Portfolio Theory

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Portfolio Theory</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="100%" align="left" valign="top"><p class="word_list"> <a href="#Harry Markowitz">Markowitz, Harry</a><p class="word_list"> <a href="#Modern portfolio theory">modern portfolio theory</a><p class="word_list"> <a href="#portfolio theory">portfolio theory</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <p class="body"> <img border="0" src="../images/portrait_harry_m.jpg" align="left" width="150" height="205"><b><a name="Modern portfolio theory">Modern portfolio theory</a></b> (MPT)—or <b><a name="portfolio theory">portfolio theory</a></b>—was introduced by <b><a name="Harry Markowitz">Harry Markowitz</a></b> with his paper "Portfolio Selection," which appeared in the 1952 <i>Journal of Finance</i>. Thirty-eight years later, he shared a Nobel Prize with Merton Miller and <a href="../articles/capital_asset_pricing_model.htm">William Sharpe</a> for what has become a broad theory for portfolio selection. </p> <p class="body">Prior to Markowitz's work, investors focused on assessing the <a href="../articles/risk.htm">risks</a> and rewards of individual <a href="../articles/security.htm">securities</a> 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 <a href="../articles/common_stock.htm">stocks</a> 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 <a href="../articles/hedging_and_diversification.htm">diversification</a>, 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.</p> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="left" id="table5"> <tr> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> <td width="9"> </td> </tr> </table><p class="body">If we treat single-period <a href="../articles/return.htm">returns</a> for various securities as random variables, we can assign them <a href="../articles/mean.htm">expected values</a>, <a href="../articles/standard_deviation.htm">standard deviations</a> and <a href="../articles/correlation.htm">correlations</a>. Based on these, we can calculate the expected return and <a href="../articles/volatility.htm">volatility</a> 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 <a href="../articles/efficient_frontier.htm">efficient frontier</a> of portfolios. An investor should select a portfolio that lies on the efficient frontier.</p> <p class="body">James Tobin (<a href="#Tobin">1958</a>) expanded on Markowitz's work by adding a risk-free asset to the analysis. This made it possible to <a href="../articles/leverage.htm">leverage</a> or deleverage portfolios on the efficient frontier. This lead to the notions of a <a href="../articles/capital_market_line.htm"> super-efficient portfolio</a> and the <a href="../articles/capital_market_line.htm">capital market line</a>. Through leverage, portfolios on the capital market line are able to outperform portfolio on the efficient frontier.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="right" id="table6"> <tr> <td align="right" width="9"> </td> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body">Sharpe (<a href="#Sharpe">1964</a>) formalized the <a href="../articles/capital_asset_pricing_model.htm">capital asset pricing model</a> (CAPM). This makes strong assumptions that lead to interesting conclusions. Not only does the <a href="../articles/market_portfolio.htm">market portfolio</a> 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 <a href="../articles/beta.htm">beta</a> and relates an asset's expected return to its beta.</p> <p class="body">Portfolio theory provides a broad context for understanding the interactions of <a href="../articles_old/glossarysystemicrisk.htm">systematic risk</a> 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 <a href="../articles/risk_management.htm">financial risk management</a> and was a theoretical precursor for today's <a href="../articles/value_at_risk.htm">value-at-risk</a> measures.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table7"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table8"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/capital_asset_pricing_model.htm">capital asset pricing model</a>—an influential model that concludes that all investors should hold the market portfolio.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/capital_market_line.htm">capital market line</a>—a set of portfolios obtainable by leveraging or deleveraging positions in a "super-efficient" portfolio.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/efficient_frontier.htm">efficient frontier</a>—a set of portfolios that each maximize expected return for a given level of risk.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/hedging_and_diversification.htm">hedging and diversification</a> Two techniques for reducing a portfolio's risk.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/market_risk.htm">market risk</a> </strong>Exposure to the uncertain market value of a portfolio.</td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Books</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table9"> <tr> <td width="100%"> <p class="explanatory_text">The following books offer different perspectives on portfolio theory. Bernstein (<a target="_blank" href="http://www.riskbook.com/link/bernstein_p_(1993).htm">1993</a>) is a must-read history of finance during the 20th century. Body, Kane and Marcus (<a target="_blank" href="http://www.riskbook.com/link/bodie_kane_marcus_(2002).htm">2004</a>) is the standard university text on finance. For the practitioner's perspective, see Fabozzi and Markowitz (<a target="_blank" href="http://www.riskbook.com/link/fabozzi_and_markowitz.htm">2002</a>). Now a classic, Markowitz (<a target="_blank" href="http://www.riskbook.com/link/markowitz_h_(1959).htm">1959</a>) is Harry Markowitz's original book on portfolio theory.