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Markowitz's Modern Portfolio Theory

Markowitz's Modern Portfolio Theory proposes that investors can construct optimal portfolios that maximize returns for a given level of risk. It suggests that risk can be reduced through diversification among unrelated assets with low correlations. The theory introduced the efficient frontier, which graphs the set of optimal portfolios that offer the highest expected return for a defined level of risk. It provides a framework to help investors select portfolios that balance risk and return.

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118 views3 pages

Markowitz's Modern Portfolio Theory

Markowitz's Modern Portfolio Theory proposes that investors can construct optimal portfolios that maximize returns for a given level of risk. It suggests that risk can be reduced through diversification among unrelated assets with low correlations. The theory introduced the efficient frontier, which graphs the set of optimal portfolios that offer the highest expected return for a defined level of risk. It provides a framework to help investors select portfolios that balance risk and return.

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SONALI H
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Markowitz’s Modern Portfolio Theory - What Is It & How It Works

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 managementindustry, 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 amixture 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 ETFs 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.

The magic of building different pairs is that by different combination it is possible to achieve basically every risk to

return combination, even different from the risk to return level of the single components.
Build your free portfolio now
MARKOWITZ EFFICIENT FRONTIER

The concept of Efficient Frontier was also introduced by Markowitz and is easier to understand than it sounds. It is

a graphical representation of all the possible mixtures of risky assets for an optimal level of Return given any level of Risk,

as measured by standard deviation.

The chart above shows a hyperbola showing all the outcomes for various portfoliocombinations of risky assets, where

Standard Deviation is plotted on the X-axis and Return is plotted on the Y-axis.

The Straight Line (Capital Allocation Line) represents a portfolio of all risky assets and the risk-free asset, which is

usually a triple-A rated government bond.

Tangency Portfolio is the point where the portfolio of only risky assets meets the combination of risky and risk-free

assets. This portfolio maximizes return for the given level of risk.

Portfolio along the lower part of the hyperbole will have lower return and eventually higher risk. Portfolios to the

right will have higher returns but also higher risk.

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