NPTEL Course

Course Title: Security Analysis and Portfolio Management

Course Coordinator: Dr. Jitendra Mahakud
Module-14
Session-27
Markowitz Optimal Portfolio Selection Model

27.1. Introduction

Harry Markowitz is generally acknowledged as the father of modern portfolio theory

after publishing his seminal paper in 1952,1 for which he (jointly) received a Nobel
Prize in 1990. The portfolio selection model of Markowitz (1952) revolutionized the
investing world by showing how to create diversified portfolios that reduce risk and
maximize return. In general portfolio selection is concerned with an individual who is
trying to allocate one’s wealth among alternative securities so that the to achieve the
investment goal. The problem was initialized by Markowitz (1952), and the solution
of his mean-variance methodology has been serving as a basis of the development of
modern portfolio theory.

As per the seminal paper of Markowitz (1952) a portfolio formation process

may be divided into two stages: (1) first stage starts with observation and experience
and ends with beliefs about the future performances of available securities, (2) second
stage starts with the relevant beliefs about future performances and ends with the
choice of portfolio. The seminal work of \Markowiz paper deals with the second stage and
follows the rule that, the investor does (or should) consider expected return a desirable thing
and variance of return an undesirable thing i.e., an investor must follow the rule of “expected
returns-variance of returns”. Put it differently, The goal of these individuals is to maximize
the expected return 'E[R]' of a particular portfolio while trying at the same time to minimize
the financial risk '  '. In this case, expected return in this model is the total dollar return from
the portfolio (interest, coupon or dividend payments) and risk is based on the variability of
these returns in a given portfolio. The method used in selecting the most desirable portfolio
involves the use of indifference curves.
27.2. Indifference Curves and Risk Return Relationship

Indifference curves reflect an investor’s attitude toward risk as reflected in his risk
return trade-off function. Indifference curves differ among investors because of

1
Markowitz, H., (1952) “Portfolio selection”. Journal of Finance, Vol. 7 No.7:, pp77-91.

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differences in risk aversion. An investor’s optimal portfolio is defined by the tangency
point between the efficient set and the investor’s indifference curve. As the curves
represent an investor's preferences for risk and return, it can be drawn on a two-
dimensional graph, where the horizontal axis usually indicates risk as measured by
standard deviation and the vertical axis indicates reward as measured by expected
return. An indifference curve represents the set of all points i.e., risk, expected return
that will give the investor the same utility or satisfaction. This produces a curve of
efficient risk-return combinations. The degree of slope associated with indifference
curves will indicate the degree of risk aversion. The indifference curves are assumed
to be positive sloping for most rational investors. For risk lovers indifference curves
are negatively sloped and convex
towards the origin.
Here in Figure 27.1, the desired
choice of indifference curve
becomes I 3 as it gives highest

return as compared to the given

level of standard deviations. The
basic assumption of the
indifference culrve analysis is of
a rational risk averse investor
willing to form an efficient
portfolio and follows the basic
(Figure 27.1 ) tent of portfolio theory i.e., the
highest return for a specific risk, or the lowest risk for a given return. However,
investors differ in the amount of risk they are willing to take for a given return and
thus can be characterised as: risk averse, risk lover and risk neutral. A risk averse
requires a greater return for a given amount of risk as compared to the risk lover. A
risk lover may be satisfied with small increase in returns for accepting the same in
crease in risk. A risk-neutral investor is only concerned with the magnitude of the
return. The degree of slope associated with indifference curves will indicate the
degree of risk aversion. The indifference curves are assumed to be positive sloping for
most rational investors. For risk lovers indifference curves are negatively sloped and
convex towards the origin. The higher a curve, the more desirable the situations lying
along it. In short, we can say that each investor has a map of indifference curves

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representing his or her preferences for expected returns and standard deviations. All
portfolios that lie on the same indifference curve are equally desirable to the investor
even though they have different expected returns and variance. Therefore it is
obvious that indifference curves do not intersect.
Investor’s Indifference Curves
Risk Fearing Risk Neutral Zero Risk Tolerance

Less Risk Fearing Risk Lover

Since most investors would expect to seek more return for additional risk, the utility
or indifference curves may have three cases such as: increasing marginal utility,
constant utility or diminishing marginal utility. A constant marginal utility would
suggest that doubling the return doubles utility or satisfaction, increasing marginal
utility indicates that increasingly larger satisfaction has to be found from the same
increase in return ( risk lover), diminishing marginal utility suggest a case for risk
averse investor.

