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Portfolio Selection Summary FMP

The document summarizes key concepts from Harry Markowitz's 1952 paper "Portfolio Selection" which introduced Modern Portfolio Theory. The theory holds that risk can be reduced by diversifying across unrelated assets and the goal of investors should be to maximize returns for a given level of risk. It outlines how looking at the variance and correlation between asset prices allows building a portfolio with the optimal risk-return tradeoff.

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Mufti Ali
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203 views3 pages

Portfolio Selection Summary FMP

The document summarizes key concepts from Harry Markowitz's 1952 paper "Portfolio Selection" which introduced Modern Portfolio Theory. The theory holds that risk can be reduced by diversifying across unrelated assets and the goal of investors should be to maximize returns for a given level of risk. It outlines how looking at the variance and correlation between asset prices allows building a portfolio with the optimal risk-return tradeoff.

Uploaded by

Mufti Ali
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Portfolio Selection

Harry Markowitz
The Journal of Finance, Vol. 7, No. 1.
(Mar., 1952), pp. 77-91.

SUMMARY

INTRODUCTION:

The Portfolio Theory broadly explains the relationship between risk and reward and has laid the
foundation for management of portfolios as it is done today with the help of mean and variance model.
It emphasizes on the significance of the relationship between securities and diversification creates optimal
portfolios and reduces risk.

According to this theory each single security has own risk and diversification we can reduce the risk but
generally cannot eliminate risk. During diversification we have to see the variance and correlation among
the securities showing how two securities co vary. This is done by choosing the quantities of various
securities carefully taking mainly into consideration the way in which the price of each security varies in
contrast to that of every other security in the portfolio rather than taking securities individually.
In other words, the theory uses mathematical models to build an ideal portfolio for an investor that gives
maximum yield subject on his risk desire by taking into concern the relationship for an investor that gives
maximum yield subject on his risk desire by taking into concern the relationship between risk and return.

CENTRAL CONCEPTS OF MARKOWITZ'S MODERN PORTFOLIO THEORY

In 1952, Harry Markowitz presented an essay on "Modern Portfolio Theory" for which he also received a
Noble Price in Economics. His findings greatly changed the asset management industry, and his theory is
still considered as cutting edge in portfolio management.

There are two main concepts in Modern Portfolio Theory, which are:
 Any investor's goal is to maximize Return for any level of Risk

 Risk can be reduced by creating a diversified portfolio of unrelated assets

Other names for this approach are Passive Investment Approach because you build the right risk to return
portfolio for broad asset with a substantial value and then you behave passive and wait as it growth.

MAXIMIZE RETURN - MINIMIZE RISK

Let's briefly define Return and Risk. Return is considered to be the price appreciation of any asset, as in
stock price, and also any Capital inflows, such as dividends. 

In general Standard Deviation is a fair measure of risk as we want a steady increase and not big swings
which might possibly end up as loss.

Risk is evaluated as the range by which the asset’s price will on average vary, known as Standard
Deviation. If an asset's price has 10% Deviation from the mean and an average expected Return of 8%
you may observe Returns between -2% and 18%.

In a practical application of Markowitz Portfolio Theory, let's assume there are two portfolios of assets
both with an average return of 10%, Portfolio A has a risk or standard deviation of 8% and Portfolio B
has a risk of 12%. As both portfolios have the same expected return, any investor will choose to invest in
portfolio A as it has the same expected earnings as portfolio B but with less risk.

It is important to understand risk; it is a necessary concept, as there would be no expected reward without
it. Investors are compensated for bearing risk and, in theory, the higher the Risk, the higher the Return.

Going back to our example above it may be tempting to presume that Portfolio B is more attractive than
Portfolio A. As portfolio B has a higher risk at 12%, it may obtain a return of 22%, which is possible but
it may also witness a return of -2%. All things being equal it is still preferable to hold the portfolio that
has an expected range of returns between +2% and +18%, as it is more likely to help you reach your
goals.

DIVERSIFIED PORTFOLIO & THE EFFICIENT FRONTIER

Risk, as we have seen above, is a welcomed factor when investing as it allows us to reap rewards for
taking on the possibility of adverse outcomes. Modern Portfolio Theory, however, shows that a mixture
of diverse assets will significantly reduce the overall risk of a portfolio. Risk, therefore, has to be seen as
a cumulative factor for the portfolio as a whole and not as a simple addition of single risks.

Assets that are unrelated will also have unrelated risk; this concept is defined as correlation. If two assets
are very similar, then their prices will move in a very similar pattern. Two exchange trade funds from the
same economic sector and same industry are likely to be affected by the same macroeconomic factors.
That is to say, their prices will move in the same direction for any given event or factor. However, two
ETFs (Exchange Traded Funds) from different sectors and industries are highly unlikely to be affected by
the same factors.

This lack of correlation is what helps a diversified portfolio of assets have a lower total risk, measured by
standard deviation than the simple sum of the risks of each asset. Without going into any detail, a bit of
math might help to explain why.

Correlation is measured on a scale of -1 to +1, where +1 indicates a total positive correlation, prices will
move in the same direction par for par, and -1 indicates the prices of these to stocks will move in opposite
directions.

If correlation between all ETF pairs is 1, then it would seem reasonable that the total risk of the portfolio
is equal to the sum of the weighted standard deviations of each individual ETF. Whereas a portfolio
where the correlation of asset pairs is lower than 1 must lead to a total risk that is lower than the simple
sum of the weighted standard deviations.

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