Epoka University Banking and Finance Department

Modern Portfolio Theory

Emirjana SHEHU eshehu08@epoka.edu.al

Portfolio Management Course Lecturer: Denada IBRUSHI

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Paper Outline

Abstract....3 Introduction: Modern Portfolio Idea....4 Key concepts on which MPT was constructed.....5 Deciding the level of risk to take..7 MPT criticisms..8 Post- modern Portfolio Theory and contributions to it.9 Personal Opinion.....11 Conclusions....12 References.....13

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Abstract In this paper, I will present Modern Portfolio Theory, which I found of particular interest to be covered in our Portfolio Management Course. Rather than trying to survey all articles or all issues covering this topic, I better preferred to discuss what I found of special interest and importance. The goal of this paper is to introduce portfolio theory in order to gain an insight into its basic concepts. Firstly, an attempt to describe the Modern Portfolio Theory (MPT) and how this theory idea came will be present and then the key concepts on which MPT was constructed. Going on with some criticisms and post developments about this theory. Ending up with a personal opinion and some general concluding remarks.

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Introduction: Modern Portfolio Idea Harry Markowitz, a graduate student of Chicago University met with a stockbroker while he was waiting to meet his professor to discuss about his doctoral thesis. Until that time, his studies were focused on linear programming, a field that applies mathematical models to maximize output for a given level of cost, or alternatively to minimize cost for a given level of output. After discussing about Markowitzs thesis line of study, the broker suggested him to apply linear programming to the problems faced by investors in stock market. However, how could he connect linear programming with investing? His approach was mainly focused on the fact that the desired output from an investors portfolio is a high return and the cost would be the volatility of return. Markowitz came up with a theory that a well-

diversified portfolio would provide maximum return for a specified level of volatility so as minimum volatility for the same level of return. Markowitz a Nobel laureate, US economist introduced the Modern Portfolio Theory (MPT) firstly in an article in 1952 and then latter on in a book in 1959. Therefore, he became "father of modern portfolio theory. Latter on many other brilliant financial economists have added to this body of research, important to be mentioned are Eugene Fama and Kenneth French, understanding this research and applying it to the practical world of investing. Markowitz used to name it simply as "Portfolio Theory," arguing that "There is nothing modern about it.. For a specific given amount of risk, MPT describes how to select a portfolio with the highest possible expected return. Alternatively, for a given expected return, MPT explains how to select a portfolio with the lowest risk possible. The essential concept on MPT is that assets of any investment portfolio should not be selected individually. What is the optimal portfolio for a given set of assets? This is one of the classic questions in finance and investing area. Investing is a tradeoff between risk and expected return. Generally, it works like that: High-risk high profit, meaning that riskier assets do have higher expected rates of return. Therefore, we can say that MPT is a form of risk-return diversification. It tries to explain how to find the best possible diversification strategy. MPT is an advanced investment decision approach that helps an investor to classify, estimate, and control the kind and amount of expected risk and return. MPT is also known as Portfolio Management Theory. Measurements of the relation between risk and return and the assumption that investors must be compensated for assuming risk are very important for this theory. Portfolio theory defers from

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the traditional security analysis in shifting importance from analyzing the characteristics of individual investments to determining the statistical relations among the individual securities that comprise the overall portfolio. The Modern portfolio theory approach is based on four fundamental steps: o Security valuation: where a universe of assets in terms of expected return and expected risk are described. o Asset allocation: decision where asset distribution among classes of investment, such as stocks or bonds occurs. o Portfolio optimization: In selecting the securities, risk and return should be considered so that to determine which portfolio of stocks offers the best return for a given level of expected risk. o Performance measurement: divides each stocks performance (risk) into market-related (systematic) and industry/security-related (residual) classifications. Over the past six decades, H. Markowitz and his followers have contributed hugely to our understanding of capital markets behavior and of the nature of risk and its relationship to investment returns. In simple terms, Markowitz started out with the assumption that investors would like to avoid risk as much as possible. He defined risk as the standard deviation of the future expected returns. Before 1952, risk was assessed on the individual security level. Markowitz proposed that instead of focusing on the risk of one security; focus on how that particular security affects the overall risk of the entire portfolio. Key concepts on which MPT was constructed
o

In buying and selling securities, there are not any transaction costs, meaning that there is no brokerage, no bid-ask spread. No taxes are paid and only risk has a determining role in which securities an investor buys.