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27.3.Optimal Portfolio Selection

The optimal portfolio is a portfolio on the efficient frontier that would yield the best
combination of return and risk for a given investor, which would give an investor the
most satisfaction. In a real world investment scenario an infinite number of portfolios
can be formed from a set of N securities. However, an investor needs to look at only a
subset of the available portfolios by following three arguments of efficient portfolio
method:
 Selected assets for the portfolio formation must have little or negative
correlation with each other, so that the overall diversifiable risk is reduced.
 Portfolio that offer maximum expected returns for varying levels of risk and
offer minimum risk for varying levels of expected return.
 All the set of the portfolios satisfying these three conditions are known as
efficient sets or efficient frontiers. The portfolio that will correspond to the
point where indifference curve is just tangent to the efficient set will be the
desired one.
In the given
example the
choice of the
desired portfolio
becomes P1 and

P2 as it gives

the higher return

with desired
level of risk for
a risk averse
(Figure 27.2 ) investor (investor-
A) and a more risk seeker investor (investor-B). Although P3 gives higher

return than P2 but it is far bellow the desired indifference curve. In other

words P2 is tangent to the efficient set frontier. With slight modifications of

the available asset classes if a new se of efficient frontier will be possible the
efficient portfolio choice of the investor may change with respect to the
investment opportunity set of attainable portfolios. From the second example

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 of Figure 27.3 we can see that although the choice of portfolio has been
changed but it still follows those portfolio which lies are tangent point of
indifference curve and the new efficient set frontier.

Therefore while
making a desired
choice an investor will
find any portfolio that
is lying on an
indifference curve that
is further northwest to
be
more desirable as
(Figure 27.3) compared to that lying not as far northwest.

27.4. Markowitz Portfolio Optimisation

Although investors differ in their risk tolerance level, they follow a consistent
approach in their selection of any portfolio in terms of the risk-return trade-off.
Following the Markowitz Portfolio Optimisation method it is possible to develop a
fairly simple decision rule for selecting an optimal portfolio for an investor that can
take both risk and return in to account. Because risk can be quantified as the sum of
the variance of the returns over time, it is possible to assign a utility score. Utility is
the expected return of the portfolio minus a risk penalty. In this case risk penalty
depends up on portfolio risk and the investor’s risk tolerance. For the computational
convenience it can be given as:
Risk Penalty (RP) = Risk Squared (RS)/Risk Tolerance (RT)
RS pt
RPpt  , Utility(U)  E (rpt )  RPpt
RTpt

Where risk squared is the variance of return of the portfolio. Risk tolerance is a
number fro zero through hundred. The magnitude of risk tolerance number indicates
the investors willingness to bear more risk for more return. Lower (higher) the figure
lower (higher) the willingness. The optimal or the best portfolio for an investor would
be the one that maximises the utility among all the possible portfolios in the efficient
frontier.

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27.5. Examples
(1) From the following information, chose the “best” portfolio for the three types og
investors:
Types of investors Risk Lover Moderate Risk Risk Averse
Risk Tolerance Level 90 % 50 % 20 %
Parameters Portfolios
I II III IV V
Expected Return (%) 12.20 13.85 12.60 19.50 10.50
Risk (%) 16.50 22.00 20.50 40.00 14.00

