POSSIBILITIES OF APPLYING MARKOWITZ PORTFOLIO THEORY ON THE CROATIAN CAPITAL MARKET Dubravka Pekanov Starčević, Ph.D. J. J. Strossmayer University of Osijek, Faculty of Economics in Osijek E-mail: [email protected] Ana ZRNIć, Ph.D. Student, J. J. Strossmayer University of Osijek, Faculty of Economics in Osijek E-mail: [email protected] Tamara Jakšić, BEcon, student J. J. Strossmayer University of Osijek, Faculty of Economics in Osijek E-mail: [email protected] POSSIBILITIES OF APPLYING MARKOWITZ PORTFOLIO THEORY ON THE CROATIAN CAPITAL... MARKOWITZ PORTFOLIO THEORY ON THE CROATIAN POSSIBILITIES OF APPLYING Abstract In order to achieve the maximum possible profit by taking the lowest possible risk, investors build a stock portfolio consisting of a specific number of stocks which, according to the principle of diversification, significantly reduce the risk of loss. To build a portfolio, in developed capital markets investors have used the Markowitz portfolio optimization model for many years that enables us to find an optimal risk-return trade-off by selecting certain stock combinations. Despite the development of the Zagreb Stock Exchange, i.e., the central trading venue in the Republic of Croatia, the Croatian capital market is still under- developed. It is characterized by numerous shortcomings such as low liquidity, lack of transparency, high stock price volatility and insufficient traffic. Accord- ingly, the aim of this paper is to provide an insight into the functioning of the Dubravka Pekanov Starčević • Ana Zrnić • Tamara Jakšić: Dubravka Pekanov Starčević • Ana Zrnić Tamara 520 Croatian capital market and to examine the possibility of building an optimal stock portfolio by using the Markowitz model. The analysis was carried out on a sample of seventeen stocks of companies listed on Zagreb Stock Exchange, which were taken for analysis on the basis of the following criteria: liquidity, affiliation to certain sectors and a positive financial result. The results have shown that underdeveloped capital markets, like the Croatian capital market, have some shortcomings that are, to a greater or lesser extent, problems in the proper application of the Markowitz model. Keywords: stock portfolio, Croatian capital market, Markowitz portfolio op- timization model, risk diversification, efficient frontier JEL Classification: G11, O16 1. INTRODUCTION In recent times, entities have started to move away from traditional forms of saving in banks and invest their money in capital market instruments. The capital market is a meeting place for supply and demand of long-term securities - stocks and bonds. Regardless of the type of securities an investor invests in, each investor aims at earning profits in the future. However, they are aware of the fact that such investments carry a certain risk of loss. Given their attitude to risk, investors may be risk-averse, they may be more prone to risk or completely indifferent to risk. Taking a greater risk offers the possibility of achieving higher total returns and vice versa. When investing, investors should take into account the principle of diversification. In other words, they need to invest in a variety of different securities, thus reducing the risk of losing the funds invested. The fundamental question is how to find a combination of securities that will allow a maximum return to being achieved at an acceptable level of risk. In 1952, Harry Max Markowitz developed a model that allows for finding an optimal risk-return trade-off by selecting a particular combination of securities. By applying the model, investors can build an optimal portfolio that will consist of those securities that promise the highest possible return at the level of risk they are willing to accept. The model is based on several basic assumptions, such as returns that are normally distributed, the existence of rational inves- tors and the existence of a liquid and efficient market. Although there has been a lot of criticism of the applicability of the model, it has been applied in more INTERDISCIPLINARY MANAGEMENT RESEARCH XV 521 developed markets for many years and it is used as a basis for developing new, more complex models. Due to numerous recent crises in capital markets, it is very important for investors to make a good investment decision in order to protect themselves from potential investment losses. The application of the Markowitz model for the purpose of finding an optimal portfolio is certainly efficient in more favor- able market conditions, but its applicability is questionable in underdeveloped markets, such as the Croatian market, that do not meet the basic assumptions of the model. This paper analyses the application of the Markowitz model to the Croatian capital market. Despite the development of the Zagreb Stock Exchange as the cen- tral trading venue in the Republic of Croatia, the Croatian capital market is still underdeveloped. It is characterized by numerous shortcomings such as low liquid- ity, lack of transparency, high stock price volatility and