Any investor takes any position of any size in any security. Any one willing to invest can either buy a million dollars worth of stock in a small speculative mining stock or buy

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one-cent worth of Berkshire Hathaway. Nothing prevents you from taking those kinds of positions.
o

Usually investors do not consider taxation when making an investment decision, and overall are indifferent in receiving dividends or capital gains.

Investors are rational and risk adverse. They are completely aware of all risk involved in any investment and will take positions based on a risk determination, asking for a higher return for accepting greater volatility.

Investors, as a whole, look at risk-return relations over same periods. A short term speculator and a long term investor do have exactly the same motivations, time horizons and profit targets.

Investors have similar views on measuring risk. All investors do possess the same information and buy or sell based on an identical assessment of the investment and all expect the same thing from an investment. A seller will be motivated to sell only in case another security has a level of volatility corresponding to their desired return. While a buyer will buy just in case this security has a level of risk corresponding to the return that he wants.

o o o

Investors attempt to control risk only by their holdings diversification. All assets together, including here also human capital, can be traded on the market. Investors can lend or borrow at the 3-month T-bill rate (the risk-free rate) and can sell short without any restriction.

Markets are not affected by politics and investor psychology.

The above mentioned are just the basic construction concepts, but in fact reality tells that transaction costs do have an important effect on whether you want to be a long term or short term investor, as do taxes have a major impact on what kind of investment to participate. Liquidity is the factor that keeps most people out of least traded issues and the difference between dividends and capital gains of course affects the type of securities investors buy. In reality, Investors are not rational; they seek for "hot" sectors and market booms and go bankrupted mainly because of speculations. Many people will buy stocks based only word of mouth, the market for thinly traded issues would be eliminated if people really appreciated the true situation of the companies. Only the government can lend and borrow at the T-bill rate. No other investor can borrow money at those rates unless they have some special concession. Short 6|Page

selling is illegal or severely restricted in many countries. Many crises and events that have occurred in the past have shown that politics and psychology have a major effect on markets. Nevertheless, having on hand these facts does not mean that we have to be discouraged and not believe in MPT. After all, almost every university throughout the world teaches MPT to finance and economics students, fund-rating services allocate stars based on a large degree on "risk adjusted" returns, fund managers structure their portfolios based on the CAPM, which is a key part of MPT. Deciding the level of risk to take Markowitz then considered how the different securities in the portfolio move in relation to one another in the same period. This is correlation and is central to the idea that an investor can actually reduce the overall risk of a portfolio by introducing riskier asset classes to the portfolio. Ultimately, this leads us to the efficient frontier line.

The above efficient frontier line represents all portfolios that have the maximum rate of return for every given level of risk, or the minimum risk for every level of return. In the above graph, point C represents the portfolio that has the maximum return at point B, for the given amount of risk at point A. while point D represents an inefficient portfolio because it is not maximizing the 7|Page

return for the risk taken. This is essentially the main theme of portfolio theory: Maximize return for amount of risk taken. This is where portfolio theory and the practical world of investing crash out. First of all, risk is defined by standard deviation. The only way to decide on a level of risk to take is to look at portfolios whose standard deviation has been calculated for past returns. In addition, by estimating an investor may find out the return that will result for a given level of risk exposure. Three factors need to be considered: 1. The expected rate of return for the asset classes considered. 2. The standard deviation of the asset classes chosen. 3. The correlation between the asset classes. Numerous problems arise at this point. Simply because of using historical data can lead to disastrous results, not always happens that history repeats itself. Future expected rates of return could be estimated using the Gordon Equation: Expected Return = Current Dividend Yield + Dividend Growth Rate The reality is that a majority of amateur and professionally managed portfolios are similar to point D in the graph; they are not being compensated fully for the risk taken. Modern Portfolio Theory criticisms Markowitz writes this about portfolio selection: The first stage starts with observations and experience and ends with beliefs about the future performances of available securities. He also writes. I believe that better methods, which take into account more information, can be found. Stating this means, that he is open to critisizms, which in fact are not little. The most widespread criticism of MPT is that it treats both upside and downside volatility as risk. At the essence of Markowitz's theory is a bell-shaped curve that shows the "normal distribution" of portfolio returns above and below a mean, known as mean variance. Each unit above or below the mean is a standard deviation. But, real investors don't experience upside volatility as risky at all. Another criticism of MPT is that allocations are determined at the beginning of the investment process and never changed, except when they are rebalanced. The bottom line is that 8|Page

