MARKOVITZ MODEL

The point has now been reached at which the mean-variance preferences can be confronted with the efficient frontier. This combination is the Markovitz model of portfolio choice and is fundamental in portfolio theory. The model permits portfolio choice to be analyzed and the composition of the chosen portfolio to be related to risk aversion. The Markovitz model makes a number of assumptions that have been implicit in the previous description but now need to be made explicit. These assumptions are: There are no transaction costs; All assets are divisible; Short selling is permitted.

The first assumption allows investors to trade costlessly so there is no disincentive to diversify or to change portfolio when new information arrives. The second assumption permits the investor to obtain an optimal portfolio no matter how awkward are the portfolio proportions. Some assets, such as government bonds, are in large denominations and indivisible. The assumption of the model can be sustained if investors can undertake indirect investments that allow the purchase of fractions of the indivisible assets. The role of short selling in extending the portfolio frontier was made clear in the previous chapter. The strong assumption is that short selling can be undertaken without incurring transaction costs.

No Risk-Free

Portfolio choice is first studied under the assumption that there is no risk-free asset. In this case the efficient frontier will be a smooth curve. The optimal portfolio is the one that maximizes the mean-variance preferences given the portfolio frontier. Maximization of utility is equivalent to choosing the portfolio that lies on the highest possible indifference curve given the constraint on risk and return combinations imposed by the efficient frontier. The point on the highest indifference curve will occur at a tangency between the indifference curve and the portfolio set. Since the investor is risk averse the indifference curves are upward sloping so the tangency point must be on the efficient frontier. This means that the portfolio chosen must have a return at least as great as the minimum variance portfolio.

Figure 5.5 shows choice of two investors with different degrees of risk aversion when there are just two risky assets available. A and B denote the locations of the two available risky assets. The more risk averse investor chooses the portfolio at p1 which combines both risky assets in positive proportions. The less risk averse investor locates at portfolio p2. This portfolio involves going short in asset A. Since no investor chooses a portfolio with a lower return than the minimum variance portfolio, asset A will never be short-sold. In addition, any portfolio chosen must have a proportion of asset B at least as great as the proportion in the minimum

variance portfolio. As risk aversion falls, the proportion of asset B increase and that of asset A falls. The same logic applies when there are many risky assets. The investor is faced with the portfolio set and chooses a point on the upward sloping part of the frontier. The less risk-averse is the investor, the further along the upward sloping part of the frontier is the chosen portfolio.

Risk-Free Asset

The introduction of a risk-free asset has been shown to have a significant impact upon efficient frontier. With the risk-free this becomes a straight line tangent to the portfolio set for the risky assets. The availability of a risk-free asset has equally strong implications for portfolio choice and leads into a mutual fund theorem.

The portfolio frontier with a risk-free asset is illustrated in Figure 5.6 with the tangency portfolio denoted by point T. The more risk-averse of the two investors illustrated chooses the portfolio p1. This combines positive proportions of the riskfree asset and the tangency portfolio. In contrast, the less risk-averse investor chooses portfolio p2 which involves going short in the risk-free to finance purchases of the tangency portfolio. The important point to note is that only one portfolio of risky assets is purchased regardless of the degree of risk aversion. What changes as risk aversion

changes are the relative proportions of this risky portfolio and the risk-free asset in the overall portfolio. Consequently, investors face a simple choice in this setting. They just calculate the tangency portfolio and then have to determine the mix of this with the risk-free. To do the latter, an investor just needs to evaluate their degree of risk aversion. This observation form the basis of the mutual fund theorem. If there is a risk free asset, the only risky asset that needs to be made available is a mutual fund with composition given by that of the tangency portfolio. An investor then only needs to determine what proportion of wealth should be in this mutual fund.

Borrowing and Lending The outcome when borrowing and lending rates are not the same is an extension of that for a single risk-free rate.

Figure 5.7 shows the outcome for three investors with different degrees of risk aversion. The most risk averse mixes the risk-free asset with the tangency portfolio at T1. The less risk-averse investor purchases risky assets only, with the choice located at p2. Finally, the investor with even less risk aversion locates at p3 which combines the tangency portfolio T2 with borrowing, so the investor is going short in the risk free asset. In this case the structure of the portfolio of risky assets held does vary as the degree of risk aversion changes. But the range of risky portfolios that will be chosen is bounded by the two endpoints T1 and T2. Also, the degree of risk aversion determines whether the investor is borrowing or lending.