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Markowitz Model and Simple Diversification

The Markowitz model provides a framework for constructing optimal portfolios that maximize expected return for a given level of risk. It assumes investors aim to maximize return for a level of risk and analyzes how risk and expected return of portfolios change as the proportions of securities vary. The model demonstrates the efficient frontier, which represents the set of optimal portfolios that offer the highest return for their level of risk.

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174 views11 pages

Markowitz Model and Simple Diversification

The Markowitz model provides a framework for constructing optimal portfolios that maximize expected return for a given level of risk. It assumes investors aim to maximize return for a level of risk and analyzes how risk and expected return of portfolios change as the proportions of securities vary. The model demonstrates the efficient frontier, which represents the set of optimal portfolios that offer the highest return for their level of risk.

Uploaded by

Aditya
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
  • Portfolio - Markowitz Model
  • Simple Diversification
  • Diversification & Portfolio Risk
  • Problems of Vast Diversification
  • The Markowitz Model
  • Concept of Markowitz Model
  • Portfolio Calculations
  • Risk & Return with Different Correlation
  • Markowitz Efficient Frontier

PORTFOLIO-

MARKOWITZ MODEL
SIMPLE DIVERSIFICATION
 Portfolio risk can be reduced by the simplest kind of
diversification.
 Portfolio means the group of assets an investor owns.
 The naive kind of diversification is known as simple
diversification.
 In the case of simple diversification, securities are selected at
random and no analytical procedure is used.
 Simple random diversification reduces the total risk. The
reason behind this is that the unsystematic price fluctuations
are not correlated with the markets systematic fluctuations.
DIVERSIFICATION & PORTFOLIO RISK
 How simple diversification reduces the risk?

Unique
Risk

Market Total Risk


Risk
5
Number of stocks
 PROBLEMS OF VAST DIVERSIFICATION
 PURCHASE OF POOR PERFORMERS
 INFORMATION INADEQUACY
 HIGH RESEARCH COST
 HIGH TRANSACTION COST
THE MARKOWITZ MODEL
 ASSUMPTION:

• The individual investor estimates risk on the basis of


variability of return i.e. the variance of returns .
• Investors decisions is solely based on the expected return and
variance of returns only.
• For a given level of risk, investor prefers high return.
• Likewise, for a given level of return investor prefers lowr risk
than higher risk.
CONCEPT OF MARKOWITZ MODEL
 Take the stock of ABC Stock ABC Stock XYZ
Co. & XYZ Co. The
returns expected from Return % 11 or 17 20 or 8
each co. and their
probabilities of Probability .5 each .5 each
occurrence , expected return return
returns and the variances Expected 14 14
are given: Return
Variance 9 36

Standard 3 6
Deviation
 The change in portfolio Stock Stock Portfolio
proportions can change the ABC(X1) XYZ(X2) Standard
portfolio risk. Taking the Deviation
same example of ABC & 100 0 3
XYZ stock, the portfolio
standard deviation is
66.66 33.3 0
calculated for different
proportions.
50 50 1.5

0 100 6
Values of Rp and standard deviation p for
varying degrees of correlation co-efficient
Proportion Proportion of Rp S.D p S.D p S.D p S.D p
of X Y security in rxy rxy rxy rxy
security in portfolio 1-X +1 -1 0 +.5
portfolio X
1.00 0.00 5.00 4.0 4.0 4.0 4.0

0.75 0.25 5.75 5.5 0.5 3.9 4.8

0.50 0.50 6.50 7.0 3.0 5.4 6.25


0.25 0.75 7.25 8.5 6.5 7.6 8.1

0.00 1.00 8.00 10.0 10.0 10.0 10.0


RISK & RETURN WITH DIFFERENT
CORRELATION

r=+1 r=-1
Rp Rp

[Link] [Link]
RISK & RETURN WITH DIFFERENT
CORRELATION

r=0 r=+0.5
Rp Rp

[Link] [Link]
MARKOWITZ EFFICIENT FRONTIER
Portfolio Expected Return (Rp)% Risk ([Link])
A 17 13
B 15 8
C 10 3
D 7 2
E 7 4
F 7 8
G 10 12
H 9 8
J 6 7.5

PORTFOLIO PORTFOLIO-- MARKOWITZ MODEL MARKOWITZ MODEL
SIMPLE DIVERSIFICATION SIMPLE DIVERSIFICATION  Portfolio risk can be reduced by the simplest kind of diversification. 
DIVERSIFICATION & PORTFOLIO RISK DIVERSIFICATION & PORTFOLIO RISK  How simple diversification reduces the risk?
 PROBLEMS OF VAST DIVERSIFICATION  PURCHASE OF POOR PERFORMERS  INFORMATION INADEQUACY  HIGH RESEARCH COST  HIGH TRA
THE MARKOWITZ MODEL THE MARKOWITZ MODEL  ASSUMPTION: • The individual investor estimates risk on the basis of variabili
CONCEPT OF MARKOWITZ MODEL CONCEPT OF MARKOWITZ MODEL  Take the stock of ABC Co. & XYZ Co. The returns expected from
 The change in portfolio proportions can change the portfolio risk. Taking the same example of ABC & XYZ stock, the
Values of Rp and standard deviation p for Values of Rp and standard deviation p for varying degrees of correlation co-e
RISK & RETURN WITH DIFFERENT RISK & RETURN WITH DIFFERENT CORRELATION CORRELATION
RISK & RETURN WITH DIFFERENT RISK & RETURN WITH DIFFERENT CORRELATION CORRELATION

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