Markowitz and Sharpe Theories of

Portfolio Management
 THEORY OF PORTFOLIO SELECTION
A normative theory for optimal investment of wealth in assets which differ in regard
to their expected return and risk

A rigorously formulated, operational theory for portfolio selection under uncertainty

An investor’s portfolio choice can be reduced to balancing two dimensions - the

expected return on the portfolio and its variance

Risk can be reduced through diversification

The risk of the portfolio, will depend not only on the individual variances of the
return of different assets, but also on the pairwise covariances of all assets

The essential aspect pertaining to the risk of an asset is not the risk of each asset in
isolation, but the contribution of each asset to the risk of the aggregate portfolio
Markowitz Theory of Portfolio
Analysis
• Mathematical formulation of diversification
• The goal – select a collection of investment
assets which has collectively lower risk than
any individual asset AND a higher reward for
the equivalent level of risk
• Assumptions – Investors’ attitudes towards
portfolio selection depend on
1. Quantification of risk, i.e. variance/standard
deviation of return
2. Risk return optimization
 Combining Securities
• Is it possible to reduce the risk of a portfolio by
incorporating into it a security whose risk is greater
than that of any of the investments held initially?
• The answer is YES. A portfolio can give same
expected return at less risk
• Implication – INTERACTIVE risk between securities
is VITAL
• The risk of portfolio is reduced by playing off one
set of variations against another
• Inversely related security returns - One security
does well when the other does poorly
  Risk of INDIVIDUAL securities – Standard Deviation OR Variance
 Risk of PORTFOLIO – Added element of INTERACTIVE risk or COVARIANCE
Portfolio of individual securities
 Positive COVARIANCE – When returns move together
Risk  Zero COVARIANCE – When returns are independent
 Negative COVARIANCE – When returns move inversely
 𝑐𝑜𝑣𝑥𝑦 = [Probability] 𝑅𝑥 − 𝑹ₓ 𝑅𝑦 − 𝑹𝑦
𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒
 Correlation coefficient between two securities is given by 𝑟𝑥𝑦 = 𝜎𝑥 ∗ 𝜎𝑦
 So covariance can also be expressed as 𝑟𝑥𝑦 𝜎𝑥 𝜎𝑦
 Coefficient of Correlation measures the strength of the relationship
between variables
The correlation coefficient varies between
 +1 (perfect co-movement in the same direction)
 0 means no co-movement
 -1 (perfect co-movement in opposite directions)
Covariance is a measure of how two variables change together, but its
magnitude is unbounded. The correlation coefficient gives the
normalized version of covariance
Portfolio Effect in a Two-Security Case
 By investing in securities, with – ve or low covariance among
themselves, risk is reduced
 Markowitz’s efficient diversification involves combining
securities with less than + ve correlation to reduce risk without
sacrificing return
 It is not enough to invest in many securities, it is necessary to
have the right securities
 Portfolio risk can be formally defined as
𝜎𝑝 = 𝑋𝑥2 𝜎𝑥2 + 𝑋𝑦2 𝜎𝑦2 + 2𝑋𝑥 𝑋𝑦 𝑟𝑥𝑦 𝜎𝑥 𝜎𝑦
𝜎𝑝 = Portfolio Standard Deviation
𝑋𝑥 = % of total portfolio value in X
𝑋𝑦 = % of total portfolio value in Y
𝜎𝑥 = Standard Deviation of X
𝜎𝑦 = Standard Deviation of Y
𝑟𝑥𝑦 = Correlation Coefficient of X and Y
Portfolio Effect in a Two-Security Case

Portfolio Risk is sensitive to

(1) The proportions of funds devoted to each stock
(2) The standard deviation of each stock
(3) The covariance between the two stocks
Portfolio risk can be brought down to zero by
rebalancing the proportions of the two stocks in
the portfolio
The preconditions are that 𝑟𝑥𝑦 = - 1
𝜎𝑦 4
And weight of X = = = 0.67
𝜎𝑥 + 𝜎𝑦 2+4
 Zero Risk Portfolio
Std. Correlation Std.
Stock Weights Deviations Coefficient Deviation

X 0.666666667 2

Y 0.333333333 4

-1

Portfolio 0.0

 The preconditions are 𝑟𝑥𝑦 = - 1

𝜎𝑦
 And weight of X =
𝜎𝑥 + 𝜎𝑦
 EFFICIENT FRONTIER

 The efficient frontier represents the best security combinations - those

that produce the maximum expected return for a given level of risk
 The efficient frontier is the basis for modern portfolio theory
 It divides the space between portfolios that are possible and those that
cannot be attained
 All portfolios on the efficient frontier are referred to as efficient
portfolios
 Efficient Frontier in a 2 Security Case
4.50%

