The Markowitz Portfolio Selection Model

-In the March 1952 issue of Journal of Finance, Harry M. Markowitz published an article titled Portfolio
Selection. In the article, he demonstrates how to reduce the risk of asset portfolios by selecting assets
whose values aren't highly correlated.

-“Don’t put all your eggs in one basket.”

Efficient frontier

- The efficient frontier is the set of optimal portfolios that offers the highest expected return for a defined
level of risk or the lowest risk for a given level of expected return. Portfolios that lie below the efficient
frontier are sub-optimal, because they do not provide enough return for the level of risk. Portfolios that
cluster to the right of the efficient frontier are also sub-optimal, because they have a higher level of risk for
the defined rate of return.

Minimum-Variance Frontier of risky assets

-In Markowitz portfolio

theory, the frontier on a chart representing a portfolio with the least amount of volatility.

That is, a minimum-

variance frontier consists of data points representing stocks with a certain level of volatility andtherefore ri
sk, while the frontier represents a portfolio in which the volatilities of each individual stock offset eachothe
r. A minimum-variance frontier is also a Markowitz efficient
frontier if it also represents the maximum level ofreturn for its level of risk.

* Volatility is a measure of a security's stability. It

indicates how much and how quickly the value of an investment, market, or market sector changes
.

Add in the risk-free asset

A risk-free asset has a certain future return. Treasuries (especially T-bills) are considered to be risk-free
because they are backed by the U.S. government. Because they are so safe, the return on risk-free
assets is very close to the current interest rate.

-Adding the risk-free asset to a portfolio reduces the overall return of the portfolio.

Individual investors chooses the appropriate mix

Harry Markowitz’s Model

- Summary: The Portfolio Theory broadly explains the relationship between risk and reward and has laid
the foundation for management of portfolios as it is done today with the help of mean and variance model.
It emphasizes onthe significance of the relationship between securities and diversification to create
optimal portfolios and reduce risk

.
According to this theory each single security has own risk and by diversification we can reduce the risk
but generally cannot eliminate risk. During diversification we have to see the variance and correlation
among the securities, showing how two securities co-vary. This is done so by choosing the quantities of
various securities carefully taking mainly into consideration the way in which the price of each security
varies in contrast to that of every other security in the portfolio, rather than taking securities individually. In
other words, the theory uses mathematical models to build an ideal portfolio for an investor that gives
maximum yield subject on his risk desire by taking into concern the relationship between risk and return.

Optimal risky portfolio is the same for all investors

Optimal Risky Portfolio

- The optimal portfolio concept falls under the modern portfolio theory. The theory assumes (among other
things) that investors fanatically try to minimize risk while striving for the highest return possible. The
theory states that investors will act rationally, always making decisions aimed at maximizing their return
for their acceptable level of risk.

Separation Property

- The property that portfolio choice can be divided into two independent tasks: (1) Determination of the
optimal risky portfolio, which is a purely mathematical problem, and (2) the personal choice of the best
mix of the optimal risky portfolio and the risk-free asset, which depends on a person's degree of risk
aversion.

Asset Allocation and Security Selection

- What is 'Asset Allocation'

Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a
portfolio's assets according to an individual's goals, risk tolerance and investment horizon. The three
main asset classes - equities, fixed-income, and cash and equivalents - have different levels of risk and
return, so each will behave differently over time.

BREAKING DOWN 'Asset Allocation'

There is no simple formula that can find the right asset allocation for every individual. However, the
consensus among most financial professionals is that asset allocation is one of the most important
decisions that investors make. In other words, the selection of individual securities is secondary to the
way that assets are allocated in stocks, bonds, and cash and equivalents, which will be the principal
determinants of your investment results.

Capital Market Theory

- builds upon the Markowitz portfolio model.

8 Main assumptions of the Capital Market Theory

All Investors are Efficient Investors: Investors follow Markowitz idea of the efficient frontier and choose to
invest in portfolios along the frontier.

Investors Borrow/Lend Money at the Risk-Free Rate: This rate remains static for any amount of money.

-zero risk

- In practice, however, the risk-free rate does not exist because even the safest investments carry a very
small amount of risk.

The Time Horizon is equal for All Investors: When choosing investments, investors have equal time
horizons for the chosen investments.

- short-term goals are those less than five years

- Intermediate-term goals are those five to 10 years

- Long-term goals are those more than 10 years

All Assets are Infinitely Divisible: This indicates that fractional shares can be purchased and the stocks
can be infinitely divisible.

-can be divided

No Taxes and Transaction Costs: It is assumed that investors results are not affected by taxes and
transaction costs.

