Chapter 17

Portfolio–
Markowitz Model
 Learning Objectives
 To understand the concept of diversification

 To understand Markowitz model

 To know the utility analysis

 To learn about the leveraged portfolio

 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.
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
Problems of Vast Diversification
 Purchase of poor performers

 Information inadequacy

 High research cost

 High transaction cost

 The Markowitz Model
Assumptions:
 The individual investor estimates risk on the basis of
variability of returns.
 Investor’s 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.
 Portfolio Return
N
R p = �X1R1
t =1

Rp = return on the portfolio

X1 = proportion of total portfolio invested in security 1
Stron lyeficng tmarke
reflAi ctedonprifma es.i
Se mistronge ficentm arket
A lpubicnf ormatin is
re flectdons ecurityp rices
Weakly eficnt market
isreflcAht tedonsricalf curityoman

R1 = expected return of security 1

 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
 r12 = correlation co-efficient of X1 and X2
covariance of X12
r12 =
σ1 σ 2
 Proportion
 X1 = 2  (1 + 2) the precondition is that the
correlation co-efficient should be –1.0, Otherwise it is
σ 22 - (r12 σ 1 σ 2)
X1 = 2
σ 1 + σ 22 - (2r12 σ 1 σ 2)

Rp and  p for varying degrees of correlation co-efficients

Proportion of X Proportion of Y Rp p p p p
security in security in r xy rxy rxy rxy
portfolio portfolio
X 1–X +1 –1 0 + 0.5

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
 Two Security Portfolios with
Different Correlation Coefficients
R p

10

B
r = – 1
r = +1
K
r = 0
D C
5 r = + .5
J
A
r = – 1

p
5 10
Markowitz Efficient Frontier
R p
A

15 B

10 G
C
H
E
D F
5
I

p
5 10 15
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 portfolios are A, B, C and D.
 Utility Analysis

 Utility is the satisfaction the investor enjoys from the

portfolio return.

 The investor gets more satisfaction of more utility in

X + 1 rupees than from X rupee.

 Utility increases with increase in return.

 Fair Gamble
 In a fair gamble which costs Re 1, the outcomes are
A and B events.
 Event ‘A’ will yield Rs 2.
 Occurrence of B event is a dead loss i.e. 0.
 The chance of occurrence of both the events are 50 : 50.
 The expected value of investment is
(½)2 + ½(0) = Re 1.
 Type of Investors
 Risk averse investor rejects a fair gamble because the
disutility of the loss is greater for him than the utility
of an equivalent gain.

 Risk neutral investor is indifferent to the fair gamble.

 The risk seeking investor would select a fair gamble

i.e. he would choose to invest. The expected utility of
investment is higher than the expected utility of not
investing.
Indifference Curve and
Efficient Frontier
R p

I4

I3

S I2

R I1
T

p
0
 Indifference Map and
Efficient Frontier

 The utility of the investor or portfolio manager

increases when he moves up the indifference map
from I1 to I4.
 He can achieve higher expected return without an
increase in risk.
 Even though the points T and S are in the I2 curve, R
is the only attainable portfolio which maximises the
utility of the investor.
 Leveraged Portfolios
 To have a leveraged portfolio, investor has to
consider not only risky assets but also risk free
assets.

 Secondly, he should be able to borrow and

lend money at a given rate of interest.
 Risk Free Asset
 The features of risk free asset are:
 absence of default risk and interest risk.
 full payment of principal and interest amount.

 The return from the risk free asset is certain and the
standard deviation of the return is nil.
 Chapter Summary
By now, you should have:

 Understood the concept of diversification

 Understood the Markowitz model

 Understood the utility analysis

 Learnt about the leveraged portfolio