The Validity of Modern Portfolio Theory: Evidence From the Nairobi Securities Exchange

Abstract

There are several researchers Markowitz (1991), Elton and Gruber (1997) that discuss the main issues that an investor faces when investing such as how to allocate resources among the variety of different securities. These issues have led to the discussion of portfolio thtories especially the Modem Portfolio theory (MPT). This study therefore seeks to form a an optimal portfolio from the NSE 20 Share Index to investigate if an investor can apply MPT in order to achieve a higher return than investing in an index portfolio( market portfolio).

Combining a strong portfolio that beat the market in the long run would be the ultimate goal for most investors. The theories that are used to analyze the problem and the empirical findings provide the essential concepts such as the standard deviation and returns of the portfolio. Further Sharpe ratio was used to achieve the optimal portfolio. The methodology constitutes of the following: the study made use of the descriptive research design. From a population of 20 companies from the NSE 20 share index, an optimal portfolio of eight companies from each sector of the index was constructed. All 20 companies were put through screen so as to come up with one company from each sector. Other companies did not meet the screen were dropped from the portfolio.

The screen was based on the most efficient security- the one with the highest return for a given level of risk, or a security from each sector with the highest Sharpe ratio was included in the portfolio. Monthly returns were calculated for the two portfolios and Sharpe measure was also used to measure their performance .The benchmark that was used to compare the result from the portfolio is the NSE -20 Share Index. This Index reflects the market as a whole.

The findings from the study indicated that the optimal portfolio outperform the market portfolio (NSE 20 Share Index Benchmark) during the selected timeframe. The Sharpe measure was in favor of the optimal portfolio. Finally it was concluded that optimal portfolio with the guidance of the MPT can surpass the NSE 20 Share Index within the selected timeframe and it has been recommended that creation of new market portfolio to be compared with different efficient portfolios would give a better result.