Material for presentation by Group B:
Modern Portfolio Theory
(Source: Book on Portfolio Management by professors S.K.Barua, V.Raghunathan and
J.R.Varma)
Modern Portfolio Theory (MPT) is based on a few simple but fundamental insights into
investor behavior. The contribution of the theory has been to put these insights into a
coherent framework for analysis and decision making. Though the theory itself may at
first sight seem complex, the insights on which it is based are quite easy to understand.
Let us, therefore, begin by discussing these fundamental notions:
- The Notion of Risk Suppose we evaluate two shares M and N for investment. We
have collected data on the returns earned by investors on these shares in the last five
years which are as follows:
Share M : 30%, 28%, 34%, 32% and 31%
Share N : 26%, 13%, 48%, 11% and 57%
If we have to choose only one of the two share3s for investment, which share shall we
choose? One approach would be to compute the average return for each share and choose
the one which has higher average return. If we do that, we find that both the shares have
an average return of 31%. Can there be any other criterion for choice? Most investors
would regard share N to be riskier as its return fluctuates substantially from year to year.
They would, therefore, prefer share M to N. Thus, investors appear to make their choices
based on two considerations: expected returns. Riskiness is measured by the variability
in returns.
- The Notion of Diversification Investors seem to follow the well-known adage, “Do
not keep all your eggs in one basket”. They invariably invest in more than one security
so that losses in one may be offset by gains in another. In this manner, investors are able
to reduce the variability of returns. - The Notion of a Portfolio The set of all securities held by an investor is called his
portfolio. The portfolio may contain just one security, but we have already seen that, in
general, it will contain several securities. One of the important contributions of MPT has
been to show that we should analyze the portfolio in its entirety and not merely a security
in isolation. - The Notion of dominance The MPT is based on two very basic and intuitively
acceptable statements about risk and return:
a. If two portfolios have identical expected returns, then investors would choose that
portfolio which has a lower risk.
b. If two portfolios have identical risks, then investors would choose that portfolio
which has a higher expected return.