practitioners may develop allocation models based solely on projections of historical data, but MPT does not. Practitioners may also ignore valuations; MPT does not. Moreover, practitioners may design allocation models and set them in stone; again, MPT does not.

When Markowitz and Sharpe had to define risk, they simply defined it as volatility, the bigger volatility of the portfolio, measured in terms of standard deviation or beta; the bigger would be the risk. They did not know that volatility was a good measure of risk, nor did they do any research to find it out. They just supposed that the market share, that is thought to be more risky than cash investments, had the highest volatility. So, it was adopted without any evidence that volatility was a good way of measuring risk. Economists find this definition of risk compelling, because it is based on an assumption that makes perfect logical sense, that investors should be risk adverse, and that in today's well informed, sophisticated markets everyone acts perfectly rationally and takes no risk that is not justified by a bounty of evidence in support. Unrealistic or not, an entire generation of investors has grown up with the idea that volatility is risk. Services that rate managed funds examine volatility as a central concern, and "risk adjusted" historic returns are frequently a major factor in determining how many stars a manager is given by the rating services. There are many problems with the whole concept. For starters, there actually isn't any permanent correlation between risk (when defined as volatility) and return. High volatility does not give better results, nor does lower volatility give lesser results. Post- modern Portfolio Theory and contributions to it Post-modern portfolio theory is just an expansion of the traditional modern portfolio theory. A portfolio optimization methodology uses the downside risk of returns instead of the mean variance of investment returns used by modern portfolio theory. The difference lies in each theory's definition of risk, and how that risk influences expected returns. Post-Modern Portfolio Theory (PMPT) uses the standard deviation of negative returns as the measure of risk, while modern portfolio uses the standard deviation of all returns as a measure of risk. The difference

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between risk, as defined by the standard deviation of returns, between the post-modern portfolio theory and modern portfolio theory is the key factor in portfolio construction. PMPT differs from MPT also, in the way returns are distributed. The two theories are very closely related with each other and the post theory is a generalization of MPT: MPT is PMPT with normally distributed returns and variance as the measure of risk.PMPT is far more complex than Markowitz portfolio theory. Markowitz used a simple mean variance model because it is easier to handle mathematically and any other approach was impractical before computers became so cheap and fast. Generally, using PMPT will not lead to dramatically to better portfolios. It will somehow improve returns. Measuring downside risk is also intuitively closer to most people's understanding of risk: it is the probability of making a loss not that of making a bigger profit than expected. The distinction is not that important if returns are symmetrical, but if we accept that real life returns are often not symmetrical, especially true in cases when volatile investments are hold for long term, then the difference matters a great deal. An important contribution to modern portfolio theory occurred in 1965 with the publication of Eugene Famas Random Walks in Stock Market Prices. The efficient markets hypothesis holds that markets are full of people trying to make a profit by predicting the future values of securities based on freely available information. Many intelligent participants compete to trade at a profit. The price they strike in trading a stock is the same for everyone, so is the value. The price the market strikes is therefore based on all the available information about a stock, everything the investors know that has happened in the past and everything they predict will happen in the future. In this sense, markets assemble and evaluate information so effectively that the price of a stock is usually our best estimate of its intrinsic value. A price is not always perfectly correct, nor is that a condition for market efficiency. The consensus view of investors can temporarily result in prices well above or well below a stocks intrinsic value. The only condition efficient markets require is that a disproportionate number of market participants do not consistently profit over other participants. Since mispricing tend to occur in both directions and since managers seem to over-and under-perform with random frequency when adjusted for risk and costs, markets seem to be efficient.

