A portfolio
involves the selection of securities. Each individual investor puts his wealth in a combination of assets depending on his wealth, income and his preferences. The traditional theory of portfolio postulates that selection of assets should be based on lowest risk, as measured by its standard deviation from the mean of expected returns. But how to gain highest returns from the lowest risk?? is what led to the development of Markowitz model.
Harry
1952. It assists in the selection of the most efficient by analyzing various possible portfolios of the given securities. By choosing securities that do not 'move' exactly together, the HM model shows investors how to reduce their risk. The HM model is also called Mean-Variance Model due to the fact that it is based on expected returns (mean) and the standard deviation (variance) of the various portfolios.
He
started with the idea of risk aversion of average investors and their desire to maximise the expected return with the least risk. Markowitz model is thus a theoretical framework for analysis of risk and return and their inter-relationships. His framework led to the concept of efficient portfolios. An efficient portfolio is expected to yield the highest return for a given level of risk or lowest risk for a given level of return.
The investor's optimal portfolio is found at the point of tangency of the efficient frontier with the indifference curve. This point marks the highest level of satisfaction the investor can obtain. R is the point where the efficient frontier is tangent to indifference curve C3, and is an
The extension of Markowitz model, overcoming of the defects, is this model. Sharpe showed that there is along the efficient frontier a unique portfolio that, when combined with lending or borrowing at the pure interest rate, dominates all other combinations of efficient portfolios.
Criticism of SIM
Single index model has been criticized because of its assumption that stock prices move together only because of common co-movement with the market. Many researchers have found that there are influences beyond the market like industry related factors that cause securities to move together.
Conclusion
If investors are risk averse its suitable for them to adopt Markowitz model, on the other hand, though SIM is criticized it is not possible by any other models to simplify calculations using empirical evidence. Therefore, in choosing the portfolio of investments, one has to analyze carefully about the possibility of risk and return and adopt the suitable methods.