Portfolio Theory

Explained: Markowitz, Harry modern portfolio theory portfolio theory

Modern portfolio theory (MPT)—or portfolio theory—was introduced by Harry Markowitz with his paper "Portfolio Selection," which appeared in the 1952 Journal of Finance. Thirty-eight years later, he shared a Nobel Prize with Merton Miller and William Sharpe for what has become a broad theory for portfolio selection.

Prior to Markowitz's work, investors focused on assessing the risks and rewards of individual securities in constructing their portfolios. Standard investment advice was to identify those securities that offered the best opportunities for gain with the least risk and then construct a portfolio from these. Following this advice, an investor might conclude that railroad stocks all offered good risk-reward characteristics and compile a portfolio entirely from these. Intuitively, this would be foolish. Markowitz formalized this intuition. Detailing a mathematics of diversification, he proposed that investors focus on selecting portfolios based on their overall risk-reward characteristics instead of merely compiling portfolios from securities that each individually have attractive risk-reward characteristics. In a nutshell, inventors should select portfolios not individual securities.

If we treat single-period returns for various securities as random variables, we can assign them expected values, standard deviations and correlations. Based on these, we can calculate the expected return and volatility of any portfolio constructed with those securities. We may treat volatility and expected return as proxy's for risk and reward. Out of the entire universe of possible portfolios, certain ones will optimally balance risk and reward. These comprise what Markowitz called an efficient frontier of portfolios. An investor should select a portfolio that lies on the efficient frontier.

James Tobin (1958) expanded on Markowitz's work by adding a risk-free asset to the analysis. This made it possible to leverage or deleverage portfolios on the efficient frontier. This lead to the notions of a super-efficient portfolio and the capital market line. Through leverage, portfolios on the capital market line are able to outperform portfolio on the efficient frontier.

Sharpe (1964) formalized the capital asset pricing model (CAPM). This makes strong assumptions that lead to interesting conclusions. Not only does the market portfolio sit on the efficient frontier, but it is actually Tobin's super-efficient portfolio. According to CAPM, all investors should hold the market portfolio, leveraged or de-leveraged with positions in the risk-free asset. CAPM also introduced beta and relates an asset's expected return to its beta.

Portfolio theory provides a broad context for understanding the interactions of systematic risk and reward. It has profoundly shaped how institutional portfolios are managed, and motivated the use of passive investment management techniques. The mathematics of portfolio theory is used extensively in financial risk management and was a theoretical precursor for today's value-at-risk measures.

Related Internal Links
capital asset pricing model—an influential model that concludes that all investors should hold the market portfolio. capital market line—a set of portfolios obtainable by leveraging or deleveraging positions in a "super-efficient" portfolio. efficient frontier—a set of portfolios that each maximize expected return for a given level of risk. hedging and diversification Two techniques for reducing a portfolio's risk. investment management The process of investing a portfolio on an ongoing basis. market risk Exposure to the uncertain market value of a portfolio. mutual fund A pooled investment vehicle that allows many parties to collectively invest in a professionally managed portfolio of assets.
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Related Books
The following books offer different perspectives on portfolio theory. Bernstein (1993) is a must-read history of finance during the 20th century. Body, Kane and Marcus (2004) is the standard university text on finance. For the practitioner's perspective, see Fabozzi and Markowitz (2002). Now a classic, Markowitz (1959) is Harry Markowitz's original book on portfolio theory. Capital Ideas Peter L. Bernstein quality   technical   1993   Investments Zvi Bodie, Alex Kane, Alan J. Marcus quality   technical   2004   Theory and Practice of Investment Management Frank J. Fabozzi and Harry M. Markowitz quality   technical   2002   Portfolio Selection Harry Markowitz quality   technical   1959
Cited Papers
Markowitz, Harry M. (1952). Portfolio selection, Journal of Finance, 7 (1), 77-91. Sharpe, William F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk, Journal of Finance, 19 (3), 425-442. Tobin, James (1958). Liquidity preference as behavior towards risk, The Review of Economic Studies, 25, 65-86.
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Related Papers
Markowitz, Harry M. (1999). The early history of portfolio theory: 1600-1960, Financial Analysts Journal, 55 (4), 5-16.
Related Forum Discussions
CAPM & normal distribution 28 Jan 2005 Does portfolio theory assume asset returns are normally distributed?
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