Page 266 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 10: Portfolio Analysis

Notes

Notes The portfolio selection process as described above is not something new; the model
was presented by Harry Markowitz briefly in 1952, and later in a complete book entitled
Portfolio Selection – Efficient Diversification of Investments (1959). One important concept that
Markowitz emphasized for the first time was that some measure of risk, and not just the
expected rate of return, should be considered when dealing with investment decision.

Markowitz’s approach to portfolio analysis and selection attracted a number of academicians
and practitioners, who subsequently began to adjust the basic framework so that practical
application could be more readily considered. Another interesting thing happened. Following
the presentation of the model, there had been a wide spread realization of how computers could
be utilized in investment decision-making. Markowitz’s own solution to portfolio selection
problem necessitates application of computers. As a final remark, we may mention that
Markowitz’s work marks the beginnings of what is today known as modern portfolio theory.
10.3 Markowitz Diversification and Classification of Risks

We have seen that the Portfolio Risk is smaller than the risk of individual assets. It indicates that
the portfolios are less risky than the isolated assets. This phenomenon has been often attributed
to Markowitz contribution. If an investor intends to diversify his investment into different
assets instead of investing the whole in one security, he is with to benefit from reduced risk
level. Further, if he can find assets with negative correlation, the combined risk works out zero
or near zero. But in reality it is difficult to find many assets with negative correlation.

Figure 10.1: Number of Stocks in a Portfolio

Diversification Risk

Systematic Risk

What will happen to portfolio risk if we go on adding more and more stocks to a portfolio? It is
logical to believe that the risk is bound to reduce as the number of stocks in a portfolio increases.
Can we eliminate risk completely? It all depends on the correlation between assets. Smaller the
correlations, lower will be the risk in the portfolio. In fact, if we can find stocks with either zero
correlation or negative correlation, the portfolio would be certainly low. But it is impossible to
find such stocks to construct our portfolios. In such a case there exists a minimum level of risk in
every portfolio, however large the number of assets in it may be.

LOVELY PROFESSIONAL UNIVERSITY 261