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Oct. 31
Portfolio Analysis in US stock market using Markowitz model
Emmanuel, Richard Enduma


Abstract

The risk management systems now
used in portfolio management are
based on Markowitz mean variance
optimization. Successful analysis
depends on the accuracy with which
risk, market returns and correlation are
predicted. The methods for forecasting
now normally used for this purpose
depend on time-series approaches
which generally ignore economic
content. This paper is trying to suggest
that explicitly incorporation of
economic variables into the process of
forecasting can improve the reliability
of such systems in managing the risk
by making a provision for a delineation
between risks related to changes in
economic activities and that
attributable to other discontinuities and
shocks.

1. INTRODUCTION

Harry Markowitz (1952), wrote his
portfolio analysis method in 1952.
Using his method, an investor can
determine an optimal portfolio with his
specific risk level. Although the method
given by Markowitz is a method of
normalization and detailed steps were
described by Markowitz (1959) in a
book, it is quite difficult to find a
published literature for an example for
its application to real life data based on
quantitative expectations of analysts or
investors. For each security expected
return, standard deviation of return and
correlation coefficient (or covariance)
of return for each pair of securities in
the set of securities that are
considered for inclusion in the portfolio
are required as data inputs for doing
the portfolio analysis. We may
presume that although analysts in
stock broking companies have been
using this method, but still they dont
describe its application for the public at
large. In this paper, we attempt to
make the optimal portfolio formation
using real life data and the objective of
the research is to provide an example
of optimal portfolio management using
real life data.

2. INPUTS REQUIRED

For analysing the portfolio using the
Markowitz method, we need the
expected return, standard deviation for
each of the securities for its holding
period to be considered for including in
the portfolio. We also have to know the
correlation coefficient or covariance
between each pair of the securities
among all the securities which are to
be included in the portfolio. This
approach explicitly makes risk
management comprehensively on the
user by making portfolio construction
in a probabilistic framework. The
results of this analysis are normally
presented in the form of the efficient
frontier, which shows expected return
on portfolio as a strict function of risk .
The approach uses three key steps in
the process

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(1) consideration of the specific
investment alternatives
(2) how to perform the optimization;
(3) how to choose the appropriate
implementation process.
The maximum return can be expected
from the resulting portfolio at minimum
risk.
Let Xi be the fraction of wealth
invested in stock i of the portfolio.
Xi: The weight of portfolio on stock i.
Therefore,
Xip = 1
i
rp: The return on the portfolio, given by
rp = Xiri
i
E(rp): Expected return of portfolio,
given by
E(rp) = XiE(ri)
Cov(rp,W): Covariances in portfolio,
given by
Cov(rp,W) = Xi *Cov(ri,W)

The above both are linear in portfolio
weights but the following is non linear.
Var(rp): Portfolio variance, given by
Var(rp) = XiXj ij
i j

In matrix formation:

Var(rp ) = XpVXp

Where Xp = [ Xp1, Xp2,.........Xpn] and
Cov(rp, rq) = XpVXq

Decomposing the formula we obtain:
Var(rp)=XiXjij= Xi2i2 + XiXj ij
i ji
= (Contribution of own variances) +
(contribution of covariance)
A portfolio with equal weights has
constant weight on all stocks, where Xi
= Xj = 1/n
The n is the number of stocks. The
sum of these weights is equal to one.
It is a very simple to understand how a
particular stock makes contribution to
the expected return or to its covariance
of a portfolio. For example, if we
expect, return of a stock is high, we
can increase the expected return in a
proportional manner by increasing the
weight of that stock.
The part associated with its beta for a
stocks variance is often called as the
stocks:
- arket risk
- systematic risk
- non-diversifiable risk
And the part associated with the
the:
- residual risk
- firm specific risk
- diversifiable risk
- non-systematic risk
- idiosyncratic risk
Simply putting, it is wise enough to sell
the stock which has much positive
higher error and buy the stock which
has much negative lower error.

3. Making of a Portfolio

The steps to make initial portfolio, and
to use technical analysis are as given
below:

1) The first step is the collection of the
historical data. The more the number
of data is, the better our calculation is.
Lets compute average and standard
deviation on each stock return
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2) Next step is to checking of the least
square result of market return on LHS
and each stocks return on RHS on the
CAPM equation. This can be done
through the software CAPM Tutor or
E-View to get result
3) Now the covariance table is to be
computed.
4) Using CAPM Tutor the frontier line
is to be computed
5) Setting the target for return keeping
a certain risk level, initial portfolio is to
be made..
6) The portfolio is to be restructured
toward the positive-negative direction
7) Buy stocks iff the return is below
return average
8) Sell stocks iff the return is over
return average
9) Use Markowitz technique of
analysis to find the appropriate timing
of trading the individual stocks and
keep restructuring the portfolio

4. Application of Markowitz
portfolio analysis in USA
stock market

We have chosen highly liquid
industries namely Software relations ,
computer Systems, Auto manufacture,
Airline, Chemicals, Investment Banks,
and Food Suppliers and have chosen
stocks in such a way that it is either
most under-performed or over-
performed stock based on mean-
variance bell curve. We used monthly
last trade data from January 1996 to
December 2010, and calculated the
price mean and variance (Table-1)

