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# 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
 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

## 0.50 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

S.Dp S.Dp
RISK & RETURN WITH DIFFERENT
CORRELATION

r=0 r=+0.5
Rp Rp

S.Dp S.Dp
MARKOWITZ EFFICIENT FRONTIER
Portfolio Expected Return (Rp)% Risk (S.Dp)
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