Question

(c) Outline the key features of Markowitz’s modern portfolio theory (MPT) and hence explain the main lessons for an investor from MPT (the use of appropriate diagrams is encouraged).

Answer 1

Modern Portfolio theory (MPT) provides a logical/mathematical framework through which investors can optimize their risk and return. The theme is that through benefit of diversification by creating a well-diversified portfolio, an investor can achieve risk reduction i.e. unsystematic risk gets reduced.

The investors are not concerned about the individual risks of their securities. They are affected by the contribution a security makes to their overall risk of portfolio. And as per MPT, through diversifying securities i.e. investing in diversified assets or industries (that are closer to negative correlation) can help investor cut-lower the unsystematic risk component of total risk. Markowitz then developed the mean-variance analysis and efficient frontiers. Efficient frontiers is the curve that joins all the efficient portfolios i.e. portfolios that have higher return on same risk or has lower risk for same returns. Refer diagram below :

(Image Source : ICAI SFM Material)

By Placing the investor's indifference curve (utility function) alongside the efficient frontiers, one can get the optimal investment portfolio. So, the lesson for investors from MPT is that :

(1) Look to diversify your portfolio with less than perfectly positively correlated assets i.e. do not put all your eggs in one basket.

(2) Identify efficient portfolios by eliminating sub-standard portfolios (that are more riskier at same or lesser return)

(3) As different investors have different risk-return preferences, the optimal portfolio of securities will vary from investor to investor.