All Investors Have the Same Probability for Outcomes: When determining the expected return, assume
that all investors have the same probability for outcomes.

No Inflation Exists: Returns are not affected by the inflation rate in a capital market as none exists in
capital market theory.

There is No Mispricing within the Capital Markets: It is assumed that the markets are efficient and that no
mispricings within the markets exist.

Capital Market Line

- is the tangent line drawn from the point of the risk-free asset to the feasible region for risky assets.

-used to measure expected return

-CML is derived from CAPM.

Systematic Risk and Unsystematic Risk

Systematic Risk (Market Risk)

- The risk inherent to the entire market or an entire market segment.

- This type of risk is both unpredictable and impossible to completely avoid.

-It cannot be diversified but can lessen risk through hedging

* Hedging is analogous to taking out an insurance policy. If you own a home in a flood-prone area, you
will want to protect that asset from the risk of flooding – to hedge it, in other words – by taking out
flood insurance. There is a risk-reward tradeoff inherent in hedging; while it reduces potential risk, it also
chips away at potential gains. Put simply, hedging isn't free. In the case of the flood insurance policy, the
monthly payments add up, and if the flood never comes, the policy holder receives no payout. Still, most
people would choose to take that predictable, circumscribed loss rather than suddenly lose the roof over
their head.

Unsystematic Risk (Company Risk)

-Risk that is inherent in each investment.

- It can be reduced through diversification.

*Diversification is a risk management technique that mixes a wide variety of investments within a portfolio.

* An investor who owned nothing but airline stocks would face a high level of unsystematic risk. By
diversifying his or her portfolio with unrelated holdings, such as health-care stocks and retail stocks, the
investor would face less unsystematic risk. However, even a portfolio of well-diversified assets cannot
escape all risk. It will still be exposed to systematic risk, which is the uncertainty that faces the market as
a whole.

Capital Asset Pricing Model(CAPM)

-A model that calculates expected return based on expected rate of return on the market, the risk-free
rate and the beta coefficient of the stock.

- is a model used to determine a theoretically appropriate required rate of return of an asset, to make
decisions about adding assets to a well-diversified portfolio.

* The general idea behind CAPM is that investors need to be compensated in two ways: time value of
money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and
compensates the investors for placing money in any investment over a period of time. The risk-free rate is
customarily the yield on government bonds like U.S. Treasuries.

The other half of the CAPM formula represents risk and calculates the amount of compensation the
investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that
compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf):
the return of the market in excess of the risk-free rate. Beta reflects how risky an asset is compared to
overall market risk and is a function of the volatility of the asset and the market as well as the correlation
between the two. For stocks, the market is usually represented as the S&P 500 but can be represented
by more robust indexes as well.

The CAPM model says that the expected return of a security or a portfolio equals the rate on a risk-free
security plus a risk premium. If this expected return does not meet or beat the required return, then the
investment should not be undertaken. The security market line plots the results of the CAPM for all
different risks (betas).

*Beta is a measure of the volatility or systematic risk of a security or a portfolio in comparison to the
market as a whole.

Remember that a major premise of the Markowitz modern portfolio theory is that risk can be reduced by
selecting assets that are not 100% correlated

The standard deviation is the square root of the sum of the portfolio’s variance.

The capital asset pricing model was the work of financial economist (and later, Nobel laureate in
economics) William Sharpe, set out in his 1970 book "Portfolio Theory and Capital Markets." His model
starts with the idea that individual investment contains two types of risk:

Systematic Risk – These are market risks that cannot be diversified away. Interest rates, recessions and
wars are examples of systematic risks.

Unsystematic Risk – Also known as "specific risk," this risk is specific to individual stocks and can be
diversified away as the investor increases the number of stocks in his or her portfolio. In more technical
terms, it represents the component of a stock's return that is not correlated with general market moves.

Modern portfolio theory shows that specific risk can be removed through diversification. The trouble is
that diversification still doesn't solve the problem of systematic risk; even a portfolio of all the shares in
the stock market can't eliminate that risk. Therefore, when calculating a deserved return, systematic risk
is what plagues investors most. CAPM, therefore, evolved as a way to measure this systematic risk.

Security Market Line

- The security market line (SML) is the line that reflects an investment's risk versus its return, or the return
on a given investment in relation to risk. The measure of risk used for the security market line is beta.

The line begins with the risk-free rate (with zero risk) and moves upward and to the right. As the risk of an
investment increases, it is expected that the return on an investment would increase. An investor with a
low risk profile would choose an investment at the beginning of the security market line. An investor with a
higher risk profile would thus choose an investment higher along the security market line.