Portfolio Selection using Cointegration and Modern Portfolio Theory: An Applicationto the Colombo Stock Exchange

Profitable stock market investments have never been easy due to the lack ofpredictability and higher risk of stock returns. Hence the necessity of portfolio selectionhas arisen in order to find the ideal portfolio which best suits the stock market behavior.This study aims at devising the ideal sector portfolio and identifying a better strategy fordeveloping the ideal sector portfolio in the Colombo Stock Exchange (CSE). It covers aperiod when CSE was one of the best performing stock exchanges in the world; the postcivil war period in Sri Lanka. In this study better portfolios were derived from twostrategies: (1) Cointegration approach; and (2) Modern Portfolio Theory (includingCapital Market Theory) where both are widely used to derive portfolios related to stockmarket trading. Then the performances of the better portfolios derived were compared bymeans of the Sharpe Ratio, Information Ratio, Return and Risk in order to determine theideal portfolio as well as the better strategy. Final conclusion of the study states that“Market portfolio” obtained from the Modern Portfolio Theory performs better than “BestCointegrated portfolio” obtained from the Cointegration approach in the consideredperiod of time by dominating most of the comparison measures. Also the ideal portfolioconsisted of eight sectors out of twenty sectors in CSE with varying weight percentages.Further the best portfolio selection method between the two strategies could have beenobtained regardless the period if the methodology is implemented for several StockExchanges. However, limitations in accessing necessary data prevented thisimplementation in the study.