The Markowitz Portfolio Theory
Concept of Expected Risk and Expected Rates of Return
Creating an optimum portfolio doesn't involve simply finding the best risk vs. return situations, but considering varying relationships between different asset classes.
In the early 1960s, there was much contemplation among investment industry professionals about risk and its implications on selecting specific securities and other types of assets when constructing an optimum portfolio. Yet, there were also no effective means or models of measuring risk available at the time. By the same token, it was very clear that to construct the optimum portfolio, capable of meeting an investor’s investment objectives within the constraints of his or her chosen investment horizon, was not going to be possible without adquate and quantifiable measures of risk.
Prompted by this largely unmet need, Harry M. Markowitz introduced the preliminary portfolio model in a paper titled Portfolio Selection, which he had published in the 1952 Journal of Finance. Markowitz was further credited with the formulation of two terms critical to the development of the portfolio theory: the expected rate of return and the expected risk measure. Note that almost four decades after publishing Portfolio Selection, Markowitz shared a Nobel Prize with Merton Miller and William Sharpe for his contribution to the development of what has become known as the capital market theory.
Investor Behavior Assumptions
The Markowitz Portfolio Theory relies on a number of assumptions regarding investor behavior; such is that investors will always seek “the second opinion.” When presented with a spectrum of alternatives, investors will consider all expected rates of return over a specified holding period.
Furthermore, investors are very much interested to know the estimated risk level of all securities contained within a portfolio. In fact, we could say that their investment decisions are solely based on these two variables: the levels of expected return and the expected risk.
Notably, for any given risk level, investors will always rather go for portfolios with higher expected returns than for those with lower returns. Alternatively, for any given expected return level, investors are likely to prefer portfolios with less risk than those with more risk.
Based on these assumptions, most of which are pretty much common sense, when comparing a single security or a portfolio of securities, only securities or portfolios with the highest expected return at the same or lower risk level are considered as efficient.
The Efficient Frontier
The Markowitz Portfolio Theory also examines the curve called the efficient frontier. The idea behind this curve is a graphic presentation of a set of portfolios that offer the maximum rate of return for any given level of risk. Alternatively, the efficient frontier identifies portfolios that offer the minimum risk for any given level of return.
The Markowitz efficient investor will seek his or hers optimum portfolio somewhere along the efficient frontier curve, depending on their individual perception of the return-risk relationship. Each portfolio on the curve will either have a higher rate of return for the same or lower risk, or lower risk for an equal or better rate of return when compared to portfolios or securities that are not on the efficient frontier.
Because portfolios enjoy benefits of diversification due to imperfectly correlated assets contained within them, the efficient frontier is really made up of portfolios rather than individual securities or assets. The two potential exemptions would be the efficient frontier curve’s end points, at the beginning of which could be the asset with the lowest risk and at the end of which could be the asset with the highest return.
What Harry Markowitz started back in the early 1960s was continued through the development of the capital market theory, whose final product, the capital asset pricing model (CAPM), allowed a Markowitz efficient investor to estimate the required rate of return for any risky security or asset.
(Source: Investment Analysis and Portfolio Management, Eighth Edition, by Frank K. Reilly and Keith C. Brown, 2005)
