Modern

Portfolio
Theory
By;
Shafiq Ahmad Sahar 22104
Mahbobullah Rahmani 22105
 contents
 Introduction
 What is MPT?
 Assumptions of Modern Portfolio Theory
 Components of Risk
 How does MPT Work?
 Diversification
 The Efficient Frontier
 How to Apply MPT
 Misunderstanding of MPT
 Two Mutual Fund Theorem
 Criticisms
 Introduction
 There’s no such thing as the perfect investment, but
crafting a strategy that offers high returns and relatively
low risk is priority for modern investors.
 In 1952, an economist named Harry Markowitz wrote his
dissertation on “Portfolio Selection”, a paper that
contained theories which transformed the landscape of
portfolio management—a paper which would earn him
the Nobel Prize in Economics nearly four decades later.
 Instead of focusing on the risk of each individual asset,
Markowitz demonstrated that a diversified portfolio is
less volatile than the total sum of its individual parts.
While each asset itself might be quite volatile, the
volatility of the entire portfolio can actually be quite low. Speaker : Shafiq
 What is MPT? Speaker : Mahbobullah

 Modern portfolio theory is an investing strategy that

minimizes market risk while maximizing returns. It
is based on the premise that markets are efficient
and utilizes diversification to spread investments
across different assets.
 Markowitz created a formula that allows an investor
to mathematically trade off risk tolerance and
reward expectations, resulting in the ideal portfolio.
 This theory was based on two main concepts:
1. Every investor’s goal is to maximize return for any
level of risk
Let’s consider the following example…
 Speaker : Mahbobullah

Continue
 A “rational investor” is asked to choose between two investments:
 Investment A and Investment B. Both are expected to increase in value by 6 percent
each year. However, Investment B is considered twice as volatile as Investment A,
meaning its value fluctuates at twice the magnitude of Investment A’s value
fluctuations.
2. Risk can be reduced by diversifying a portfolio through individual, unrelated
securities
Under the MPT—or mean-variance analysis—an investor can hold a high-risk asset,
mutual fund, or security, so long as this high-risk investment is minimized by all
underlying assets. The portfolio itself is balanced in a way that its overall risk is lower
than some of its underlying investments. Risk is defined as the range by which an asset’s
price will vary on average, but Markowitz split risk into two subsequent categories.
 Assumptions of Modern Portfolio Theory
1. The market is efficient and all investors have in their knowledge all the facts
about the stock market and so an investor can continuously make superior
returns either by predicting past behavior of stocks through technical analysis
or by fundamental analysis of internal company management or by finding out
the intrinsic value of shares. Thus, all investors are in equal category.
2. All investors before making any investments have a common goal. This is the
avoidance of risk because they are risk averse.
3. All investors would like to earn the maximum rate of return that they can
achieve from their investments.

Speaker : Shafiq
 Speaker : Mahbobullah
Continue…
4. Markowitz brought out the theory to find out how the security returns are correlated
to each other. By combining the assets in such a way that they give the lowest risk
maximum returns could be brought out by the investor.
5. The investors base their decisions on the expected rate of return of an investment.
The expected rate of return can be found out by finding out the purchase price of a
security dividend by the income per year and by adding annual capital gains.
6. From the above, it is clear that every investor assumes that while making an
investment he will combine his investments in such a way that he gets a maximum
return and is surrounded by minimum risk.
7. The investor can reduce his risk if he adds investment to his portfolio.
8. The investor assumes that greater or larger the return that he achieves on his
investments, the higher the risk factor surrounds him. On the contrary, when risks are
low the return can also be expected to be low.
9. An investor should be able to get higher return for each level of risk “by determining
the efficient set of securities”.
MPT assumes that investors are risk averse,
meaning that given two portfolios that offer
the same expected return, investors will prefer
the less risky one.
Thus, an investor will take on increased risk
only if compensated by higher expected
returns. Conversely, an investor who wants
higher expected returns must accept more risk.
The exact trade-off will be the same for all
investors, but different investors will evaluate
the trade-off differently based on individual
risk aversion characteristics.

Speaker : Shafiq
 Components of Risk
 According to MPT, there are two components of risk
for individual stock returns.

Systematic Risk

Unsystematic
Risk

Speaker : Shafiq
 Speaker : Mahbobullah

Diversification
 An investor can reduce portfolio risk
simply by holding combinations of
instruments that are not perfectly
positively correlated. If all the asset pairs
have correlations of 0—they are perfectly
uncorrelated—the portfolio's return
variance is the sum over all assets of the
square of the fraction held in the asset
times the asset's return variance (and the
portfolio standard deviation is the square
root of this sum).
 Speaker : Mahbobullah

The Efficient Frontier

 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.
 At every level of return, investors can create a portfolio that offers the lowest possible risk.
 For every level of risk, investors can create a portfolio that offers the highest return.
Any portfolio that falls outside the Efficient Frontier is considered sub-optimal for one of two
reasons:
1. It carries too much risk relative to its return, or too little return relative to its risk.
2. A portfolio that lies below the Efficient Frontier doesn’t provide enough return when
compared to the level of risk.
 Efficient Frontier Graph

Speaker : Shafiq
 Speaker : Mahbobullah

How to Apply MPT

 MPT requires an investor take the time to define
 Time horizon
 Sources of return
 Sources’ expected returns
 Sources’ expected covariances with each other
 Sources’ expected ratio of return to risk
 Constraints
 Maximize expected utility
 Rebalance
 Review
 Speaker : Mahbobullah

Two Mutual Fund Theorem

 This theorem states that any portfolio on the efficient frontier
can be generated by holding a combination of any two given
portfolio on the frontier; the latter two given portfolios are the
"mutual funds" in the theorem's name. So in the absence of a
risk-free asset, an investor can achieve any desired efficient
portfolio even if all that I accessible is a pair of efficient mutual
funds. If the location of the desired portfolio on the frontier is
between the locations of the two mutual funds, both mutual
funds will be held in positive quantities. If the desired portfolio
is outside the range spanned by the two mutual funds, then one
of the mutual funds must be sold short (held in negative
quantity) while the size of the investment in the other mutual
fund must be greater than the amount available for investment
(the excess being funded by the borrowing from the other fund).
 Pros and Cons of Modern Portfolio Theory (MPT)

Pros Cons
 No timing the market  Not based on modern data
 Suitable for average investor  Standardized assumptions
 Decreases risk in investing

Speaker : Shafiq Speaker : Mahbobullah

 Speaker : Mahbobullah

Criticisms
 Despite its theoretical importance, critics of MPT
question whether it is an ideal investment tool,
because its model of financial markets does not
match the real world in many ways. The risk, return,
and correlation measures used by MPT are based on
expected values, which means that they are
mathematical statements about the future (the
expected value of returns is explicit in the above
equations, and implicit in the definitions of variance
and covariance). In practice, investors must substitute
predictions based on historical measurements of asset
return and volatility for these values in the equations.
Very often such expected values fail to take account
of new circumstances that did not exist when the
historical data were generated.
 References
 https://www.guidedchoice.com/video/dr-harry-markowitz-father-of-modern-portfoli
o-theory/
 https://www.thebalance.com/what-is-mpt-2466539
 https://www.thestreet.com/investing/modern-portfolio-theory-14903955
 https://www.wallstreetmojo.com/modern-portfolio-theory/
 https://www.investopedia.com/terms/m/modernportfoliotheory.asp