Question

According to Markowitz, an investment in risky security is presumed to select an investment portfolio which is on the EFFICIENT FRONTIER and tangent on the investor indifference curve. However, in practice neither the efficient frontier nor the INDIFFERENCE CURVE can be estimated with high degree of accuracy. Therefore, the PORTFOLIO THEORY may be redundant. Explain the term in in capital letters in the above statement and critically asses their validity with reference to be above theoretical argument.

Answer 1

Portfolio is the group of securities that an investor tend to invest in order to optimise return with minimal risk.

Portfolio management is a process encompassing many activities aimed at optimising the investment of one's fund. it involves 5 phases.

1. Security analysis : analysing the value of each available securities based on their return and risk.

2. Portfolio analysis : analysing and comparing the available portfolio of investment based of risk and return.

3. Portfolio selection : After analysing the risk and return the investor tends to select a portfolio with maximising his return in minimal risk.

4. Portfolio revision : as time passes the value of securies will change, new securities where introduced, and investment amount may fluctuate, so that a revision is needed in the changed scenario.

5. Portfolio evaluation: it provides a mechanism for identifying weakness in investment process for improving these deficient areas.

The portfolio selection process. The portfolio selection process has inspired a lot of models in order to optimize the set of securities than an investor may select according to a number of specific decision criteria such as risk, return, planning horizon, and so on. Markowitz portfolio selection. Modern portfolio theory (MPT) is a method for constructing a portfolio of securities. It was introduced by Harry Markowitz in the early 1950s. Markowitz's portfolio selection approach allows investors to construct a portfolio that gives investors the best risk/return trade-off available.

1. The efficient frontier: The Markowitz efficient set, also called the efficient frontier, is a mathematical concept that reflects the combinations or portfolios that generate the maximum expected return for various levels of risk. In modern portfolio theory, the efficient frontier (or portfolio frontier) is an investment portfolio which occupies the 'efficient' parts of the risk-return spectrum. Formally, it is the set of portfolios which satisfy the condition that no other portfolio exists with a higher expected return but with the same standard deviation of return (i.e., the risk). The efficient frontier was first formulated by Harry Markowitz in 1952.

The efficient frontier rates portfolios (investments) on a scale of return (y-axis) versus risk (x-axis). Compound Annual Growth Rate (CAGR) of an investment is commonly used as the return component while standard deviation (annualized) depicts the risk metric. The efficient frontier theory was introduced by Nobel Laureate Harry Markowitz in 1952 and is a cornerstone of modern portfolio theory (MPT).

The efficient frontier graphically represents portfolios that maximize returns for the risk assumed. Returns are dependent on the investment combinations that make up the portfolio. The standard deviation of a security is synonymous with risk. Ideally, an investor seeks to populate the portfolio with securities offering exceptional returns but whose combined standard deviation is lower than the standard deviations of the individual securities.1 The less synchronized the securities (lower covariance) then the lower the standard deviation. If this mix of optimizing the return versus risk paradigm is successful then that portfolio should line up along the efficient frontier line.

A key finding of the concept was the benefit of diversification resulting from the curvature of the efficient frontier. The curvature is integral in revealing how diversification improves the portfolio's risk / reward profile. It also reveals that there is a diminishing marginal return to risk. The relationship is not linear. In other words, adding more risk to a portfolio does not gain an equal amount of return. Optimal portfolios that comprise the efficient frontier tend to have a higher degree of diversification than the sub-optimal ones, which are typically less diversified.

Optimal Portfolio

One assumption in investing is that a higher degree of risk means a higher potential return. Conversely, investors who take on a low degree of risk have a low potential return. According to Markowitz's theory, there is an optimal portfolio that could be designed with a perfect balance between risk and return. The optimal portfolio does not simply include securities with the highest potential returns or low-risk securities. The optimal portfolio aims to balance securities with the greatest potential returns with an acceptable degree of risk or securities with the lowest degree of risk for a given level of potential return.3 The points on the plot of risk versus expected returns where optimal portfolios lie are known as the efficient frontier.

