Principles of Modern Portfolio Theory

Portfolio selection is very different from the selection of securities. According to Markowitz, a good portfolio is not a long list consisting of a large number of stocks and bonds. Essentially, the theory aimed to create the best portfolio to meet the needs of the investor . The basic point emphasized by Markowitz is that diversification is not enough to make the maximum expected return and the risk of the portfolio should be kept a minimum. The point provide to add the securities whose return are negative correlation in portfolio. Therefore, the main task of the investor choose “efficient portfolios” to share the money among stock in a manner to reduce the average weight of covariance on a certain level of the expected rate of return . Modern portfolio theory based on very simple and basic ideas. However, the calculations related to the expected return and risk increases, if the number of securities in the portfolio increases. For example, a portfolio of N securities needs to be calculated correlation coefficient of [N (N-1)] / 2 units.

Uncertainty of Returns

Harry Markowitz said that investment therapist should not expect to being a prophet by stating that the uncertainty is the first noticeable feature about the issue of the investment and he or she is expected to make the right choice by using the information in hand in the current environment (Kocaman 1995). Yield is the estimated values provided at the end of a period of time by an investment or a portfolio. For example, the expected return on each stock in a term can be calculated as follows (Harrington 1987, pp.58):

 

Ti: Dividends at the end of periodi Fi: market value at the end of periodi Fi-1: market price of the previous period.

Estimated values is equivalent to the values that occur rarely. Th e degree of inaccuracy of the estimates or the inexact status of the estimates is measured by variance. Variance measures the width of the distribution of expected returns from investment. The correlation coefficient takes values between +1 and -1

Correlation Coefficient (+1)

To limit the risk of the portfolio is not possible in the case of being a full correlation between the returns of securities in the portfolio (CAB=1). Because the prices of securities in the portfolio varies in the same direction. In other words, the portfolio is composed of a single securities.

Correlation Coefficient (0)

If there is no relationship between securities returns in the portfolio, the portfolio risk can be reduced by using diversification.

Correlation Coefficient (-1)

The probability of the negative relationship between returns of the securities is a rare situation. In case of a negative correlation coefficient, portfolio risk can be downloaded to a minimum. If the correlation coefficient is -1, there is the a perfect negative correlation between the securities. In this case, the risk of the portfolio composition of a particular stock will be zero. In the portfolio diversification the correlation coefficient between securities is desirable at a value close to -1 or -1. However, the market is not always possible to find it. The situation in which correlation coefficient is -1 is possible to show with the following figures.

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