4.00%
3.86%

3.50% 3.51%

3.17%
3.00%
2.82%

Portfolio Mean
2.50% 2.47%

2.13%
2.00%
1.78% Efficient Frontier
1.50% 1.43%

1.09%
1.00%
0.74%
0.50%
0.39%

0.00%
0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00%

Portfolio Standard Deviation

 • The collection of all possible portfolios is given by
Efficient Frontier for the broken egg shaped region i.e. feasible region
AFXMNO
n-Security case
• The efficient frontier is given by the line segment
AFX which contains all the efficient portfolios
• A portfolio is efficient if and only if there is no
alternative with
The same E(𝑹𝒑 ) and a lower 𝝈𝒑
The same 𝝈𝒑 and a higher E(𝑹𝒑 )
A higher E(𝑹𝒑 ) and a lower 𝝈𝒑

• Portfolio Z is inefficient because portfolios B and D

dominate Z

• The Efficient Frontier is the same for all investors

since portfolio theory is based on the assumption
that all investors have homogeneous expectations
Optimal Portfolio & • To determine the optimal portfolio, the
Indifference Curves investor’s risk-return trade-off must be known
• These indifference curves reflect the investor’s
risk-return trade-off
• 𝑰𝑷 and 𝑰𝑸 represent the indifference curves of
two investors P and Q
• Most investors are risk averse
• They want more returns for more risk and
hence indifference curves are upward sloping
• Q is more risk averse than P and expects
higher return than P for the same risk
• The steeper the slope of the indifference
curve, the greater the degree of risk aversion
Indifference Map
• This is an indifference map for
investor P

• All points on a given indifference

curve offer the same level of
satisfaction – points A and B on 𝑰𝒑𝟏 , R
and S on 𝑰𝒑𝟐

• The level of satisfaction increases as

one moves upwards and leftwards

• 𝑰𝒑𝟐 represents a higher level of

satisfaction than 𝑰𝒑𝟏
Optimal Portfolio • The optimal portfolio is found
at the point of tangency
between the efficient frontier
and an indifference curve
• This point represents the
highest possible level of
satisfaction
• Investor P’s optimal portfolio
is P*
• Investor Q’s optimal portfolio
is Q*
Optimal Portfolio with • Suppose the investor can lend and borrow at a
Lending & Borrowing risk-free rate 𝑅𝑓
• If he lends a part of his funds at the risk-free rate
and invests the balance in S, he can obtain any
risk-return combination along the line segment
𝑅𝑓 S
• If he borrows money at 𝑅𝑓 and invests it along
with his own funds, he can reach any point
beyond S like E or V
• Note that though the investor can invest along
Line I, no rational investor would do so, since all
portfolios on Line II dominate those on Line I
• With the opportunity of lending and borrowing,
the efficient frontier changes from AFX to 𝑅𝑓 SV
which dominates AFX
 • A conservative investor would choose U
Optimal Portfolio with while an aggressive investor would
choose V
Lending & Borrowing • But both choose some combination of
lending/borrowing at 𝑅𝑓 and a portfolio
Risk free of risky assets
borrowing
• For a conservative investor, the weight of
the risk free asset is higher, while for the
aggressive investor the weight of the risk
Risk free
lending
free asset is negative and the weight of
the S is more than 1
• Thus the task of portfolio selection can be
separated into 2 steps
 Identification of S, the optimal portfolio
of risky securities
 Choice of a combination of 𝑅𝑓 and S,
depending on the investor’s risk appetite
• This is the celebrated Separation
Theorem of James Tobin
Example of Lending & Borrowing
• Say, an investor has own investible fund of Rs.1000/- on which he earns a
return of 12% thus entailing earnings of Rs.120/-
• Now, say he lends Rs.400/- at the risk free rate of 6%, he would earn Rs. 24
• On the balance Rs.600, at a rate of return of 12%, he earns Rs.72/-
• Thus his total earnings is Rs.96/-, thus entailing a return of (96/1000) *100
= 9.6%
• Now, say that he borrows Rs.400/- at the risk free rate of 6% for a total
borrowing cost of Rs.24/-
• He invests the entire fund of Rs.1400/- at a return of 12% giving him
earnings of Rs.168/-
• His NET earnings would be Rs. (168 – 24) = Rs. 144/- thus entailing a net
rate of return of (144/1000) * 100 = 14.4%
• The leveraged portfolio gives him higher returns than an unleveraged one.
• Caution – This is true when market investments give returns higher than
the risk free rate. In times of depression, this strategy of leveraged
portfolios is not advisable.
 Sharpe Single Index Model
 The Markowitz portfolio selection model is very information intensive
 When dealing with a large number of securities, the number of inputs for
portfolio analysis is too large.
 For N securities, the number of inputs to compute portfolio return and risk
are N expected returns, N variances of returns and (𝐍𝟐 −N)/2
covariances/correlation coefficients, thus requiring a total N(N+3)/2 inputs
 Say, we have 3 securities, we would need 3 expected returns, 3 security
variances and 3 correlation coefficients, thus totalling 3(3+3)/2 = 9 inputs
 The number of inputs needed keeps increasing with the number of securities
in the portfolio

