s-s, the efficient
frontier shifts up and to the left –
as it allows disinvest in poor
investments (hence gain if they do
poorly)
Extension of the efficient frontier
to the right – arises as s-s
increases the risk and return on
the portfolio, as s-s can involve
huge losses.
Efficient Frontier with
and without Short Sales
 B. Leveraged Portfolios –
Markowitz did not allow for
borrowing and lending
opportunities, though it
recognizes the existence of
both systematic and
unsystematic risk.
(i) Risk free asset – investment
in risk free asset is referred to
risk free lending. Standard
deviation of risk free asset = 0.
Hence, covariance = 0.
(ii) Investing in both risk free
and risky asset –
Reward-to-risk-ratio = (Return-
risk free return) / standard
deviation
Reward-to-Risk Ratio
By combining the securities
in portfolio T with risk free
securities at rf, the investor
would actually reduce risk
more than the reduction in
return. The reduction of risk
makes the combination of
securities more attractive at
point P than an all equity
portfolio at U.
Rf – T = lending portfolio
T – Z = borrowing portfolio
Real life lending and
borrowing curves
Critique of the Model
Why assume all rational
investors are risk averse?
Why is variance most
appropriate measure of
risk? – for a long term
investor price volatility is
not a real risk.
Investment managers are
vary of mathematics.
Managers more
comfortable with individual
returns rather than
covariance.
The entire portfolio needs
to be revaluated even if 1
security changes.
Sharpe’s Single Index
Model
The Security
Characteristic Line -
Dimensions
SCL – Different
Dimensions
SCL - Variances
Portfolio Characteristic
Line
PCL – Portfolio Beta
Constructing the
optimal portfolio
To determine which securities
are to be included in the
optimum portfolio, the
following steps are
necessary:
1. Calculate the excess return
to Beta ratio for each security
under review and rank them.
2. The optimum portfolio
consists of investing in all
securities for which (Ri-T) /
Beta(i,m) is > a particular cut-
off point.
Other Portfolio theories

Capital Market theory &

CAPM
Security Market Line
Arbitrage Pricing Theory