Portfolio

Markowitz Model

8/4/15

Dr. Amit Gupta

Simple Diversification
Portfolio risk can be reduced by the
simplest kind of diversification.
In the case of common stocks,
diversification reduces the unsystematic
risk or unique risk.
But diversification cannot reduce
systematic or undiversifiable risk.

8/4/15

Dr. Amit Gupta

Diversification and Portfolio

Risk
p

U n iq u e
R is k
T o ta l R is k
M a rk e t
R is k
5

10

15

20

N u m b e r o f S to c k s
8/4/15

Dr. Amit Gupta

Problems of Vast
Diversification
Purchase of poor performers
Information inadequacy
High research cost
High transaction cost

8/4/15

Dr. Amit Gupta

The Markowitz Model

Assumptions:
The individual investor estimates risk on
the basis of variability of returns.
Investors decision is solely based on the
expected return and variance of returns
only.
For a given level of risk, investor prefers
higher return to lower return.
Likewise, for a given level of return
investor prefers lower risk than higher risk.
8/4/15

Dr. Amit Gupta

Portfolio Return
N

R p = X1R1
t =1

Rp = return on the portfolio

X1 = proportion of total portfolio invested in
security 1
R1 = expected return of security 1
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8/4/15

Dr. Amit Gupta

Portfolio Risk
p = X12 12 + X 22 22 + 2X1 X 2 (r12 1 2 )

p = portfolio standard deviation

X1 = percentage of total portfolio value in
stock X1
X2 = percentage of total portfolio value in
stock X2
1 = standard deviation of stock X1
2 = standard deviation of stock X2
covariance
of
X
12
rr12
= correlation co-efficient
of X1 and X2
12 =

1 2

8/4/15

Dr. Amit Gupta

Proportion
X1 = 2 (1 + 2) the precondition is that the
correlation co-efficient should be 1.0, Otherwise it is

22 (r12 1 2 )
X1 = 2
1 + 22 (2r12 1 2)
Rp and p for

varying degrees of correlation coefficients

Proportion of X
Proportion of Y
p
p
security in
security in
rxy
rxy
portfolio
portfolio
X
1X
1
0
+ 0.5
1.00
4.0
0.75
8/4/15
3.9

4.0
4.8

0.00
0.25

Dr. Amit Gupta

Rp
r xy

rxy
+1

5.00

4.0

4.0

5.75

5.5

0.5

Two Security Portfolios with

Different Correlation
Coefficients
R p

10
B
r = 1
r = +1

K
D
5

r = 0
C

r = + .5

A
r = 1
5

8/4/15

Dr. Amit Gupta

10

p
9

Markowitz Efficient Frontier

R p
A
15

10

E
F

D
5

5
8/4/15

10
Dr. Amit Gupta

15

p
10

Markowitz Efficient Frontier (Contd.)

Each of the portfolio along the line or
within the line ABCDEFGHI is possible.
When the attainable sets are examined,
some are more attractive than others.
Portfolio B is more attractive than
portfolios F and H because B offers more
return on the same level of risk.
Among all the portfolios, the portfolios
which offer the highest return at a
particular level of risk are called efficient
portfolios.
Here the efficient Dr.portfolios
8/4/15
Amit Gupta
are A, B, C and11