Understand Markowitz’s ‘Portfolio Selection’ theory and become a rational investor

According to Markowitz’s theory, an optimal portfolio would offer a perfect balance between risk and return. It contains securities with the greatest potential returns with an acceptable level of risk

“Uplabdh hain Jo Vikalp Saare, Uname Se Sarvottam Chun Lo Mat Intzaar Karo

Jo Chaaha Hardam Hota Hi Nahi, Markowitz Ke Siddhant Ko Sweekaar Karo”

Translation: ‘Go for the best available investment option, don’t cry for the moon;

Desires rarely come true, accept the Markowitz theory, don’t be a loon.’

There used to be a popular Indian television series titled ‘Mungeri Lal Ke Hasin Sapane’ that was aired on Star Plus from 2002 to 2004. The show was based on the novel by the same name by Vibhuti Narayan Rai. It was directed by Prakash Jha. The story revolves around a middle-aged peon working in a government office in a small town in Uttar Pradesh.

The novel explores the mundane life of Mungeri Lal and his fantasies, wherein he becomes oblivious of the realities surrounding him. His dreams of a life far from reality leaves him shattered when confronted with the hard facts of life.

Let me tell you that there are many Mungeri Lals in the investment world, who simply fantasize about the returns without taking cognizance of the corresponding risks that are associated with it. Many times, they wish for the return of equity with risk of sovereign bond.

Way back in 1952, economist Harry Markowitz wrote his dissertation on “Portfolio Selection”, a paper that contained theories which transformed the landscape of portfolio management-a paper which would earn him the Nobel Prize in Economics nearly four decades later.

Markowitz theory of portfolio management:

The Markowitz theory assumes that investors are rational and behave in a manner to maximise their utility with a given level of income or money. It further assumes that investors have free access to fair and correct information on returns and risks. However, both assumptions have their own limitations. Let’s analyse these.

“Man is a rational animal” is a philosophical concept. This leads to the paradox that man can rationalise, both rational and irrational, things. Robert A Heinlein rightly says, “Man is not a rational animal, he is a rationalising animal.”

These concepts and definitions are so true in the field of finance because investors often behave in an irrational manner and go on rationalising them.

Similarly, it’s also not possible to assume that investors have free access to fair and correct information on returns and risk. There are bound to have a few investors who are privy to certain information which the investors at large do not have access to. That’s why there is so much illegal insider trading in the market.

According to Markowitz’s theory, an optimal portfolio would offer a perfect balance between risk and return. It contains securities with the greatest potential returns with an acceptable level of risk. It also features securities with the lowest degree of risk for a certain level of return. Optimal returns tend to lie along the efficient frontier.

A graphical representation of Markowitz Portfolio Theory is given below where the capital alphabet represents a portfolio (a mix of securities).

The graph that is produced is not to study the theoretical concept in detail but to understand the basics of investment.

The shaded area of the graph contains the investment opportunity set of attainable portfolio. But a rational investor in line with minimising risk and maximising return will always choose a portfolio that lies on the curve PQSVW known as the efficient frontier. Portfolios above the efficient frontier (higher level of return with same level or low level of risk) may be desirable but do not exist. These portfolios exist only in ‘Mugeri Lal Ke Hasin Sapane’. Similarly, portfolios below the efficient frontier are not desirable at all.

Conclusion:

It is advisable, whenever an investor charters a new territory of investment, he must either understand the concept of optimal portfolio by himself or take the help of a financial advisor for a fee.

If any advice comes for free, we must ponder over what Pulak Prasad has to say, “Except for filial love, nothing in life comes free.”

(The writer is executive Vice-president, SBI Funds Management Ltd; Translation and text by Manoj Kumar Sinha, senior Vice-president and Zonal Head (East), SBI Funds Management Limited)