Letter of Transmittal

August 7, 2018
Dr. M. Farid Ahmed
Professor
Department of Finance
University of Dhaka

Subject: Submission of Term Paper

Dear Sir
It is a great pleasure for me to submit the term paper on the topic of - “Portfolio Management”
that you have asked to prepare on class lecture. I have prepared this report, as mandatory
requirement of the course - “Investment Analysis (F-604)”. To make this report up to the
standard, I have tried my level best to fulfill the requirements by implementing the knowledge
that I have gathered from class.

Thank you very much for giving me the opportunity and necessary guidance as well as direction
which were needed to prepare this type of report.
I express my heart full gratitude to you to go through this report and make your valuable
comments.

Sincerely yours,
Rifat Bin Helal
ID# 37069
 Executive Summary

Portfolio management is an essential concept in the field of investment. The purpose of this
report is to provide a brief explanation of the steps involved in the portfolio management
process, Markowitz’s portfolio theory, how this theory can be applied to create efficient
investment portfolio, the market portfolio, the importance of the capital market line and security
market line and the selection of optimal portfolios. The report includes an understanding of the
basic portfolio theory with its underlying assumptions, the mathematical representation of the
model with the calculations of alternative risk and expected rate of return measures and the
derivation of the efficient frontier. The central objective of the report is to demonstrate the
importance of diversification and how investors can apply the portfolio theory to actually create
an efficient, well-diversified optimum portfolio.
Portfolio of Assets

Portfolio means a combination of financial assets and physical assets. The financial assets are
shares, debentures and other securities while physical assets include gold, silver, real estates, rare
collections, etc. So, an investment portfolio is a collection of different asset classes such as
stocks, bonds, mutual funds, cash equivalents, real estate etc. Many different types of securities
can be used to build a diversified portfolio, but stocks, bonds and cash are generally considered a
portfolio's core building blocks. The essence of portfolio is that assets are held for investment
purposes and not for consumption purposes. These different types of investments are held
together to accomplish an appropriate risk-return portfolio allocation. An investment portfolio is
constructed based on the expected return, the risk that the investor is willing to accept and the
level of liquidity. Portfolios can be held directly by investors or can be managed by professional
fund managers or portfolio managers. Investors should construct an investment portfolio in
accordance with risk tolerance and investing objectives and constraints.

Definition of Portfolio Management

Portfolio management can be defined as, “the process of selecting a bunch of securities that
provides the investing agency a maximum return for a given level of risk or alternatively ensures
minimum risk for a given level of return.” Investment portfolio composing securities that yield a
maximum return for given levels of risk or minimum risk for given levels of returns are termed
as “efficient portfolio”.

The investors, through portfolio management, attempt to maximize their expected return
consistent with individually acceptable portfolio risk. Portfolio management thus refers to
investment of funds in such combination of different securities in which the total risk of portfolio
is minimized while expecting maximum return from it. As returns and prices of all securities do
not move exactly together, variability in one security will be offset by the reverse variability in
some other security. Ultimately, the overall risk of the investor will be diversified.

Steps in the Portfolio Management Process

Portfolio management process is an on-going way of managing an investor’s portfolio of assets.

There are various components and sub-components of the process that ensure a portfolio is
tailored to meet the client’s investment objectives well within his constraints. Portfolio managers
need to chart out specific strategies for the portfolio management to maintain the risk-return
trade-off. The portfolio management process is an integrated compilation of steps implemented
in a consistent way to create and manage a suitable portfolio of assets to achieve client’s
specified goals. The portfolio management process has the following steps:
1. Identification of Investment Objectives and Constraints: The identification of the
investor’s objectives and investment constraints is the foremost task in the portfolio
management process. The portfolio managers should focus on the objectives and
constraints of an investor in the first place. The objective of an investor may be regular
income with minimum level of risk, or capital appreciations or future provisions.
Similarly, there can be various constraints to investment such as, liquidity needs or time
horizon. The relative importance of both the objectives and constraints should be
properly specified at this stage.
2. Investment Policy Statement: Once the objectives and constraints are identified, the
next task is to state the investment policy of the investor. This is a road map and all
investment decisions are based on the policy statement to ensure that they are appropriate
for the investor.
3. Formulate Capital Market Expectations: The third step is to form expectations
regarding the capital markets. This security analysis involves both micro analysis and
macro analysis. For example, analyzing one security is micro analysis. On the other hand,
macro analysis is the analysis of all the securities in the market. Fundamental analysis
and technical analysis helps to identify the securities that can be included in portfolio of
an investor. Risk and return of various asset classes are forecasted over a long term to
choose portfolios that either maximizes the expected return for certain levels of risk or
minimize the portfolio risk for certain levels of expected return.
4. Selecting the Asset Mix: The next major step in portfolio management process is
identifying the different assets that can be included in portfolio in order to spread risk and
minimize loss. The expectation of the capital markets is combined with decided
investment allocation strategy to choose specific assets for the investor’s portfolio.
Generally, the portfolio managers use the portfolio optimization technique while deciding
the portfolio composition. In this step, the relationship between securities has to be
clearly specified. Portfolio may contain the mix of preference shares, equity shares,
bonds, debentures, mutual funds etc. The percentage of the mix depends upon the risk
tolerance and investment limit of the investor.
5. Formulation of Portfolio Strategy: After certain asset mix is chosen, the next step in
the portfolio management process is formulation of an appropriate portfolio strategy.
There are two choices for the formulation of portfolio strategy, namely
i) an active portfolio strategy
ii) a passive portfolio strategy.

