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Modern Portfolio Theory

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Submitted By honeymay1008
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Assumptions of Portfolio Theory
• Investors are rational. • Investors are basically risk averse. • Investors wants to maximize the returns from his/her investments for a given level of risk. • Investor portfolio includes all of his/her assets and liabilities. • The relationship between the returns of assets in the portfolio is important since the returns from these investments interact with each other.

Risk Aversion
• Portfolio Theory assumes investors are basically risk averse. • Risk aversion means an investor, given a choice between two assets with equal rates of return, will select the asset with the lower level of risk. • Does not imply everybody is risk averse. • Most investors when committing large sums of money in developing an investment portfolio are risk averse. • This means investors expect a positive relationship between expected return and expected risk.

Definition of Risk
• Risk is the uncertainty of future outcomes. • Probability of an adverse outcome.

Markowitz Portfolio Theory
• Developed by Harry Markowitz in the 1950s. • Won a Nobel Prize for his work. • Basic portfolio model derived the expected rate of return for a portfolio of assets and an expected risk measure.

Markowitz Portfolio Theory
• He used variance of the rate of return as a measure of portfolio risk under a reasonable set of assumptions. • He also derived the formula for computing variance of a portfolio.

Assumptions of Markowitz Model
• Investors consider each investment alternative as being represented by a probability distribution of expected returns over some holding period. • Investors maximize one period expected utility, and their utility curves demonstrate diminishing marginal utility of wealth. • Investors estimate the risk of the portfolio on the basis of the variability of expected returns.

Assumptions of Markowitz Model
• Investors base…...

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