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The above is the reason there is an ongoing debate about passive vs. active management. We include it our discussion because the empirical data supports its findings. It is also a segue into the Fama/French Three Factor Equity Model. Eugene Fama, of the University of Chicago and Kenneth French, of Dartmouth College have identified what they believe to be are the sources of risk within the capital markets. They are leading candidates for a Nobel Prize for this model. The three equity factors are: 1. Market Factor: Stocks have higher expected returns than fixed income. 2. Size Factor: Small cap stocks have higher expected returns than large cap stocks. 3. Price Factor: Lower-priced value stocks have higher expected returns than higherpriced growth stocks. Within the bond market, they believe the following: 1. Maturity Risk: Longer-term instruments are riskier than shorter-term instruments but DO NOT provide higher expected rates of return. 2. Default Risk: Lower credit quality is riskier than higher credit quality but that lower credit quality share similar risk/reward characteristics with equities, therefore should not be a part of the bond portfolio. 3. Therefore, the fixed income portion of a portfolio should be restricted to short and intermediate high quality instruments. Understanding the three-factor model is one more building block in achieving the ultimate goal of return maximization for a chosen level of risk. Many investors try to beat the market through specific security selection, market timing or trying to identify the best mutual funds or money managers. Portfolio theory aims to provide superior returns than the market through proper risk exposure.

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Personal opinion Modern portfolio theory is an ongoing hot topic of researches that aims to determine how the capital markets work. There is no one person or idea that dominates, but a collection of ideas accumulated over at least the last 60 years. It is complex. Applying the theory to the practical world of investing is itself very complex. I think that the problem with this theory is that it states volatility (SD) same with risk. Moreover, if we consider this idea, MPT is based on so-called "buy and hold" strategy, where risk or the volatility is inevitable part of every financial instrument and this risk is linked to the given expected return on investment. Another important point is that the MPT uses the standard deviation of all returns as a measure of risk. However, I think that measuring the positive returns and negative ones separately will be more efficient.

Conclusions o Though modern portfolio theory represents the best thinking we have on the way capital markets behave and are likely to behave in the future, we must remember that MPT is far from perfect. o Greatest contribution of MPT is the establishment of a risk return formal framework for decision-making. o The gist of MPT is that the market is hard to beat and that the people who beat the market are those who take above-average risk. It is also implied that these risk takers will get their comeuppance when markets turn down. o Recent advances in portfolio theory and computer technology today provide investors with capabilities unheard even a few years ago. Among these is Post-Modern Portfolio Theory (PMPT), which uses downside risk and asymmetrical return distributions, providing analysts with flexibility and accuracy in constructing efficient portfolios unavailable under traditional Markowitz mean-variance methodology. o By providing a more accurate and robust framework for constructing optimal portfolio mixes, Post-Modern Portfolio Theory has made much needed improvements to the fundamental work done by Markowitz and Sharpe on portfolio theory

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o Modern portfolio theory holds that when various uncorrelated assets are combined in a portfolio, return is improved and risk is lowered. The risk level of the individual security does not matter as long as its return varies from the other securities in the portfolio.

References Blume, M. (1971), On the assessment of risk, Journal of Finance, March. Ederington, L. H. (1986), Mean-variance as an approximation of expected utility maximization, Working Paper 86 - 5, School of Business Administration, Washington University, St. Louis, Missouri. LINTNER, J. (1965). The valuation o f risky assets and the selection of risky investments in stock portfolios and capital budgets. Review of Economics and Statistics Markowitz, H.M. (March 1952). "Portfolio Selection. The Journal of Finance Markowitz, H.M. (1959). Portfolio Selection: Efficient Diversification of Investments SHARPE, W. F. (1963). A simplified model for portfolio analysis, Management Science Wiley, Yale University Press, 1970, Basil Blackwell, 1991.

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