Modern Approaches to

Portfolio Construction
Portfolio construction has come a long way with the advent of new techniques
and technologies. Let's explore the modern approaches that can enhance your
portfolio strategy.

Joel Jose
M.Com Finance and Taxation (M3)
 INTRODUCTION
• Individual securities have risk return characteristics of their own. The
future return expected from a security is variable and this variability of
returns is termed as risk.
• It is rare to find investors investing their entire wealth in a single security.
This is because most investors have an AVERSION TO RISK.
• It is hoped that if money is invested in several securities simultaneously,
the loss in one will be compensated by the gain in others. Thus, holding
more than one security at a time is an attempt to spread and minimize risk
by not putting all our eggs in one basket.
• Such a group of securities held together as an investment is what is known
as a PORTFOLIO.
• The process of creating such a portfolio is called DIVERSIFICATION.
• From a given set of securities, any number of portfolios can be
constructed. A rational investor attempts to find the most efficient of these
portfolios. The efficiency of each portfolio can be evaluated only in terms
of the expected return and risk of the portfolio as such.
• Thus, determining the expected return and risk of different portfolios is a
primary step in portfolio management. This step is designated as
PORTFOLIO ANALYSIS.
 •To build wealth, you’ll need a balanced, diversified
portfolio that reflects your investment goals, risk
tolerance, and time horizon.
•Portfolio construction is a process of selecting securities
optimally by taking minimum risk to achieve maximum
returns.
PORTFOLIO •It is possible only through Diversification.
CONSTRUCT WHAT IS DIVERSIFICATION?
ION •Portfolio diversification is the process of investing your
money in different asset classes and securities in order
to minimize the overall risk of the portfolio.
•Investing all your investible funds would be great as
long as the stock’s performance is good. But in case the
market takes a sudden U-turn, you could stand to lose
your entire investment in a single blow.
 There are two prominent
approaches to portfolio
construction:
APPROACHES
of PORTFOLIO • Traditional Approach
• Modern Approach
CONSTRUCTIO
A. Modern Portfolio Theory
N (Markowitz Model)
B. Sharpe's Single index Model
 TRADITIONAL APPROACH
A good portfolio is a collection of securities
belonging to diverse industries. Traditional
approach to portfolio construction or portfolio
analysis is based on the concept of diversification
(not putting all your eggs in the same basket). It is a
balanced approach as it gives equal importance to
both risk and return. Under this approach, the
financial plan of the investor is evaluated in detail.
Then appropriate securities are selected for
inclusion in the portfolio. Hence portfolio approach
involves two important decisions:
• Determining the investment objectives of the
investor
• Determining the securities to be included in the
portfolio
 MODERN
APPROACHES
•The proper goal of portfolio construction is to a
create a portfolio that satisfies the basic objectives
of an investors which is to maximize his
returns and minimize his risks on investment.
•Such a portfolio will be called OPTIMAL
PORTFOLIO.
•The conceptual framework and analytical tools
for determining the optimal portfolio in disciplined
and objective manner have been provided by
Harry Markowitz in his pioneering work on
portfolio analysis described in his 1952 Journal of
Finance article and subsequent book in 1959
MARKOWITZ MODERN
PORTFOLIO THEORY
•The modern portfolio theory (MPT) is a practical
method for selecting investments in order to
maximize their overall returns within an acceptable
level of risk. This mathematical framework is used to
build a portfolio of investments that maximize the
amount of expected return for the collective given
level of risk.
•American economist Harry Markowitz pioneered this
theory in his paper "Portfolio Selection," which was
published in the Journal of Finance in 1952. He was
later awarded a Nobel Prize for his work on modern
portfolio theory.
•A key component of the MPT theory is
diversification. Most investments are either high risk
and high return or low risk and low return. Markowitz
argued that investors could achieve their best results
by choosing an optimal mix of the two based on an
assessment of their individual tolerance to risk.
 RISK TOLERANCE
Risk tolerance is the degree of risk that an investor is willing to endure given the volatility in the value of an
investment. An important component in investing, risk tolerance often determines the type and amount of
investments that an individual chooses.

A. AGGRESSIVE INVESTMENT PORTFOLIO: Aggressive investment strategy aims at the highest possible return. It
is suitable for investors who have high risk tolerance and longer time horizon. Aggressive portfolios
generally have a higher proportion of investment in equities and lesser investments in fixed income
securities.

B. BALANCED OR MODERATE INVESTMENT PORTFOLIO: A moderate investment portfolio is meant for

individuals with a longer time horizon and moderate risk tolerance. It seeks long-term capital appreciation
and current income and therefore investible funds are invested in equities, debts and money market
instruments in a balanced manner.

