Diversification Case

Introduction:

The passive portfolio is a portfolio that is constructed upon the principle of diversification, and the goal is to match the particular market index's return, and it can be altered when only market index is altered, this is also known as buy-and hold strategy to construct a portfolio.

The basic technique to select the portfolio under passive strategy is Markowitz Portfolio Selection Model 1952, other techniques or alternative techniques are

Geometric mean return, Safety First, Stochastic Dominance and Return Distribution.

Passive portfolio strategy is based on Random Walk theory 1953,he proposed that stock prices follow a random path and that these random movements indicate efficient market. Market efficiency is of three types i-e weak form efficiency ,semi -strong form efficiency and strong form.

Under passive portfolio management your aim is to match the performance of the market and you can accomplish this aim by minimizing the tracking assets

Tracking error ∆t=∑wi Ri -Rb

Return of the portfolio subtracted from return of the bench mark index tracking error is as close to as zero.

If the EMH does exist this implies that return for gathering information is zero and there would be no reason to actively trade. Supply and demand will not interact and market will collapse.

Markowitz portfolio selection model 1952

The Markowitz portfolio selection model provides the basis for the modern portfolio theory, in this model he showed how to reduce the standard deviation on assets in a portfolio by selecting assets which don't move in same direction i-e they are negatively correlated.

He advised to identify those assets which give maximum return for a given level of risk and then form portfolio by combining these assets. His model consist of a

A quadratic programming equation which tends to minimize the risk associated with each possible expected rate of return subject to the constraint of an efficiency frontier.

He considers that for an investor return is a desirable thing and risk is not desirable for an investor. He proposed that the investor put all his wealth in funds which have greater discounted values and if two or more securities have greater discounted values any of these or any combination of these are as good as other.

He said that stock followed a pattern of normal distribution and historical returns of the assets over some specified period of time is available with the help of which calculate the logramathic returns of those assets and then perform risk adjusted analysis of the stock to select the stock which gives lower risk at certain return, the basic aim is to maximize the utility of investor that can be done by maximizing the Sharpe Ratio and minimize the