Portfolio theory The theory of portfolio was developed by Markowitz in 1952, where through the introducing this theory

he won Nobel Prize in economics in 1990. Portfolio theory is about the ability of the investors to diversify the unsystematic risk by holding portfolio which is consists of number different shares or securities. Portfolio analysis determines the future risk and return by holding various types of shares and individual securities. An investor can reduce the portfolio risk by, adding security with greater individual risk to other securities which have lover risk in the portfolio which consist of many securities, by doing this we will get lower risk result, because risk depends greatly on the covariance among returns of individual securities. So an individual can reduce the expected risk level of portfolio asset if he made a proper diversification. So the rational investors will invest only on the efficient frontier to maximize their utilities, since it gives them maximum return for a given level of risk or minimum risk for a given level of return. They can do this by combining the risk free assets like government securities to the market portfolio which are the risky asset. Rational investors therefore select the optimal portfolio on the capital market line at the point of tangency with their utility curve. There are two main approaches for analysis of portfolio Traditional approach. Modern approach.

TRADITIONAL PORTFOLIO APPROACH: The traditional approach basically deals with two major decisions. Traditional security analysis recognizes the key importance of risk and return to the investor. Most traditional methods recognize return as some dividend receipt and price appreciation over a forward period. But the return for individual securities is not always over the same common holding period, nor are the rates of return necessarily time adjusted. An analysis may well estimate future earnings and a P/E ratio to derive future price. He also will estimate the dividend. Usually the traditional portfolio approach select stocks from different industry, for an example like company from two different industries, when selecting them also make sure they select popular or familiar mutual stocks and evaluate the risk and reward individually but all this are performed without the involvement of any calculation. These methods are still practiced by mutual funds and insurance company. The traditional methods are more objectively specified in explicit terms. Which are determining the objectives of the portfolio and Selection of securities to be included in the portfolio.

Normally this is carried out in four to six steps. Before formulating the objectives, the constraints of the investor should be analyzed. Within the given frame work of constraints, objectives are formulated. Then based on the objectives securities are selected. After that risk and return of the securities should be studied. The investor has to assess the major risk categories that he or she is trying to minimize. Which Compromise the risk and non-risk factors which has to be carried out. Finally relative portfolio which is assigned to securities like bonds, stocks and debentures and the diversification is carried out.

The modern portfolio approach The modern portfolio approach does not take over traditional theory but it improved the traditional theory, so they technically they do not replace it they take the benefit of the traditional theory and comply into the modern theory. They include a new part where they introduce the calculation part where there is concept of standard deviation and concept of beta, so know the risk and reward are mathematically measured Harry M. Markowitz has credited and introduced the new concept of risk measurement and their application to the selection of portfolios. He started with the idea of investors and their desire to maximize expected return with the least risk. Markowitz model is a theoretical frame work for analysis of risk and return and their relationships. He used statistical analysis for the measurement of risk and mathematical programming for selection of assets in a portfolio in an efficient manner. His framework lead to the concept of efficient portfolios, which are expected to yield the highest return for, given a level of risk or lowest risk for a given level of return. Risk and return are two aspects of investment considered by investors. The expected return may vary depending on the assumptions. Risk index is measured by the variance or the distribution around the mean its range and traditionally the choice of securities depends on lower variability where Markowitz emphasizes on the need for maximization of returns through a combination of securities. The risk of each security is different from that of other and by proper combination of securities, called diversification, one can form a portfolio where in that of the other offsets the risk of one partly or fully. In other words, the variability of each security and covariance for his or her returns reflected through their inter-relationship should be taken into account. Thus, expected returns and the covariance of the returns of the securities with in the portfolio are to be considered for the choice of a portfolio.

ASSUMPTIONS OF MARKOWITZ THEORY: The analytical frame work of Markowitz model is based on several assumptions regarding the behavior of investor: a) The investor invests his money for a particular length of time known as holding period. At the end of holding period, he will sell the investments. b) Then he spends the proceeds on either for consumption purpose or for reinvestment purpose or sum of both. The approach therefore holds good for a single period holding. c) The market efficient in the sense that, all investors are well informed of all the facts about the stock market. d) Since the portfolio is the collection of securities, a decision about an optimal portfolio is required to be made from a set of possible portfolio. e) The security returns over the forth coming period are unknown, the investor could therefore only estimate the Expected return(ER). f) All investors are risk averse. g) Investors study how the security returns are co-related to each other and combine the assets in an ideal way so that they give maximum returns with the lowest risk. h) He would choose the best one based on the relative magnitude of these two parameters. i) The investors base their decisions on the price-earnings ratio. Standard deviation of the rate of return, which is been offered on the investment, is it the one of the important criteria considered by the investors for choosing different securities.