Solution:
Parameters Portfolios
I II III IV V
Expected Return (%) 12.20 13.85 12.60 19.50 10.50
Risk (%) 16.50 22.00 20.50 40.00 14.00
Risk squared 272.25 484.00 420.25 1600.00 196.00
Risk Penalty (%) I II III IV V
Risk Lover 3.03 5.38 4.67 17.78 2.18
Moderate Risk 5.45 9.68 8.41 32.00 3.92
Risk Averse 13.61 24.20 21.01 80.00 9.80
Utility I II III IV V
Risk Lover 9.17 8.47 7.93 1.72 8.32
Moderate Risk 6.75 4.17 4.19 -12.50 6.58
Risk Averse -1.41 -10.35 -8.41 -60.50 0.70
From the above it is obvious that for risk lover and moderate risk taker portfolio I is the
best option, whereas for risk averse portfolio V will be best option.
(2) . Based on the following information, identify the portfolio that is best suitable for
an investor with risk tolerance of 70 %.
Portfolios
I II III IV V
Real Estate 50.00 % 33.3 % 25.00 %
Fixed Income 25.00 % 20.00 % 16.7 %
International Bond 20.00 % 16.7 %
National Equity 33.0% 25.00 % 20.00 % 16.7 %
International equity 20.00 % 16.7 %
Cash Equivalents 50 % 33.4 % 25.00 % 20.00 % 16.7 %
Total 100 % 100 % 100 % 100 % 100 %
Portfolio Parameters (%)
Expected Return or E(R) 7.60 9.13 9.48 9.73 9.85
Expected Variance 0.19 0.52 0.61 0.74 0.75
Standard Deviation 4.32 7.24 7.79 8.59 8.67
Risk Tolerance 50..00 50.00 50.00 50.00 50.00
Risk Penalty 0.37 1.05 1.21 1.47 1.50
Utility 7.23 8.08 8.26 8.26 8.35

Ans:

We know that, Risk Penalty = Risk squared / Risk Tolerance, and Utility = Expected
Return – Risk Penalty. Grom the given information we have:

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 Portfolios
I II III IV V
Risk squared 0.190 0.520 0.610 0.740 0.750
Risk Penalty 0.271 0.743 0.871 1.057 1.071
Expected 7.600 9.13 9.480 9.730 9.850
Return
Utility 7.329 8.387 8.609 8.673 8.779
In the above given results, , portfolio V is the best alternative as it is having the
highest utility among all the given portfolios.

Portfolio Theory and Financial Crises

Now and then financial media raised the big question: does modern portfolio theory hold up during
the financial crisis of 2008? Before the crisis until the recession has been in the next neighbour’s
chair financial landscape was over populated by hedge funds and leveraged investments. The
disaster in the stock market has toppled a few of what have been long thought to be the pillars of
good investment practice. The pain of the wealth loss can be felt from the Wall street to the main
street and even to the far west to the Dalal street. Fundamental pillars like portfolio strategy and
portfolio diversification has been questioned further. Nevertheless unlike academicians most of
practitioners tend to ask “Did the Modern Portfolio Theory work in 2008?”. To have a more
concerned view point give the more fundamental justification in this regard several financial news
media have asked for the view point of the father of modern portfolio theory and non other than
Harry Markowitz. The following paragraph gives a compilation of several powerful statements by
Markowitz and his views in this regard. Markowitz’s observations were as follows:

“The main objective of portfolio theory is to select assets that have little or negative correlation
with each other, so that the overall diversifiable risk is reduced. Investors should estimate the likely
returns, risks and correlations among various asset classes and use these inputs to conduct a Modern
Portfolio Theory analysis. If you want greater return on average, you have to take on greater risk. If
you want less month-to-month and year-to-year fluctuations, you have to accept less return on the
average in the long run. But much depends upon how you split up your investment pie.”

In recent times financial engineers who bundled complex mortgage-based and other securities
violated the first principle of his portfolio theory. Our current credit crisis arose from an imbalance
of risk and return in portfolios of mortgage-backed and other debt securities. Markowitz stress as
per the portfolio theory “diversifying sufficiently among uncorrelated risks can reduce portfolio risk
toward zero…but financial engineers should know that's not true of a portfolio of correlated risks.
But the investments were often more highly correlated and riskier than anticipated. Generally, asset
classes move roughly in proportion to their historical betas. However, it is sometimes said that
portfolio theory fails during a financial crisis because all asset classes go down and all correlations
go up”.

