Question

Modern portfolio theory refers to the process of selecting such a mix of securities for the purpose of achieving maximum expected returns given a level of market risk. Explain what is meant by this. In your answer, distinguish between total risk and systematic risk, diversification and the impact of correlation between different securities.

Answer 1

Modern Portfolio Theory (MPT) is an investing model in which investors invest with the motive of taking the minimum level of risk and earning the maximum amount of return for that level of acquired risk. The modern portfolio theory is a helpful tool for the investors as it helps them in choosing the different types of investments for the purpose of the diversification of the investment and then making one portfolio by considering all the investments.

According to the modern portfolio theory, all the investments that are selected are combined together in a way that reduces the risk in the market through the means of diversification and at the same time also generates a good return in the long term to the investors.

Modern Portfolio theory has the certain assumption that is to be considered while making any decisions in order to arrive at the conclusion that risk, return and the diversification relationships hold true. The different assumptions of the modern portfolio theory are as follows:

• Returns from the assets are distributed normally.
• The investor making the investment is rational and will avoid all the unnecessary risk associated.
• Investors will give his best in order to maximize returns for all the unique situations provided.
• All investors are having access to the same information.
• The cost pertaining to the taxes and trading is not considered while making decisions
• All the investors are having the same views on the rate of return expected.
• The single investors along are not sizeable and capable enough for influencing the prices prevailing in the market.
• Unlimited capital at the risk-free rate of return can be borrowed.

Portfolio risk consists of 2 components:

1. Systemic risk.
2. Diversifiable risk.

Systemic Risk:

Systemic risks, also known as systematic risks, are risks that affect all assets, such as general economic conditions, and, thus, systemic risk is not reduced by diversification.

Diversifiable risks

Diversifiable risks are risks specific to particular assets, such as factors that affect particular businesses and their stocks. Diversifiable risks can be reduced to the extent that the coefficients of correlation of the assets in the portfolio approaches.

Total Risk of Portfolio = Systemic risk + Diversifiable risk.

Covariance is a statistical measure of how 1 investment moves in relation to another. If 2 investments tend to be up or down during the same time periods, then they have positive covariance. If the highs and lows of 1 investment move in perfect coincidence to that of another investment, then the 2 investments have perfect positive covariance. If 1 investment tends to be up while the other is down, then they have negative covariance. If the high of 1 investment coincides with the low of the other, then the 2 investments have perfect negative covariance. The risk of a portfolio composed of these assets can be reduced to zero. If there is no discernible pattern to the up and down cycles of 1 investment compared to another, then the 2 investments have no covariance.

Because covariance numbers cover a wide range, the covariance is normalized into the correlation coefficient, which measures the degree of correlation, ranging from -1 for a perfectly negative correlation to +1 for a perfectly positive correlation. An uncorrelated investment pair would have a correlation coefficient close to zero. Note that since the correlation coefficient is a statistical measure, a perfectly uncorrelated pair of investments will rarely, if ever, have an exact correlation coefficient of zero.

The most diversified portfolio consists of securities with the greatest negative correlation. A diversified portfolio can also be achieved by investing in uncorrelated assets, but there will be times when the investments will be both up or down, and thus, a portfolio of uncorrelated assets will have a greater degree of risk, but it is still significantly less than positively correlated investments. However, even positively correlated investments will be less risky than single assets or investments that are perfectly positively correlated. However, there is no reduction in risk by combining assets that are perfectly correlated.