The limitation of the portfolio theory are The theory does not show the market This is because the risk, return, and correlation measures used by portfolio theory are based on expected values, since it is the mathematical statements about the future. This is because the investors substitute the prediction of historical measurements of asset return and volatility into the equation and these expected values does not take into account the new circumstances that is not exist when historical data are generated. The investors are also stuck with estimating key parameters from past market data because portfolio theory shows risk in terms of likelihood for it to happen but it does not say anything about why this losses might happen so the risk measurement are probabilistic in nature and not structural. Mathematical risk measurement are only useful when it reflects the investors true concern so there is no point minimizing a variable that nobody cares about in practice. Furthermore portfolio theory uses the mathematical concept of variance to quantify risk, and this might be justified under the assumption of elliptically distributed returns such as normally distributed returns, but for general return

distributions other risk measures like coherent risk measures might better reflect investors' true preferences. Portfolio theory does not account for the personal, environmental, strategic, or social dimensions of investment decisions. It only attempts to maximize risk-adjusted returns, without regard to other consequences. So its complete reliance on asset prices makes it vulnerable to all the standard market failures such as those arising from information asymmetry, externalities, and public goods. It also rewards corporate fraud and dishonest accounting. The portfolio theory does not take its own effect on asset prices into account Diversification really can eliminate nonsystematic risk, but it also can cause the increase of systematic risk this is because diversification forces the portfolio managers to invest in assets without analyzing their fundamentals they only want to eliminate the portfolio nonsystematic risk. So this tends increase demand which pushes up the price of the asset which when analyzed individually will show little fundamental value but the whole portfolio becomes more expensive and this causes the probability of a positive return decrease. Risk free rate Based on the portfolio theory it seems like it is logical to borrow or hold risk free assets which tend s to increase the portfolio returns but in the real world finding a truly risk free asset is very difficult, government backed bonds are presumed to be risk free but in reality it is not, for an example Securities such as Treasury bonds are free of default risk, but expectations of higher inflation and interest rate can change and effect its value. The assumption of portfolio theory is unrealistic where it assumes that investors can borrow at the risk free rate, this is because individuals and companies are not risk free and so they will not be able to borrow at the risk free rate, actually they will be charged a premium to show the risk. The higher the risk the higher the premium needs to be paid. The theory also suggested that an investor can lend and borrow an unlimited amount of risk free rate but in reality every creditor have a credit limit or constraints. Identifying the market portfolio There are also problem with identifying the market portfolio as it requires the knowledge of risk and return of all the risky investment and their corresponding correlation coefficients. Even if the make-up of market portfolio is identified there is also the problem to construct it due to the transaction cost. But this cost will be prohibitive in the case of smaller investors Change in market portfolio The composition of market portfolio also will change overtime this is due to the shift in the risk free rate of return and in the envelope curve and this will hence the efficient frontier.

Selling and buying portfolio It can be very tough to sell a portfolio to investors which are not familiar with the Benefits of sophisticated portfolio management techniques. Other than that portfolio theory also assumes that it is possible to select stocks whose individual performance is independent of other investments in the portfolio. But market histories have shown that there are no such instruments, in term of market stress, where even though the investment seems to be independent but it is actually related to each other. Investors are not price takers The portfolio theory assumes that all investors are price takers and their actions do not influence prices. But in reality sudden action of the investors which causes sufficiently large sales or purchases of individual assets can shift the market price of the assets. Investors also may not be able to assemble the theoretically optimal portfolio if the market moves too much while they are buying the required securities. There is no Correlations between assets are fixed and constant forever. Correlations between assets depend on systemic relationships between the underlying assets, and the correlation changes when the relationships change. Example like during the time of one country declaring war on another country or during a market crash only at this time or during the period financial crisis all the asset will became positively correlated, this due to all the asset move down together. But there is no such thing as correlation at the normal time. Portfolio theory ususlay breaks down easily during the time the investors need protection from the risk.

All investors are not risk averse and rational so the assumption of portfolio theory are wrong this is because there are also investors which are risk takers where they take risk even if there is no high return or compensation because they have high risk tolerance, where they are willing to take lower return for higher risk. There are also investors with herd behavior" where they are willing to accept lower returns for higher risk. For an example like Casino gamblers who clearly pay for risk and it is possible that some stock traders will pay for risk as well. All investors do not have access to the same information Not all the investors have access to the same information at the same time this is because in real market there is information asymmetry, where there is insider trading which means there are investors who more informed than the other investors. Other than that estimating the mean, there are no consistent estimator for performing the subsampling and the covariance matrix of return where number of assets are the same as the order of the number of periods which shows it is a difficult statistical tasks

The other limitation of portfolio theory is 1) Portfolio theory uses short term volatility to determine whether the expected rate of return from a security should be assigned high or a low expected variance, but if an investor has limited liquidity or liquidity constraints, and he or she is a truly a long term holder so the price volatility per share does not really show a risk. 2) Security analysts are not comfortable in calculating covariance among securities while assessing the possible ranges of error in their expectations. 3) The assumption of portfolio theory that there is no taxes and transaction cost where in reality financial products are subject both to taxes and transaction costs for an example like broker fees, and taking these into account will alter the composition of the optimum portfolio. 4) The assumption of portfolio theory that Asset returns are normally distributed random variables. But in reality it is frequently observed that returns in equity and other market are not normally distributed.