Selecting Investments

Assume a risk-seeking investor uses the efficient frontier to select investments. The investor would select securities that lie on the right end of the efficient frontier. The right end of the efficient frontier includes securities that are expected to have a high degree of risk coupled with high potential returns, which is suitable for highly risk-tolerant investors. Conversely, securities that lie on the left end of the efficient frontier would be suitable for risk-averse investors.

Limitations

The efficient frontier and modern portfolio theory have many assumptions that may not properly represent reality. For example, one of the assumptions is that asset returns follow a normal distribution. In reality, securities may experience returns that are more than three standard deviations away from the mean in more than 0.3% of the observed values.4 Consequently, asset returns are said to follow a leptokurtic distribution or heavy-tailed distribution.

Additionally, Markowitz posits several assumptions in his theory, such as that investors are rational and avoid risk when possible; there are not enough investors to influence market prices; and investors have unlimited access to borrowing and lending money at the risk-free interest rate. However, reality proves that the market includes irrational and risk-seeking investors, there are large market participants who could influence market prices, and there are investors who do not have unlimited access to borrowing and lending money.

2. An indifference curve is a graph that shows a combination of two goods that give a consumer equal satisfaction and utility, thereby making the consumer indifferent. Indifference curves are heuristic devices used in contemporary microeconomics to demonstrate consumer preference and the limitations of a budget. Recent economists have adopted the principles of indifference curves in the study of welfare economics.

An indifference curve is a graph that shows a combination of two goods that give a consumer equal satisfaction and utility, thereby making the consumer indifferent. Indifference curves are heuristic devices used in contemporary microeconomics to demonstrate consumer preference and the limitations of a budget. Recent economists have adopted the principles of indifference curves in the study of welfare economics.

Standard indifference curve analysis operates on a simple two-dimensional graph. Each axis represents one type of economic good. Along the curve or the line, the consumer has no preference for either combination of goods because both goods provide the same level of utility to the consumer. For example, a young boy might be indifferent between possessing two comic books and one toy truck, or four toy trucks and one comic book

The Principles and Characteristics of Indifference Curve Analysis

Indifference curves operate under many assumptions, for example, each indifference curve is convex to the origin, and no two indifference curves ever intersect. Consumers are always assumed to be more satisfied when achieving bundles of goods on higher indifference curves.

If a consumer's income increases, the curve will move higher up on a graph because the consumer can now afford more of each type of good.

Many core principles of microeconomics appear in indifference curve analysis including individual choice, marginal utility theory, income, and substitution effects, and the subjective theory of value. Indifference curve analysis emphasizes marginal rates of substitution (MRS) and opportunity costs. All other economic variables and possible complications are treated as stable or ignored unless placed on the indifference graph.

Most economic textbooks build upon indifference curves to introduce the optimal choice of goods for any consumer based on that consumer's income. Classic analysis suggests that the optimal consumption bundle takes place at the point where a consumer's indifference curve is tangent with their budget constraint.

The slope of the indifference curve is known as the MRS. The MRS is the rate at which the consumer is willing to give up one good for another. If the consumer values apples, for example, the consumer will be slower to give them up for oranges, and the slope will reflect this rate of substitution.

Criticisms and Complications

Indifference curves, like many aspects of contemporary economics, have been criticized for oversimplifying or making unrealistic assumptions about human behavior. One noteworthy criticism is that indifference is conceptually incompatible with economic action, and every action necessarily demonstrates preference, not indifference. Otherwise, no action would take place.

Other critics note that it is theoretically possible to have concave indifference curves or even circular curves that are either convex or concave to the origin at various points. Consumer preferences might also change between two different points in time rendering specific indifference curves practically useless.

According to Markowitz, an investment in risky security is presumed to select an investment portfolio which is on the EFFICIENT FRONTIER and tangent on the investor indifference curve. However, in practice neither the efficient frontier nor the INDIFFERENCE CURVE can be estimated with high degree of accuracy. The efficient frontier and modern portfolio theory have many assumptions that may not properly represent reality. Indifference curves, like many aspects of contemporary economics, have been criticized for oversimplifying or making unrealistic assumptions about human behavior.