MPT | Markowitz Theory | Portfolio Analysis | Portfolio Management | Modern theory

Summary

Modern Portfolio Theory (MPT), introduced by Harry Markowitz in 1952, focuses on optimizing investment portfolios by balancing risk and return. The theory emphasizes diversification, aiming to reduce unsystematic risk by combining assets with low or negative correlations. MPT posits that investors can construct efficient portfolios by considering expected returns, variability, and covariance between asset returns. The theory rests on assumptions that investors are rational, risk-averse, and seek to maximize utility. Overall, MPT provides a mathematical framework for creating portfolios that offer the best trade-off between risk and return.

Takeaways

• 😀 Modern Portfolio Theory (MPT) was proposed by Harry Markowitz in 1952 to help investors construct portfolios that maximize expected returns while managing risk.
• 😀 Investors aim to balance two main factors: risk and return. The goal is to maximize returns at the lowest level of risk.
• 😀 Risk is divided into two types: systematic risk (market-wide risk) and unsystematic risk (specific to individual securities).
• 😀 Systematic risk is denoted by Beta and cannot be controlled, whereas unsystematic risk can be reduced through diversification.
• 😀 Diversification involves combining different securities in a portfolio to lower the overall risk by offsetting risks of individual securities.
• 😀 An efficient portfolio is one where the expected yield is highest for a given level of risk or where the risk is minimized for a given return.
• 😀 Three key parameters for building an efficient portfolio: expected return, standard deviation (risk), and covariance between asset returns.
• 😀 Lower correlations between assets help reduce the total risk of a portfolio, making it more efficient. A diversified portfolio should ideally have assets with negative or low correlations.
• 😀 Modern Portfolio Theory emphasizes the trade-off between risk and reward. Investors seeking higher returns must accept higher risks.
• 😀 The theory assumes that investors are rational, risk-averse, have access to accurate information, and aim to maximize their utility given their income level.
• 😀 In MPT, investors are assumed to always prefer higher returns for the same level of risk, and they base decisions on expected returns and standard deviation of those returns.

Q & A

What is Modern Portfolio Theory (MPT)?

Modern Portfolio Theory (MPT) is a framework developed by Harry Markowitz in 1952 that helps investors build portfolios that maximize expected returns for a given level of risk or minimize risk for a given level of return.

What are the two types of risk in portfolio management?

The two types of risk are systematic risk and unsystematic risk. Systematic risk affects the entire market and cannot be controlled, while unsystematic risk is specific to an individual asset and can be reduced through diversification.

How does diversification help in reducing risk?

Diversification reduces unsystematic risk by combining assets whose returns are not perfectly correlated, so the negative performance of one asset may be offset by the positive performance of another.

What does an efficient portfolio mean in the context of Modern Portfolio Theory?

An efficient portfolio is one where the expected return is the highest possible for a given level of risk or the risk is minimized for a given level of expected return. The portfolio is optimized for both return and risk.

What are the three key parameters to consider when forming an efficient portfolio?

The three key parameters are: 1) Expected return, 2) Variability of return (measured by standard deviation), and 3) Covariance between the returns of different assets in the portfolio.

What is the role of covariance in portfolio construction?

Covariance measures how the returns of two assets move in relation to each other. If the covariance is negative or negligible, the portfolio's overall risk is reduced, making it more efficient.

What is the trade-off between risk and reward according to Modern Portfolio Theory?

The trade-off is that higher returns generally require taking on higher risk. Investors must balance their desire for higher returns with their risk tolerance, optimizing their portfolio accordingly.

What assumptions does Modern Portfolio Theory make about investors?

MPT assumes that investors are rational, seek to maximize utility, have access to accurate information, are risk-averse, make decisions based on expected returns and standard deviation, and prefer higher returns for the same level of risk.

How does systematic risk differ from unsystematic risk?

Systematic risk is market-wide and affects all assets, such as economic downturns or geopolitical events, and cannot be avoided. Unsystematic risk, on the other hand, is specific to a particular asset or sector and can be reduced through diversification.

Can you provide an example of an efficient portfolio?

An example of an efficient portfolio could be one consisting of stocks from different sectors, such as TCS, Oropharma, and Tata Motors. These assets have low or negative correlation, reducing overall risk and making the portfolio more efficient.