insufficient traffic. Accord- ingly, the aim of this paper is to determine whether, despite the aforementioned problems, the model can provide satisfactory results. The aim is also to clarify the theoretical assumptions of the Markowitz model and its applications, provide an insight into the situation on the Croatian capital market and examine the possibil- ity of building an optimal stock portfolio by using the Markowitz model. Four research hypotheses have been set up according to the research subject. The main hypotheses: • The Markowitz model is applicable to the Croatian capital market. POSSIBILITIES OF APPLYING MARKOWITZ PORTFOLIO THEORY ON THE CROATIAN CAPITAL... MARKOWITZ PORTFOLIO THEORY ON THE CROATIAN POSSIBILITIES OF APPLYING • An increased number of stocks in the portfolio reduces the overall risk. Auxiliary hypotheses: • All joint stock companies whose shares are part of the CROBEX index achieved a positive financial result in 2017. • The selected optimal portfolio will be sectorally diversified. 2. LITERATURE REVIEW When building a portfolio, most investors want to take advantage of the ben- efits of diversification in order to achieve the expected return with the least risk possible. The key issue here is how to determine and measure the optimal risk- return trade-off. Fabozzi et al. (2002) state that the trade-off between risk and return is explained by modern portfolio theory (MPT). Harry Max Markowitz Dubravka Pekanov Starčević • Ana Zrnić • Tamara Jakšić: Dubravka Pekanov Starčević • Ana Zrnić Tamara 522 is considered the founder of modern portfolio theory. Although the fundamen- tals of the portfolio model were set up in 1952, seven years later, he developed a theory according to which it is possible to achieve the optimal risk-return trade- off by selecting a certain combination of securities. Xia et al. (2000) state that the basis of the Markowitz model is to achieve the expected return of a portfolio as return on investment and variance of the expected return of a portfolio as invest- ment risk. Accordingly, Wang & Zhu (2002) indicate that every investor has the following two goals: to maximize the expected return and to minimize portfolio risks. Therefore, the Markowitz model is a mathematical model that enables us to find such a combination of securities that will enable investors to achieve the highest possible return at the level of risk they are willing to accept. A portfolio consisting of such securities is called an efficient portfolio. An efficient portfolio is a portfolio that, among all combinations of the same level of risk, promises the highest return, i.e., the one which, of all combinations, gives the same return at the lowest risk (Sharpe; 1963, 278; Mao & Särndal; 1966, 324). The Markowitz model (1952) is based on several basic assumptions: returns on stocks are normally distributed, investors want to maximise their economic utility, investors are rational and risk-averse, investors are well informed about all relevant facts necessary to make an investment decision, there are neither transaction nor tax costs and securities are perfectly divisible. One of the as- sumptions of the model is that investors are risk-averse and that they wish to maximise their profit or wealth. Steinbach (2001) explains that the final issue in the portfolio selection context is related to how investors forecast the future, which is presented by the probability of property restitution. If the investors have to choose between two securities that will enable them to achieve the same return, they will choose the one with a lower risk of loss. The investors will be prepared to assume a higher risk only if it will enable them to achieve a much higher return. Hence, when selecting a portfolio, a rational investor will always invest in the portfolio with the best trade-off between risk and return, i.e., in the one that yields a higher expected return for the same level of risk. Although the Markowitz model is one of the most significant innovations in the area of​​ portfolio construction, his basic assumptions have been criticised. Jerončić & Aljinović (2011) criticise the assumption referring to returns on stocks that are normally distributed since they are the result of prices formed by market forces that are not random but are based on economic rules as well as investor’s forecasts and expectations. This deviation from normal distribution becomes INTERDISCIPLINARY MANAGEMENT RESEARCH XV 523 evident during the economic crisis or exceptional economic progress. It is also considered that the assumption about risk-averse investors is not fully accurate, that investors cannot be fully informed and have at their disposal all the facts necessary to make a good investment decision. Omisore et al. (2011) point out that the theory does not take into account the personal, ecological, strategic or social dimensions of investment decisions. An obstacle to the model includes the absence of transaction and tax costs and the assumption that securities can be perfectly divisible.