C. CONSERVATIVE INVESTMENT PORTFOLIO: Conservative investors are willing to accept little to no volatility in
their investment portfolios. Retirees or those close to retirement age are often included in this category as they
may be unwilling to risk a loss to their principal investment and have a short-term investment strategy.
 MARKOWITZ
MEAN-VARIANCE
MODEL
The modern portfolio theory of
Markowitz model includes:
1. Markowitz Mean - Variance
Model
2. Markowitz Portfolio Utility Theory
- Portfolio Optimization
 Markowitz’s assumptions

Harry Markowitz argues that

The model assumes that investors Diversification is important. But
The model assumes that there are markets will always work
are rational and the theory assumes diversification
only two different types of assets in a certain direction and will
will always behave in a certain is the only way to
—low returns and high returns.​​ always be efficient. But this
manner.​​ minimize investment risks.​​
is not always the case.​​

The Markowitz model of portfolio

assumes that every investor has
unlimited access to information Markowitz assumes that all The model mentions a bracket of
about market changes. In reality, investors are risk-averse, but that bearable loss—but not all real-
investors often lack the time is not universally true.​​ world investors can afford that. ​
and expertise to gather relevant
data.​​
A. Portfolio Return and Portfolio Risk-Basic Inputs of the Theory

After the selection of eligible securities to be included in the portfolio, the investors proceed to calculate the risk and returns of
the individual securities. For this, the expected returns (mean) and risks (standard deviation or variance of returns) Then,
portfolio return and risk are calculated.

i. Portfolio Return
Portfolio return is simply the weighted average of the returns of the individual securities in the portfolio.

Portfolio Return = Weighted average of expected returns of the individual securities in the portfolio

here,

= Expected return of the portfolio

= Proportion of funds invested in security i (weight of security "I' in the porfolio)
n = number of securities in the portfolio
= Expected return of security
ii. Portfolio Risk

• Portfolio risk is a term used to describe the potential

loss of value or decline in the performance of an
investment portfolio due to various factors, including
market volatility, credit defaults, interest rate changes,
and currency fluctuations.
• Unlike portfolio returns, risk of a portfolio is not the
weighted average of the risks of the individual
securities in the portfolio.
Standard Deviation/Variance of the Portfolio ≠ Weighted
average of standard deviations/ variances of individual
securities
•This inequality arises due to the presence of interactive
risk.
•It indicates how return of a security moves with the
returns of other securities.
Co-variance of a portfolio refers to the
measurement of interactive risk or the degree to
which returns of individual securities in the
portfolio move together. A positive co-variance
of a portfolio which consists of two securities
means that the returns of the two securities
move together. On the other hand, negative co-
variance indicates that the returns of the
securities move in the opposite direction. If the
movements are independent, co-variance will
be close to zero.

The co-variance between two securities, x and y

can be calculated as follows.
= Return of security ‘x’
= Return of security ‘y’
= Expected (mean) Return of security ‘x’
= Expected (mean) Return of security ‘y’
N = Number of Observations
Co-variance of a portfolio is an absolute measure of interactive risk. While studying the relationships, Coefficient of
Correlation is considered to be superior to co-variance. This is because coefficient of correlation is a relative
measure which facilitates comparison. Moreover, it is the standardized measure of covariance.

y=

Hence,

COVARIANCE BETWEEN x AND y = Coefficient of correlation between x and y *

Standard deviation of x *
Standard deviation of y
Hence in case of a portfolio consisting of two securities x1 and x2 the PORTFOLIO RISK or PORTFOLIO VARIANCE
consists of three element:
a) Risk of security 1 (x1) =
b) Risk of security 2 (x2) =
c) Interactive risk between x1 and x2 =

Therefore, portfolio variance can be calculated as follows :

= + +

Where,
= Portfolio Variance
= Proportion of fund in the first security
= Proportion of fund in the second security
= Variance of the first security
= Variance of the second security
= Standard deviation of first security
= Standard deviation of second security
= Co-efficient of correlation between first and second security
Q. Find out the co-variance or interactive risk of X and Y from the following data:

MONTHS RETURNS X RETURNS Y

MARCH 10 15
APRIL 15 9
MAY 20 6
JUNE 10 10
JULY -5 -15
 MONTHS RETURNS - RETURNS - [ - ][ - ]

A.
X Y
MARCH 10 0 15 10 0
APRIL 15 5 9 4 20
x = 50 / 5 = 10 MAY 20 10 6 1 10
y = 25 / 5 = 5 JUNE 10 0 10 5 0
JULY -5 -15 -15 -20 300
330

= 330/5
= 66
Q. The following information is available

Particulars Stock A Stock B

Standard Deviation 15% 8%
Proportion of investment 0.6 0.4
Co-efficient of 0.60
Correlation

Find out:
a) Co-variance between A and B
b) Portfolio Risk
=
= 0.60 * 15 * 8
= 72

= + +
= + + 2 * .6 * .4 * .60 * 15 * 8
= 81 + 10.24 + 34.56
= 125.8

Standard =
deviation
= 11.22%
 Markowitz Bullet
The efficient frontier is the set of optimal
portfolios that offer the highest expected
return for a defined level of risk or the
lowest risk for a given level of expected
return. Portfolios that lie below the
efficient frontier are sub-optimal
because they do not provide enough
return for the level of risk. Portfolios that
cluster to the right of the efficient
frontier are sub-optimal because they
have a higher level of risk for the defined
rate of return.
The capital allocation line (CAL), also known as the capital market link (CML), is a line
created on a graph of all possible combinations of risk-free and risky assets. The graph
displays the return investors might possibly earn by assuming a certain level of risk with
their investment. The slope of the CAL is known as the reward-to-variability ratio.

A tangency portfolio is a portfolio that lies at the point where the efficient frontier is
tangent to the highest possible capital market line (CML) in the risk-return space. This
portfolio offers the highest risk-adjusted return for a given level of risk, combining optimal
diversification and asset allocation.