Number of Securities Number of Inputs
10 65
50 1325
100 5150
 Sharpe Single Index Model
• Relationship between return of each
security and return of broad market
index instead of individual relationship
of each security with all other securities
• All stocks are affected by movements in
the stock market
• The relationship with the market is
measured by respective betas
 • The major assumption of the Sharpe Single Index Model, developed
by William F. Sharpe, is that covariances of security returns can be
explained by a single factor – the stock market index like the BSE
200
• The returns on an individual stock can be decomposed into 3 factors
Sharpe 1. Returns related to the market index returns. The relationship to
Single Index the market index depends on the sensitivity of the stock to the
market index and is denoted by a coefficient β, which may have a
Model value equal to/less than/more than 1 and which may be +ve or –
ve. This part of the return is given by the term 𝒓𝒇 + β𝒊 (𝒓𝒎 − 𝒓𝒇 )
where 𝒓𝒇 is the risk free rate and 𝒓𝒎 is the return on the market
index.
2. An individual factor which is the excess return of the stock when
the market index return is zero. This is the α coefficient.
3. An unexpected factor related to the microeconomic events that
affect only the firm. Over a large number of observations, this
factor will have an average value of zero and is termed as 𝒆𝒊
• Security return is thus given by 𝒓𝒊 = α𝒊 + 𝒓𝒇 + β𝒊 (𝒓𝒎 − 𝒓𝒇 ) + 𝒆𝒊
• Portfolio return is weighted average of security returns with the
weights being the proportions invested in the respective securities -
𝑹𝒑 = 𝒘𝒊 {α𝒊 + 𝒓𝒇 + β𝒊 (𝒓𝒎 − 𝒓𝒇 ) + 𝒆𝒊 }
 Security Risk
Sharpe
• Security risk or variance has 2 components -
Single Index systematic (market) risk and unsystematic (unique)
Model risk
• Security Variance =
(𝐒𝐞𝐜𝐮𝐫𝐢𝐭𝐲 𝐁𝐞𝐭𝐚𝟐 ) 𝐌𝐚𝐫𝐤𝐞𝐭 𝐕𝐚𝐫𝐢𝐚𝐧𝐜𝐞 +
𝐔𝐧𝐢𝐪𝐮𝐞 𝐬𝐞𝐜𝐮𝐫𝐢𝐭𝐲 𝐯𝐚𝐫𝐢𝐚𝐧𝐜𝐞
• 𝝈𝟐𝒊 = 𝜷𝟐𝒊 𝝈𝟐𝒎 + 𝝈𝟐 𝒆𝒊
• Security SD √𝝈𝟐𝒊 = √(𝜷𝟐𝒊 𝝈𝟐𝒎 + 𝝈𝟐 𝒆𝒊 )
 Numerical Example
Stock/Index E(r) Beta Unique SD
A 14% 0.9 30%
B 17% 1.2 40%
Market Index 1
Risk-free assets 8% 0
The SD of the index is 22%. The portfolio consists of 30% of A,
45% of B, and 25% of risk-free assets
 Portfolio Return = (0.3 X 0.14)+(0.45 X 0.17)+(0.25 X 0.08) =
0.1385 = 13.85%
 Variance of A = 𝟎. 𝟗𝟐 𝑿 𝟐𝟐𝟐 + 𝟑𝟎𝟐 = 𝟏𝟐𝟗𝟐. 𝟎𝟒
 SD of A = √ 𝟏𝟐𝟗𝟐. 𝟎𝟒 = 35.95%
 Variance of B = 𝟏. 𝟐𝟐 𝑿 𝟐𝟐𝟐 + 𝟒𝟎𝟐 = 𝟐𝟐𝟗𝟔.96
 SD of B = √ 𝟐𝟐𝟗𝟔. 𝟗𝟔 = 47.93%
 Portfolio Risk
• Portfolio Variance = (Sum of Weighted Security Beta X
Market SD)^2 + Sum of (Weighted unique security SD)^2
• 𝝈𝟐𝒑 = (∑𝑾𝒊 𝜷𝒊 𝝈𝒎)^𝟐 + ∑(𝑾𝒊 𝝈 𝒆𝒊 )^𝟐
• Sum of Weighted Security Beta = (0.3 X 0.9) + (0.45 X 1.2) +
(0.25 X 0) = 0.81
• (Sum of Weighted Security Beta X Market SD)^2 = (0.81 X
22)^2
• Sum of (Weighted unique security SD)^2 = (0.3 X 30)^2 +
(0.45 X 40)^2 + ( 0.25 X 0)^2
• Portfolio Variance = (0.81 X 22)^2 + (0.3 X 30)^2 + (0.45 X
40)^2 + ( 0.25 X 0)^2 = 722.55
• Portfolio SD = √722.55 = 26.88%
 Sharpe Single Index Model
 For N securities, the number of inputs to compute
portfolio return and risk are N expected returns, N
variances, N covariances with the market, variance and
return of the market index (2 inputs) thus needing a
total of (3N) + 2 inputs
Number of Securities Number of Inputs
10 32
50 152
100 302
 CONCLUSION
While Markowitz’s work on portfolio
theory is focuses on optimal portfolio
selection, with the formulation of the
Capital Asset Pricing Model, William F.
Sharpe used Markowitz’s model as an
explanatory theory, for ascertaining
price formation for financial assets