AN OPTIMUM PORTFOLIO SELECTION PROBLEM

MARKOWITZ PORTFOLIO THEORY

DIVERSIFICATION

RISK

RETURN
 DIVERSIFICATION

REDUCES UNSYSTEMATIC RISK

SIMPLE DIVERSIFICATION

RANDOM DIVERSIFICATION

CALCULATION OF DIVERSIFICATION
FOR EACH PORTFOLIO
RELATIONSHIP OF PORTFOLIO
RISK
As portfolio size increases total risk line
starts decreasing. It flattens after a certain
point. Beyond this point risk cannot be
reduced.
Total risk consists of systematic and
unsystematic risk. Systematic risk is
usually one fourth of total risk.
Diversification reduces unsystematic risk.
Diversification Cannot Reduce
Systematic Risk. Systematic
Risk is Called Un- diversifiable
Risk.
p

Unique
Risk

Market
Risk Total Risk

5 10 15 20
Number of Stocks
PROBLEMS OF DIVERSIFICATION.
1. Purchase of Poor Performers.
2. Inadequate Information.
3. Transaction Costs.
4. Cost of Research.
 MARKOWITZ MODEL
Assumptions:
1. Individual Investor Estimates Risk on the Basis of
Variability of Returns
2. Individual Prefers Higher Return to Lower Risk
3. For Similar Returns Investor Prefers Lower Risk
to Higher Risk.
4. Investor Prefers Diversification Over Single Stock.

Unique
Risk

Market Total Risk

Risk
Holding two securities may reduce the portfolio risk
too. The portfolio risk can be calculated with the help
of the following formula.
p = X12 2X22 22 + 2X1X2 (r12
2
p = portfolio standard deviation
X1 = percentage of total portfolio value in stock X
1

X2 = percentage of total portfolio value in stock X 2

=standard deviation of stock X 1

2 = standard deviation of stock X 2

rr12 == covariance
12
correlation co-efficient of X and X
of X12
1 2

2
Using the above example given in the return analysis, the
portfolio risk can be estimated. Let us assume two companies
ABC and XYZ. ABC as X1
and XYZ as X2. Now the covariance is : X12

N
( R1 R1) ( R2 R2)
1
Cov. Of X12 =N
i=1

R = covariance of X12
1 2
 RISK AND RETURN WITH DIFFERENT CORREELATION

r=+1 r=-1
Rp Rp

9 9

7 7

5 5

3 3-
=
1 5 1 10 p 1 5 1 10 p
 r=0 r = +0.5
Rp Rp

9 9

7 7

5 5

3 3
-=
1 5 1 10 p 1 5 1 10 p
Rp
r = -1
10
B
r = +1
K
r=0
D JC r = + 0.5
5
A
r = -1

=
5 10 p
 EFFICIENT FRONTIER

15 A
B

10 C
H G
E
D F

5 I

=
5 10 15
Marginal utility and Return Indifference Curves of the Risk Fearing
Rp
l5
A B
l4
l3
l2
Unity

C l1

Return p
Indifference Curves of the Risk Loving Indifference Curve of Less Risk Fearing
l5
Rp Rp l4
l3
l5 l2
l4 l1
l3
l2
l1

p p
Rp Rp
l4
l3
l2 w ing
o rro
l1 B S

R
ding
L en
P

0 0
p p
Indifference Curve and Efficient Frontier Efficient Frontier with Borrowing and
Lending