An active portfolio strategy attempts to earn a superior risk adjusted return by adapting to
market timing, switching from one sector to another sector according to market condition,
security selection or a combination of all of these. A passive portfolio strategy on the
other hand has a pre-determined level of exposure to risk. The portfolio is broadly
diversified and maintained strictly.
 6. Portfolio Execution: Once the portfolio composition is finalized, the portfolio is
executed. Portfolio executions are equally important as high transaction costs can reduce
the performance of the portfolio. Transaction costs include both explicit costs like taxes,
fees, commissions, etc. and implicit costs like bid-ask spread, opportunity costs, market
price impacts, etc. Hence, the execution of the portfolio needs to be appropriately timed
and well-managed.
7. Portfolio Performance Evaluation and Monitoring: The investment performance of
the portfolio must be evaluated regularly to measure the achievement of objectives and
the skill of the portfolio manager. Both absolute returns and relative returns can be used
as a measure of performance while analyzing the performance of the portfolio.
The portfolio manager needs to monitor and evaluate risk exposures of the portfolio and
compares it with the strategic asset allocation. This is required to ensure that investment
objectives and constraints are being achieved. The manager monitors the investor’s
circumstances, economic fundamentals and market conditions. Portfolio rebalancing
should also consider taxes and transaction costs.

Investment Policy Statement

A policy statement is a formal written document created to govern investment decision making
after taking into account the client’s objectives and constraints. This statement is formulated in
the planning stage of the portfolio management process. It carries significance important in the
construction and implementation of an effective and well diversified portfolio.

Role: Investment policy statement has the following roles to play:

 Endorse long-term discipline in all the portfolio decisions.

 Easily implemented by both current as well as future investment advisors.
 Protect against short-term portfolio reallocation in case the changing markets or the
performance of the portfolio causes overconfidence or panic.

Elements: An investment policy statement has these following elements:

 A complete client description providing enough background so that any investment

advisor can understand the client’s situation.
 A purpose with respect to investment objectives, policies, goals, portfolio limitations and
restrictions.
 Identification of responsibilities and duties of all the parties involved.
 A formal statement depicting objectives and constraints.
 A schedule for reviewing the performance of the portfolio and the policy statement.
 Ranges of asset allocation and guidelines regarding rigidity and flexibility when devising
or modifying the asset allocation.
 Instructions for adjustments in the portfolio and rebalancing.
Impact of Risk Tolerance and Time Horizon on Portfolio Asset Allocations

i) Risk Tolerance: While a financial advisor can develop a generic portfolio model for an
individual, an investor's risk tolerance should have a significant impact on what a portfolio looks
like. Risk tolerance is more than a function of an individual’s psychological makeup. It is
affected by several factors such as, a person’s current insurance coverage and cash reserves. Risk
tolerance is also affected by an individual’s family situation and by his or her age. Risk tolerance
is also influenced one’s current net worth and income expectations. Depending on their level of
risk tolerance investors might choose their portfolio investments. For example, a conservative
investor might favor a portfolio with large-cap value stocks, broad-based market index funds,
investment-grade bonds, and a position in liquid, high-grade cash equivalents. In contrast, a risk-
tolerant investor might add some small-cap growth stocks to an aggressive, large-cap growth
stock position, assume some high-yield bond exposure, and look to real estate, international and
alternative investment opportunities for his portfolio.

