Topic: Markowitz Theory (with assumptions)

Introduction:-
Markowitz Theory of Portfolio Optimization was developed by Harry Markowitz. He was the 1st economist
to show quantitatively ‘why’ & ‘how’ diversification minimises the risk. For his several contributions, he
was honoured with the Nobel Prize in the year 1990. This theory is also known as risk return optimization
theory & the theory of mean variance efficient portfolios. He explains that an investor may have several
combinations of securities giving different rate of returns and at different degrees of risk. Among these
combinations, some frontiers may be dominated frontiers, some may be minimum variance frontiers and
some may be efficient frontiers. A rational investor always tries to operate either at minimum variance
frontier giving more return than risk or he may operate or any of the efficient frontiers depending upon the
available resources and the capital allocation lines.

 Dominated Portfolio/Frontier: It reflects more risk and return.

Assumptions:-
1) The market is efficient and all investors have in their knowledge all the facts about the stock market
and so an investor can continuously make superior returns either by predicting past behaviour of
stocks through technical analysis or by fundamental analysis of internal company management or
by finding out the intrinsic value of shares. Thus, all investors are in equal category.
2) All investors before making any investments have a common goal. This is the avoidance of risk
because they are risk averse.
3) All investors would like to earn the maximum rate of return that they can achieve from their
investments.
4) The investors base their decisions on the expected rate of return of an investment. The expected
rate of return can be found out by finding out the purchase price of a security dividend by the
income per year and by adding annual capital gains. It is also necessary to know the standard
deviation of the rate of return expected by an investor and the rate of return which is being offered
on the investment. The rate of return and standard deviation are important parameters for finding
out whether the investment is worthwhile for a person.
5) Markowitz brought out the theory that it was a useful insight to find out how the security returns
are correlated to each other. By combining the assets in such a way that they give the lowest risk
maximum returns could be brought out by the investor.
6) From the above, it is clear that every investor assumes that while making an investment he will
combine his investments in such a way that he gets a maximum return and is surrounded by
minimum risk.
7) The investor assumes that greater or larger the return that he achieves on his investments, the
higher the risk factor surrounds him. On the contrary, when risks are low the return can also be
expected to be low.
8) The investor can reduce his risk if he adds investment to his portfolio.
 9) An investor should be able to get higher return for each level of risk “by determining the efficient
set of securities”.

Diversification:-
Markowitz postulated that diversification should not only aim at reducing the risk of a security by reducing
its variability or standard deviation, but by reducing the covariance or interactive risk of two or more
securities in a portfolio. As by combination of different securities, it is theoretically possible to have a range
of risk varying from zero to infinity.

Markowitz theory of portfolio diversification attaches importance to standard deviation, to reduce it to

Advantages:-
1) It helps in evaluation and in managing risks and returns associated with the investments. With the
help of analysis, the assets which are under-performing assets and the assets having an excessive
risk with respect to returns can be scrutinized and then replaced with the new one.
2) The theory is an important tool for avoiding the financial ruin because by following these theory
traders don’t rely on only one investment for their financial stability rather they diversify their
portfolio in order to get the maximum return with minimum risk.

Disadvantages:-
1) In the case of the modern portfolio theory, past performance of the company under consideration
is taken. The performance of the past never provides the guarantee for the result that could arise in
the future. Considering only the past performances sometimes leads to over passing of the newer
circumstances which might not be there when historical data were considered but could play an
important role in taking the decision.
2) This theory assumes that there is a normal distribution of the return on an asset within a class of
assets which is proved to be wrong for individual equities as the correlations of asset class may
change over the period of time.
3) In this theory, there is an assumption that securities of any of the sizes can be bought and sold
which doesn’t hold true as some of the securities have minimum order sizes which cannot be dealt
in the fraction.
4) Modern Portfolio Theory even though is accepted widely all over the world and also applied by
different investment institution, but at the same time it has also been criticized by different persons
particularly by representatives of the behavioral economics who challenges the assumptions of the
Modern portfolio theory on the parameters of investor rationality and the expectations for the
return.
Conclusion:-
The main idea or the purpose of the Modern portfolio theory says that the risk undertaken and return
expected is linked directly which means that in order to achieve the greater rate of expected returns, an
investor must have to take a higher level of risk. Also, the theory says that the overall risk of the portfolio
having securities can be reduced through the means of diversification. In case two different portfolios are
given to the investor having the same level of expected return then the rational decision would be to
choose the portfolio having lower total risk.

Modern Portfolio Theory even though is accepted widely all over the world and also applied by different
investment institution, but at the same time, it has also been criticized by different persons. However,
regardless of the different criticism Modern portfolio theory is a working strategy having a diversified
investment which is implemented by different risk managers, investment institutions and related persons.