Markowicz the Objective of Modern

Markowicz

The objective of modern portfolio theory, as explained by Harry Markowitz, is to maximize the risk-return dynamic of a portfolio. An efficient portfolio, therefore, is one that delivers the highest possible return given the portfolio's risk level. This objective is achieved through a number of steps. The most important is the determination of the efficient frontier. The risk level of the assets must also be taken into consideration, and their impact on the total risk of the portfolio must also be considered. This paper will explain in detail the steps in creating a truly efficient portfolio, with each of the objectives along the way outlined as well. Modern portfolio theory attempts to determine the best way to build a portfolio, the result being the optimum complete portfolio. This portfolio lies along the efficient frontier, albeit at no set point. The specific point is set by the risk preferences of the investor.

Modern portfolio theory is centered on the idea that there are two kinds of risk. The first type is systemic risk. This is the risk in the total economy, and in basic portfolio theory systemic risk cannot be diversified away. A fully diversified portfolio would be expected to perform in line with the market, which means that it is still subject to broad-based risk. The other form of risk is non-systemic, or firm-specific risk. This is the risk to which each firm is subject as a result of its conduct of business. This risk derives from a wide range of influences, both internal and external.

Modern portfolio holds that with sufficient diversification, firm-specific risk can be eliminated. This is because for the sum total of investment options, the risk factors for each option will eventually cancel each other our. In other words, a perfectly diversified portfolio mirrors the market. A key tenet of modern portfolio theory is that a diversified portfolio can be created that will replicate market performance. This is to say that a portfolio can be constructed with x number of securities that will have market risk only, with a statistically insignificant margin for error.

Risk of any asset is considered relative to the market (non-systemic) risk. In equities markets, this risk variable is the beta, which is the volatility of the security relative to the volatility in the market overall. In debt securities, the risk can be measured by the yield of the security, and the variance of that yield from the risk free rate. The risk free rate is assumed to be Treasury securities, since Treasury securities are backed by the U.S. government and therefore are considered to have essentially no risk of default.

Markowitz explained that for each level of risk, there was a set of potential returns. In the capital asset pricing model, which was developed on the basis of Markowitz's work, the asset is viewed in terms of its expected return. In Markowitz, the expected return was not explicitly stated, but was viewed as a range of potential returns. The highest point in the range is considered to be the maximum possible return on the portfolio for that particular risk level. This is the most efficient portfolio. The objective of any portfolio, therefore, is to reach this return point for the given risk level. If the return is lower, then that means that the portfolio is inefficient. If the return is higher, than under Markowitz that means that the portfolio's risk profile has been altered.

When the points of maximum portfolio return are calculated for a complete range of risk levels along a graph, this results in a curve known as the efficient frontier. Points below the efficient frontier represent an inefficient portfolio; points above the frontier are impossible. The portfolio manager can move the portfolio along the frontier at any point. It is not the total return of the portfolio that is relevant, only the return relative to the amount of risk that is contained within the portfolio. Flowing from this, it is understood that any portfolio that sits along the efficient frontier will have no firm-specific risk. The composition of the portfolio does not necessarily reflect the market, but it does reflect a risk-adjusted version of market returns. This is known as the capital market line, and reflects the optimal return for a portfolio given a specific risk free rate and standard deviation (risk) for that portfolio.

In order to construct an efficient portfolio, a number of steps need to be undertaken. In order to being construction, the portfolio manager needs to consider the objectives, based on the risk-return equation. The mean-variance criterion can be used to help with this process. The mean-variance criterion means either choosing to select the highest mean return for a portfolio given a set level of risk (variance), or choosing the lowest variance portfolio for a given mean return. In other words, the portfolio manager can either take a view of the portfolio based on maximizing return or minimizing risk. The latter is known as the minimum variance portfolio. No matter which is chosen, the optimal portfolio will lie along the efficient frontier, and therefore be known as an efficient portfolio.

It should be noted that the efficient portfolio is based on theoretical concepts. In reality, there are sources of inefficiency such as transaction costs, information costs, asset access and other factors that can reduce a portfolio manager's ability to create a truly efficient portfolio. Asset access is a significant constraint on creating an efficient portfolio. Even in the most sophisticated and mature markets, the ideal security may not be available, or it may be subject to constraints such as transaction costs or irrational high prices that shift he return dynamic away from the theoretical ideal. As a result, most financial managers focus less on reaching the frontier as they do on coming as close as they can, given the constraints that they face. This is known as the feasible portfolio, the best portfolio possible given the assets available.

At any risk level above zero, the efficient portfolio will be constructed of a wide range of securities. The first consideration for any particular security is risk. The market price of risk is the premium that is placed on any security for the additional risk that it entails above a risk free asset. To build an efficient portfolio, securities within that portfolio should have a market price of risk that is lower than the risk -- these are underpriced securities. It should be understood, however, that the price of securities relates to the market's view of the risk, based on perfect information, so any difference between your information and the market's information should be taken with caution.

The Markowitz portfolio model consists of multiple risky assets and a risk-free asset -- this is the optimal complete portfolio. In this portfolio the risk-free asset limits the potential return of the portfolio. The orientation therefore is towards the minimum variance portfolio. The ideal portfolio will be at the risk level where the minimum variance frontier intersects with the efficient frontier. Without the risk-free asset, the portfolio could theoretically be oriented towards any risk level. If an investor wishes to have near infinite risk in exchange for near infinite return, that is possible within the theoretical context of the optimum risky portfolio. In reality, investors do not have near-infinite risk, and it is the limitations of investor risk that ultimately structure and shape the optimum complete portfolio.

Under modern portfolio theory, the ideal portfolio in a universe with a risk-free asset will essentially be constructed of the client's ideal portfolio and that risk-free asset. The client's portfolio will be constructed based on the optimum risky portfolio. This is the portfolio that has the highest Sharpe ratio -- the balance of risk and return. This point is located along the efficient frontier. The specific makeup of this portfolio is uncertain, but its characteristics are relatively set.