Markowitzs Mean Variance Model

Mean Variance Model was the first step in the direction of systematic allocation of funds in different financial securities. This model favours to construct the portfolio rather to invest all funds in one security. Investing in security is more risky compared to investment in portfolio. If all the fund is allocated to single security it is likely that its value will directly affected by the variability in market. Investors will experience high fluctuations in the return of security which will pose risk the investor.  Mean Variance model is widely used in formulation highly diversified portfolios like Hedge Funds.

Portfolio ReturnAccording to Mean Variance Model Portfolio Return is the Weighted Average Return of individual stocks in the Portfolio.
N

Rp !

w E (R )
i i i !1

Portfolio Risk-

Mean Variance Model stats that when two or more securities are combined in the portfolio there is need to consider interactive risk or covariance. If the rate of return of two or more securities moves together, their interactive risk or covariance is positive. On the other hand if the rate of return of securities is independent, interactive risk is zero.
W 2 ! wi wj Covarinace ij

j ij

r W iW

Correlation Matrix- Correlation matrix in Mean Variance Model depicts the correlation coefficient of various stocks in the portfolio.
BSNL BSNL VSNL RE Infosys Wipro Cadila SBI PNB ABB ACC 1 0.80 0.40 0.20 0.10 -0.50 0.30 0.97 0.20 0.10 1 0.50 0.30 -0.30 -0.40 0.10 0.70 0.40 0.70 1 0.20 0.50 -0.40 -0.20 0.10 0.40 -0.20 1 0.30 0.20 0.10 0.40 -0.20 0.40 1 0.10 -0.30 0.20 0.50 0.30 1 0.40 0.60 -0.70 -0.60 1 -0.40 -0.30 -0.20 1 0.10 0.40 1 0.50 1 VSNL RE Infosys Wipro Cadila SBI PNB ABB ACC

Formulation of Portfolio
Total Investment= Rs. 1,00,000/Stock 1 Stock 2 E(R) 10% 12% S.D 10 15 Invest 20,000 40,000
N p

Stock 3 8% 5 40,000
r W iW

st1 st1 st2 st3 1 0.30 0.50

st2 1 0.40

st3

i!1

j ij

2 p

! w 1 w 1 r 1 . 1W 1W
2 3

 w 1 w 2 r 1 . 2 W 1W
1

 w 1 w 3 r 1 . 3 W 1W
3 2

 w 2 w 2 r 2 .2 W 2W  w 3 w 3 r 3 . 3 W 3W

 w 2 w 1 r 2 . 1W 2 W  w 3 w 1 r 3 . 1W 3 W
1

 w 2 w 3 r 2 .3W 2W  w 3 w 2 r 3 . 2 W 3W

Portfolio E(R)= 0.20*10+0.40*12+0.40*8=10% Pt Risk = 0.20*0.20*1*10*10+0.20*0.40*0.30*10*15+0.20*0.40*0.50*10*5 +0.40*0.40*1*15*15+0.40*0.20*0.30*15*10+0.40*0.40*0.40*15*5 +0.40*0.40*1*5*5+0.40*0.20*0.50*5*10+0.40*0.40*0.40*5*15 =64.8 or 8.0

Efficient Market Frontier

Efficient frontier show the risk and return trade off of investors. Any portfolios below this line are not efficient enough in providing adequate profit based on the risk level. Portfolios that lie low on the line have lower risk but also a lower rate of return, portfolios higher on the line carry greater risk but can produce a bigger return.