ii) Time Horizon: Similar to risk tolerance, investors should consider how long they have to
invest when building a portfolio. Investors should generally be moving to a more conservative
asset allocation as the goal date approaches, to protect the portfolio's principal that has been built
up to that point. Investors with long investment horizons generally require less liquidity and can
tolerate greater portfolio risk. Investors with shorter time horizons generally favor more liquid
and risky investments because losses are harder to overcome during a short time frame. For
example, an investor saving for retirement may be planning to leave the workforce in five years.
Despite the investor's comfort level investing in stocks and other risky securities, he may want to
invest a larger portion of the portfolio's balance in more conservative assets such as bonds and
cash, to help protect what has already been saved. Conversely, an individual just entering the
workforce may want to invest his entire portfolio in stocks, since he may have decades to invest,
and has the ability to ride out some of the market's short-term volatility.

Both risk tolerance and time horizon should be considered when choosing investments to fill out
a portfolio.
Portfolio Management Strategies
Portfolio Management Strategies refer to the approaches that are applied for the efficient
portfolio management in order to generate the highest possible returns at lowest possible risks.
There are two basic approaches for portfolio management including: Active Portfolio
Management Strategy and Passive Portfolio Management Strategy.

A) Active Portfolio Management Strategy

The active portfolio management relies on the fact that particular style of analysis or
management can generate returns that can beat the market. It involves higher than average costs
and it stresses on taking advantage of market inefficiencies. It is implemented by the advices of
analysts and managers who analyze and evaluate market for the presence of inefficiencies.

The active management approach of the portfolio management involves the following styles of
the stock selection.

I) Top-down Approach: In this approach, managers observe the market as a whole and decide
about the industries and sectors that are expected to perform well in the ongoing economic cycle.
After the decision is made on the sectors, the specific stocks are selected on the basis of
companies that are expected to perform well in that particular sector.

II) Bottom-up: In this approach, the market conditions and expected trends are ignored and the
evaluations of the companies are based on the strength of their product pipeline, financial
statements, or any other criteria. It stresses the fact that strong companies perform well
irrespective of the prevailing market or economic conditions.

B) Passive Portfolio Management Strategy

Passive asset management relies on the fact that markets are efficient and it is not possible to
beat the market returns regularly over time and best returns are obtained from the low cost
investments kept for the long term.

The passive management approach of the portfolio management involves the following styles of
the stock selection.
I) Efficient Market Theory: This theory relies on the fact that the information that affects the
markets is immediately available and processed by all investors. Thus, such information is
always considered in evaluation of the market prices. The portfolio managers who follows this
theory, firmly believes that market averages cannot be beaten consistently.

II) Indexing: According to this theory, the index funds are used for taking the advantages of
efficient market theory and for creating a portfolio that impersonate a specific index. The index
funds can offer benefits over the actively managed funds because they have lower than average
expense ratios and transaction costs.

Markowitz Portfolio Theory

The basic portfolio model was developed by Harry Markowitz in 1952. Markowitz derived the
expected rate of return and an expected risk measure for a portfolio of assets. He showed that the
variance of rate of return was a meaningful measure of portfolio risk under a set of certain
assumptions. Markowitz derived the formula for computing the variance of a portfolio and
indicated the importance of diversifying and also showed how to effectively diversify.

The model is based on the following set of reasonable assumptions:

1. Investors consider each investment alternative as being represented by a probability

distribution of expected returns over a holding period.
2. Investors maximize one period expected utility, and their utility curves demonstrate
diminishing marginal utility of wealth.
3. Investors estimate the risk of portfolio on the basis of the variability of expected returns.
4. Investors base their decisions solely on expected return and risk, so their utility curves are
a function of expected return and the expected variance of returns only.
5. For a given level of risk, investors prefer higher returns to lower returns. Similarly, for a
given level of expec6ed return, investors prefer less risk to more risk.