Calculation of Input Variables: The
expected returns are calculated as the
difference between current market
price and target of each security,
shown as a percentage of current
market prices. Monthly returns,
needed to find the co-variances are
calculated for each stock from the
monthly closing prices. The covariance
matrix for the 10 stocks is calculated
by using excel covariance function and
the monthly covariance is converted
into annual covariance by multiplying it
with 12. Re-balance is taken when
minimum two of all stock optimal
portfolio weights increased or
decreased by 1 %, compared with
previous month.
We have considered a risk-aversion
coefficient A and a skewness-
preference coefficient B in the cubic
utility function
( ) ( ) ( ) ( )
3 1 1
2 6
U r E r A Var r B E r E r = +

.
The input data is thus made ready for
the next step for the analysis. We have
used CAPM tutor to decide the weight,
for example


We have supposed the cost of trading
0.05% of actual capital movement
Software
Relations
Computer
Systems
Auto
Manufactur
e
Under-mean AVT Corp Evans & Ford Motor
stock Sutherland
Computer



Weight 3.7% -0.65% 38.99%
Over-mean

Intel Corp Sun Toyota
stock Microsystem
s
Motor
Corp
Weight 0.01% 5.19% 12.14%
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5. Portfolio Analysis

The software which is used is the
excel optimizer by Markowitz and Todd
(2000) explained in the book Mean
Variance Analysis and Portfolio
Choice.

The software requires as input the
above mentioned variables and the
lower and upper boundaries for the
ratio of each security in the portfolio
and additional constraints, if any.

The portfolio analysis is being done
with lower and upper boundaries for
investment in a single stock as zero
(zero percent) and one (100 percent)
respectively. The additional constraint
being specified is that the sum of the
ratios of all securities has to be 1 or
100%, for the amount available for
investment. We have collected the 30-
day Treasury-Bill rate as the proxy for
the risk-free rate and the monthly
return data of the CRSP value-
weighted index as a proxy for the
market portfolio

6. RESULTS AND FINDING


1200000

1000000

800000

600000

400000

200000


Graph 1 : Performance of a few
stocks in Time series


7. LIMITATAIONS

Mean-variance optimization has
several limitations which affects its
effectiveness. First, model solutions
are often sensitive to changes in the
inputs. Suppose if there is a small
increase in expected risk then it can
sometimes produce an unreasonable
large shift into stocks. Secondly, the
number of stocks that are to be
included in the analysis is normally
limited. Last but not the least,
allocation of optimal assets are as
good as the predictions of prospective
returns, correlation and risk that go
into the model.

8. CONCLUSION & FUTURE
SCOPE

Markowitzs portfolio analysis may be
operational and can be applied to real
life portfolio decisions. The optimal
portfolios constructed by this analysis
represent the optimal policy for the
investors who want to use this for
estimating target price.

Mean variance findings are so
important in portfolio theory and in
technical analysis that they bring the
common mathematical trunk of a
portfolio tree.
From the view point of theory, because
market is random, the skewed
distribution becomes simply noise of
market. The technical analysis, on the
other hand, particularly in momentum
analysis, keeps the distortion as an
investment opportunity. So, it might not
be possible to be complicated with
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Oct. 31
each other. However, in the world of
real trading, performance is itself the
most important matter in any case, so
it is better to utilize the each specific
character.

Finally, the investigation tells that the
adroit utilization of technical analysis
would contribute high-performance
and stabilization in real trading. I used
the example of mean variance
investigation, but technical tool
application and comprehension are
surely key factor of an individual
performance.

The software for portfolio analysis, the
Todds program can be operated with
256 companies. In any particular case,
brokers normally do not give more
than 256 buy recommendations at any
point in time. Hence, the software
program is not a limitation. But
certainly there is scope to improve the
software, as more investors may use
the methodology, and thereby need
easy to use and efficient software
combined with more facilities to come
out with various measurements.

Table 1
An example of selected 10 stocks in
USA stock market

































Symbo
l
Company Name LAST Mean Varian
ce
Stdev Bell
Positio
n
GM General Motors Corporation 80.1
25
64.48
974
77.27
004
8.790
338
1.77
9 HMC Honda Motor Co., Ltd. 70.56
25
75.73
484
75.13
075
8.66
78
-
0.59
7
ESCC Evans & Sutherland Computer
Corporation
11.6
25
17.29
817
30.56
043
5.528
149
-
1.02
6
DELL DELL Computer 57.68
75
36.08
401
87.91
632
9.376
37
2.30
4 WCO
M

MCI Worldcom 43.18
75

45.70
229

121.9
327

11.04
231

-
0.22
8
ACNA
F
Air Canada

10.6
25
5.490
169
4.332
692
2.081
512
2.46
7 AMR AMR Corporation 30 27.79
872
12.01
035
3.465
595
0.63
5 SUNW Sun Microsystems, Inc. 96.1
25
33.68
026
607.1
716
24.64
085
2.53
4 BAC Bank of America Corporation 50 64.11
428
109.2
709
10.45
327
-
1.35
0
BK Bank of New York Company, Inc. 38.68
75
34.65
055
15.05
585
3.880
186
1.04
0
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