What are the basic assumptions behind the Markowitz portfolio theory?
Answers
Answer:
Explanation:
The Portfolio Theory of Markowitz is based on the following assumptions:
(1) Investors are rational and behave in a manner as to maximise their utility with a given level of income or money.
(2) Investors have free access to fair and correct information on the returns and risk.
(3) The markets are efficient and absorb the information quickly and perfectly.
(4) Investors are risk averse and try to minimise the risk and maximise return.
(5) Investors base decisions on expected returns and variance or standard deviation of these returns from the mean.
(6) Investors choose higher returns to lower returns for a given level of risk.
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A portfolio of assets under the above assumptions is considered efficient if no other asset or portfolio of assets offers a higher expected return with the same or lower risk or lower risk with the same or higher expected return. Diversification of securities is one method by which the above objectives can be secured. The unsystematic and company related risk can be reduced by diversification into various securities and assets whose variability is different and offsetting or put in different words which are negatively correlated or not correlated at all.
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Assumptions of Modern Portfolio Theory
At the heart of MPT is the idea that risk and return are directly linked, meaning that an investor must take on higher risk to achieve greater expected returns.