Under these assumptions, a single asset or a portfolio of assets is considered to be efficient if no

other asset or portfolio of assets offers higher expected return with the same(or lower) risk or
lower risk with the same(or higher) expected return.
Expected Returns, Variance and Standard Deviation of a Portfolio

Expected Returns of a Portfolio

Portfolio return is the monetary return experienced by a holder of a portfolio. Portfolio returns
can be calculated on a daily or long-term basis to serve as a method of assessing a particular
investment strategy. Dividends and capital appreciation are the main components of portfolio
returns. Expected return of a portfolio is calculated as the weighted average of the likely profits
of the assets in the portfolio, weighted by the likely profits of each asset class. Expected return is
calculated by using the following formula:

Example: For a simple portfolio, of two mutual funds, one investing in stocks and the other in
bonds, if we expect the stock fund to return 10% and the bond fund to return 6% and our
allocation is 50% to each asset class, we have the following:

Expected return (portfolio) = (0.1)*(0.5) + (0.06)*(0.5) = 0.08, or 8%

The expected return for a hypothetical portfolio with four risky assets is shown in the following
tabular form:

Weight(Wi) Expected Security Expected Portfolio Return

(percent of portfolio) Return(Ri) (Wi* Ri)
0.20 0.10 0.0200
0.30 0.11 0.0330
0.30 0.12 0.0360
0.20 0.13 0.0260
E(R)port= 0.1150
Variance of a Portfolio

Variance (σ2) is a measure of the dispersion of a set of data points around their mean value. In
other words, variance is a mathematical expectation of the average squared deviations from the
mean. It is computed by finding the probability-weighted average of squared deviations from the
expected value. Variance measures the variability from an average (volatility). Volatility is a
measure of risk, so this statistic can help determine the risk an investor might take on when
purchasing a specific security. The variance of a portfolio's return is a function of the variance of
the component assets as well as the covariance between each of them. Covariance is a measure
of the degree to which returns on two risky assets move in tandem. A positive covariance means
that asset returns move together. A negative covariance means returns move inversely.
Covariance is closely related to "correlation," wherein the difference between the two is that the
latter factors in the standard deviation. Modern portfolio theory says that portfolio variance can
be reduced by choosing asset classes with a low or negative covariance, such as stocks and
bonds. This type of diversification is used to reduce risk. Portfolio variance looks at the
covariance or correlation coefficient for the securities in the portfolio. Portfolio variance is
calculated by multiplying the squared weight of each security by its corresponding variance and
adding two times the weighted average weight multiplied by the covariance of all individual
security pairs. Thus, we get the following formula to calculate portfolio variance in a simple two-
asset portfolio:

= + +2 ,

Or
= + +2 ,

For example, let’s assume a simple two asset portfolio, where,

E(R1)=0.20, E(1)= 0.10, W1= 0.50

E(R2)= 0.20, E(2)= 0.10 , W2=0.50

The correlation between the assets is, r= 0.50

So, the portfolio variance is, 0.00749956

Standard Deviation of a Portfolio

Standard deviation can be defined in two ways:

1. A measure of the dispersion of a set of data from its mean. The more spread apart the data, the
higher the deviation. Standard deviation is calculated as the square root of variance.

2. In finance, standard deviation is applied to the annual rate of return of an investment to

measure the investment's volatility. Standard deviation is also known as historical volatility and
is used by investors as a gauge for the amount of expected volatility.

Standard deviation is a statistical measurement that sheds light on historical volatility. For
example, a volatile stock will have a high standard deviation while a stable blue chip stock will
have a lower standard deviation. A large dispersion tells us how much the fund's return is
deviating from the expected normal return

Standard deviation (σ) is found by taking the square root of variance:

= + +2 ,

For example, if we take the square root of the previous variance, then the standard deviation of
the portfolio is, 0.0866.

We used a two-asset portfolio to illustrate this principle, but most portfolios contain far more
than two assets. The formula for variance becomes more complicated for multi-asset portfolios.
All terms in a covariance matrix need to be added to the calculation.
Types of Risks Associated with a Portfolio

Systematic Risk

This risk is inherent to the entire market or an entire market segment. Systematic risk, also
known as “un diversifiable risk,” “volatility” or “market risk,” affects the overall market, not just
a particular stock or industry. This type of risk is both unpredictable and impossible to
completely avoid. It cannot be mitigated through diversification, only through hedging or by
using the right asset allocation strategy.

For example, putting some assets in bonds and other assets in stocks can mitigate systematic risk
because an interest rate shift that makes bonds less valuable will tend to make stocks more
valuable, and vice versa, thus limiting the overall change in the portfolio’s value from systematic
changes. Interest rate changes, inflation, recessions and wars all represent sources of systematic
risk because they affect the entire market. Systematic risk underlies all other investment risks.

