Page 295 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes 11.11 Modern Portfolio Theory

Portfolio management is concerned with efficient management of investment in the securities.
An investment is defined as the current commitment of funds for a period in order to derive a
future flow of funds that will compensate the investing unit:
1. For the time the funds are committed

2. For the expected rate of inflation
3. For the uncertainty involved in the future flow of funds
The portfolio management deals with the process of selection of securities from the number of
opportunities available with different expected returns and carrying different levels of risk and
the selection of securities is made with a view to provide the investors the maximum yield for
a given level of risk or ensure minimise risk for a given level of return.
1. Markowitz Mean-variance Model: Harry Markowitz is regarded as the father of modern
portfolio theory. According to him, investors are mainly concerned with two properties
of an asset: risk and return, but by diversification of portfolio it is possible to trade-off
between them. The essence of his theory is that risk of an individual asset hardly matters
to an investor. What really counts is the contribution it makes to the investor’s total risk.
By turning his principle into a useful technique for selecting the right portfolio from a
range of different assets, he developed ‘Mean Variance Analysis’ in 1952. The thrust has
been on balancing safety, liquidity and return depending on the taste of different investors.
The portfolio selection problem can be divided into two stages, first finding the mean-
variance efficient portfolios and secondly selecting one such portfolio. Investors do not
like risk and the greater the riskiness of returns on an investment, the greater will be the
returns expected by investors. There is a trade-off between risk and return, which must be
reflected in the required rates of return on investment opportunities. The standard deviation
(or variance) of return measures the total risk of an investment. It is not necessary for an
investor to accept the total risk of an individual security. Investors can and do diversify to
reduce risk. As number of holdings approach larger, a good deal of total risk is removed
by diversification.

Assumptions: This model has taken into account of risks associated with investments –
using variance or standard deviation of the return. This model is based on the following
assumptions:
(a) The return on an investment adequately summarises the outcome of the investment.
(b) All investors are risk-averse. For a given expected return he prefers to take minimum
risk, obviously for a given level of risk the investor prefers to get maximum expected
return.

(c) Investors are assumed to be rational in so far as they would prefer greater returns to
lesser ones given equal or smaller risk and risk averse. Risk aversion in this context
means merely that, as between two investments with equal expected returns, the
investment with the smaller risk would be preferred.
(d) ‘Return’ could be any suitable measure of monetary inflows such as NPV, but yield
has been the most commonly used measure of return, in this context, so that where
the standard deviation of returns is referred to we shall mean the standard deviation
of yield about its expected value.
(e) The investors can visualise a probability distribution of rates of return.

290 LOVELY PROFESSIONAL UNIVERSITY