Further he says “modern portfolio theory presents the user with a risk – return trade off curve. If
you want high return on the average, you have to put up with volatility in the short run.” Pointing
towards the wealth loss in the financial crisis he further added “while it is true that the well-advised
investor may encounter unanticipated hardships, the ill-advised investor courts almost certain
disaster.”
Compiled from the following Source (accessed as on 03/06/2012).
( 1 ) “Harry Markowitz - Father of Modern Portfolio Theory - Still Diversified”, http://post.nyssa.org/nyssa-news/2011/12/harry-
markowitz-father-of-modern-portfolio-theory-still-diversified.html ,December 28, 2011
(2) “The Father of Portfolio Theory on the Crisis, The Wall Street Journal”,
http://online.wsj.com/article/SB122567428153591981.html , November 3, 2008
(3) “Nobel Laureate Harry Markowitz is Interviewed by Research Magazine”,
http://www.1stglobal.com/articles/detail/News/IntheNews/Nobel-Laureate-Harry-Markowitz-is-Interviewed-by-Research-
Magazine,Aug 1, 2011
__________________________________________________________________________
Additional Readings:
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  Alexander, Gordon, J., Sharpe, William, F. and Bailey, Jeffery, V.,
“Fundamentals of Investment, 3rd Edition, Pearson Education.
 Bodie, Z., Kane, A, Marcus,A.J., and Mohanty, P. “ Investments”, 6th Edition,
Tata McGraw-Hill.
 Fisher D.E. and Jordan R.J., “Security Analysis and Portfolio Management”,
4th Edition., Prentice-Hall.
 Jones, Charles, P., “Investment Analysis and Management”, 9th Edition, John
Wiley and Sons.
 Prasanna, C., “Investment Analysis and Portfolio Management”, 3rd Edition,
Tata McGraw-Hill.
 Reilly, Frank. and Brown, Keith, “Investment Analysis & Portfolio
Management”, 7th Edition, Thomson Soth-Western.
__________________________________________________________
Additional Questions with Answers
Session-27. Portfolio Selection Models
_________________________________________________________
1. . How to select the securities for investment?
Portfolio Selection based on three fundamental characteristics:
• Diversification to avoid unsystematic risk
• Diversification should be on the correlation between the different securities
• The correlation should be negative
2. Explain Markowitz Theory of Optimal Portfolio Selection?
Ans. Markowitz Theory: Markowitz portfolio selection model generates a frontier of
efficient portfolios which are equally good. Different investors will estimate the
efficient frontier differently. Does not address the issue of riskless borrowing or
lending and element of uncertainty in application

• It is based on the risk and investor preference

• It discusses about the choosing the best option on the efficient frontier
• Optimal Portfolio: Higher Indifference curve Gives Higher level of utility.
Selection of efficient portfolio in the efficient frontier is the point where
efficient frontier is tangent to the indifference curve
Markowitz Portfolio Optimisation:
• The optimal portfolio of an investor would be one from the opportunity set
that maximizes utility

Utility = Expected Return of the portfolio – Risk Penalty

Risk Penalty = Variance of the portfolio

Risk Tolerance
• Risk Tolerance varies between 0 to 100
• The size of the risk tolerance number reflects the investors willing ness to bear
more risk for more return
3. How the nature of Indifference Curve will be different for Different types of
investors?
Ans:

Efficient Map and Efficient Frontier for Risk Fearing Investor’s Indifference
Hypothetical Investor Curves

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 Less Risk Fearing Investor’s Indifference Curves Risk Lover Indifference Curves

Nature of Indifference Curve for Different Investors:

• The degree of slope associated with indifference curves will indicate the
degree of risk aversion
• The indifference curves are assumed to be positive sloping for most rational
investors
• For risk lovers indifference curves are negatively sloped and convex towards
the origin
Nature of Indifference curve for different set of individual investors:
4. Why investment theory talks about an Optimal Portfolio?
Ans.
• Optimal Portfolio: Higher Indifference curve Gives Higher level of utility

Portfolio in which the risk-reward combination is such that it yields the maximum
returns (provides the highest utility) possible under the current and anticipated
circumstances. Thus, an optimal portfolio is the portfolio that considers the investor's
own greed and/or how risk averse he/she. Although Markowitz Theory of Optimal
Portfolio is quantitative, Individual investor’s optimal portfolio is subjective.