If you want to know how much systematic risk a particular security, fund or portfolio has, you
can look at its beta, which measures how volatile that investment is compared to the overall
market. A beta of greater than 1 means the investment has more systematic risk than the market,
less than 1 means less systematic risk than the market, and equal to one means the same
systematic risk as the market.

Whereas this type of risk affects a broad range of securities, unsystematic risk affects a very
specific group of securities or an individual security. Unsystematic risk can be mitigated through
diversification.

Unsystematic Risk

Company or industry specific hazard that is inherent in each investment. Unsystematic risk, also
known as “nonsystematic risk,” "specific risk," "diversifiable risk" or "residual risk," can be
reduced through diversification. By owning stocks in different companies and in different
industries, as well as by owning other types of securities such as Treasuries and municipal
securities, investors will be less affected by an event or decision that has a strong impact on one
company, industry or investment type. Examples of unsystematic risk include a new competitor,
a regulatory change, a management change and a product recall.

For example, the risk that airline industry employees will go on strike, and airline stock prices
will suffer as a result, is considered to be unsystematic risk. This risk primarily affects the airline
industry, airline companies and the companies with whom the airlines do business. It does not
affect the entire market system, so it is an “unsystematic” or “nonsystematic” risk.
An investor who owned nothing but airline stocks would face a high level of unsystematic risk.
By diversifying his or her portfolio with unrelated holdings, such as health-care stocks and retail
stocks, the investor would face less unsystematic risk. However, even a portfolio of well-
diversified assets cannot escape all risk. It will still be exposed to systematic risk, which is the
uncertainty that faces the market as a whole. Even staying out of the market completely will not
take an investor’s risk down to zero, because he or she would still face risks such as losing
money from inflation and not having enough assets to retire.

Investors may be aware of some potential sources of unsystematic risk, but it is impossible to be
aware of all of them or to know whether or when they might occur. An investor in health-care
stocks may be aware that a major shift in government regulations could affect the profitability of
the companies they are invested in, but they cannot know when new regulations will go into
effect, how the regulations might change over time or how companies will respond.

Market Portfolio

A market portfolio is a theoretical bundle of investments that includes every type of asset
available in the world financial market, with each asset weighted in proportion to its total
presence in the market. The expected return of a market portfolio is identical to the expected
return of the market as a whole. Because a market portfolio is completely diversified, it is subject
only to systematic risk, or risk that affects the market as a whole, and not to unsystematic risk,
which is the risk inherent to a particular asset class. The market portfolio exists at the point at
which the securities markets line touches the efficient frontier. The market portfolio is an
important concept from the point of view of modern portfolio theory, but it is important to note
that it is not practical to actually construct a market portfolio in this sense as it would have to
include every single available asset, not just listed securities, but all alternative investments as
well. That said, it is difficult to believe that the market portfolio would lie on the efficient
frontier if it was also not true that the portfolio of all investments in a smaller universe of
investments did not also lie on the efficient frontier of that smaller universe. This is the
justification for promoting index tracking as an investment strategy: if the above is correct, then
the optimum combination of risk and reward (e.g. the highest return for a given level of risk) will
always be produced by the market portfolio plus risk free assets, and an index tracker is the best
available proxy for the market portfolio. It also implies that the combination of risk and return
can be improved (higher return for the same risk) by expanding the universe of investments. This
is the key justification for investing globally, and for investing in alternative assets. The concept
of a market portfolio still have some importance without modern portfolio theory, but it would
not be as central, nor would it imply the same advantages for tracker funds.
As a simple example of a theoretical market portfolio, assume three companies exist: Company
A, Company B and Company C. The market capitalization of Company A is $2 billion, the
market capitalization of Company B is $5 billion, and the market capitalization of Company C is
$13 billion. Thus, the global market capitalization is $20 billion. The market portfolio consists of
each of these companies, which are weighed in the portfolio as follows:

Company A portfolio weight = $2 billion / $20 billion = 10%

Company B portfolio weight = $5 billion / $20 billion = 25%

Company C portfolio weight = $13 billion / $20 billion = 65%

The Market Portfolio in the Capital Asset Pricing Model

The market portfolio is an essential component of the capital asset pricing model (CAPM). The
CAPM shows what an asset's expected return should be based on its amount of systematic risk.
The relationship between these two items is expressed in an equation called the security market
line. The equation for the security market line is:

Expected return = Rf + B x (R(m) - R(f))

Where,

R(f) = the risk-free rate

R(m) = the expected return of the market portfolio

B = the beta of the asset in question versus the market portfolio

For example, if the risk-free rate is 3%, the expected return of the market portfolio is 10%, and
the beta of the asset with respect to the market portfolio is 1.2, the expected return of the asset is:

Expected return = 3% + 1.2 x (10% - 3%) = 3% + 8.4% = 11.4%

Economist Richard Roll suggested in a 1977 paper that it is impossible to create a truly
diversified market portfolio in practice because this portfolio would need to contain a portion of
every asset in the world, including collectibles, commodities and basically any item that has
marketable value. This is known as "Roll's Critique.
Security Market Line

Security market line (SML) is the representation of the capital asset pricing model. It displays the
expected rate of return of an individual security as a function of systematic, non-diversifiable
risk.

The Y-intercept of the SML is equal to the risk-free interest rate. The slope of the SML is equal
to the market risk premium and reflects the risk return trade off at a given time.

When used in portfolio management, the SML represents the investment's opportunity cost
(investing in a combination of the market portfolio and the risk-free asset). All the correctly
priced securities are plotted on the SML. The assets above the line are undervalued because for a
given amount of risk (beta), they yield a higher return. The assets below the line are overvalued
because for a given amount of risk, they yield a lower return.

There is a question about what the SML looks like when beta is negative. A rational investor will
accept these assets even though they yield sub-risk-free returns, because they will provide
"recession insurance" as part of a well-diversified portfolio. Therefore, the SML continues in a
straight line whether beta is positive or negative. A different way of thinking about this is that the
absolute value of beta represents the amount of risk associated with the asset, while the sign
explains when the risk occurs.
The Efficient Frontier

The efficient frontier represents the set of portfolios that has the maximum rate of return for
every given level of risk or the minimum risk for every level of return. Every portfolio that lies
on the efficient frontier has either a higher rate of return for equal risk or lower risk for an equal
rate of return than some portfolio beneath the frontier. Portfolios that lie below the efficient
frontier are sub-optimal, because they do not provide enough return for the level of risk.
Portfolios that cluster to the right of the efficient frontier are also sub-optimal, because they have
a higher level of risk for the defined rate of return. If a risk-free asset is also available, the
opportunity set is larger, and its upper boundary, the efficient frontier, is a straight line segment
emanating from the vertical axis at the value of the risk-free asset's return and tangent to the
risky-assets-only opportunity set. All portfolios between the risk-free asset and the tangency
portfolio are portfolios composed of risk-free assets and the tangency portfolio, while all
portfolios on the linear frontier above and to the right of the tangency portfolio are generated by
borrowing at the risk-free rate and investing the proceeds into the tangency portfolio.
Optimal Portfolio

One assumption in investing is that a higher degree of risk means a higher potential return.
Conversely, investors who take on a low degree of risk have a low potential return. According to
Markowitz's theory, there is an optimal portfolio that could be designed with a perfect balance
between risk and return. The optimal portfolio does not simply include securities with the highest
potential returns or low-risk securities. The optimal portfolio aims to balance securities with the
greatest potential returns with an acceptable degree of risk or securities with the lowest degree of
risk for a given level of potential return. The points on the plot of risk versus expected returns
where optimal portfolios lie is known as the efficient frontier.

Selecting Investments

Assume a risk-seeking investor uses the efficient frontier to select investments. The investor
would select securities that lie on the right end of the efficient frontier. The right end of the
efficient frontier includes securities that are expected to have a high degree of risk coupled with
high potential returns, which is suitable for highly risk-tolerant investors. Conversely, securities
that lie on the left end of the efficient frontier would be suitable for risk-averse investors.

Limitations

The efficient frontier and modern portfolio theory have many assumptions that may not properly
represent reality. For example, one of the assumptions is that asset returns follow a normal
distribution. In reality, securities may experience returns that are more than three standard
deviations away from the mean more than 0.03% of the observed values. Consequently, asset
returns are said to follow a leptokurtic distribution, or heavy tailed distribution.

Additionally, Markowitz's theory assumes investors are rational and avoid risk when possible,
there are not large enough investors to influence market prices, and investors have unlimited
access to borrowing and lending money at the risk-free interest rate. However, the market
includes irrational and risk-seeking investors, large market participants who could influence
market prices, and investors do not have unlimited access to borrowing and lending money.