</p> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table10"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap559"> <area target="_blank" href="http://www.riskbook.com/link/bernstein_p_(1993).htm" shape="rect" coords="0, 0, 81, 124"> </map> <img border="0" src="../images/book_bernstein_peter_(1993)_125.jpg" usemap="#FPMap559" width="82" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table11"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/bernstein_p_(1993).htm"> Capital Ideas</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Peter L. Bernstein</b></td> </tr> <tr> <td width="10%"> <map name="FPMap560"> <area target="_blank" coords="2, 1, 89, 15" shape="rect" href="http://www.riskbook.com/main/ratings.htm"> </map> <img border="0" src="../images/star_6.gif" usemap="#FPMap560" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"> <map name="FPMap561"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/tech_0.gif" usemap="#FPMap561" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">1993</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap562"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/bernstein_p_(1993).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap562" width="146" height="20"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table12"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap563"> <area target="_blank" href="http://www.riskbook.com/link/bodie_kane_marcus_(2002).htm" shape="rect" coords="0, 0, 98, 124"> </map> <img border="0" src="../images/book_bodie_kane_marcus_(2004)_125.jpg" usemap="#FPMap563" width="99" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table13"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/bodie_kane_marcus_(2002).htm"> Investments</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Zvi Bodie, Alex Kane, Alan J. Marcus</b></td> </tr> <tr> <td width="10%"> <map name="FPMap572"> <area target="_blank" coords="2, 1, 89, 15" shape="rect" href="http://www.riskbook.com/main/ratings.htm"> </map> <img border="0" src="../images/star_6.gif" usemap="#FPMap572" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"><map name="FPMap573"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/tech_2.gif" usemap="#FPMap573" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">2004</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap566"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/bodie_kane_marcus_(2002).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap566" width="146" height="20"></td> </tr> </table> </td> </tr> </table> <span style="font-family: Times New Roman; letter-spacing: -0.2pt"> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table14"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap571"> <area target="_blank" href="http://www.riskbook.com/link/fabozzi_and_markowitz.htm" shape="rect" coords="0, 0, 82, 124"> </map> <img border="0" src="../images/book_fabozzi_markowitz_(2002)_125.gif" usemap="#FPMap571" width="83" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table15"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/fabozzi_and_markowitz.htm">Theory and Practice of Investment Management</a></td> </tr> </span> <tr> <td colspan="3"> <p class="author"><b>Frank J. Fabozzi and Harry M. Markowitz</b></td> </tr> <span style="font-family: Times New Roman; letter-spacing: -0.2pt"> <tr> <td width="10%"> <img border="0" src="../images/star_6.gif" usemap="#FPMap572" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"> <img border="0" src="../images/tech_2.gif" usemap="#FPMap573" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">2002</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap366"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/fabozzi_and_markowitz.htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap366" width="146" height="20"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table16"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap574"> <area target="_blank" href="http://www.riskbook.com/link/markowitz_h_(1959).htm" shape="rect" coords="0, 0, 81, 124"> </map> <img border="0" src="../images/book_markowitz_harry_(1959)_125.gif" usemap="#FPMap574" width="82" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table17"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/markowitz_h_(1959).htm"> Portfolio Selection</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Harry Markowitz</b></td> </tr> <tr> <td width="10%"> <map name="FPMap575"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/star_classic.gif" usemap="#FPMap575" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"> <map name="FPMap576"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/tech_2.gif" usemap="#FPMap576" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">1959</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap37"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/markowitz_h_(1959).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap37" width="146" height="20"></td> </tr> </table> </td> </tr> </table> </span> </td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Cited Papers</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table18"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_paper_glossary.gif" width="21" height="15">Markowitz, Harry M. (1952). <a target="_blank" href="http://cowles.econ.yale.edu/P/cp/p00b/p0060.pdf">Portfolio selection</a>, <i>Journal of Finance</i>, 7 (1), 77-91.<p class="explanatory_text"> <img border="0" src="../images/bullet_paper_glossary.gif" width="21" height="15"><a name="Sharpe">Sharpe</a>, William F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk, <i>Journal of Finance</i>, 19 (3), 425-442.<p class="explanatory_text"> <img border="0" src="../images/bullet_paper_glossary.gif" width="21" height="15"><a name="Tobin">Tobin</a>, James (1958). Liquidity preference as behavior towards risk, <i> The Review of Economic Studies</i>, 25, 65-86.</td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Papers</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table19"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_paper_glossary.gif" width="21" height="15">Markowitz, Harry M. (1999). The early history of portfolio theory: 1600-1960, <i>Financial Analysts Journal</i>, 55 (4), 5-16.</td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Forum Discussions</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table20"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_bullhorn_narrow.gif" align="left" width="27" height="22"><a target="_top" href="http://www.riskarchive.com/link_thread/05-1/000005c3.htm">CAPM & normal distribution</a> <i>28 Jan 2005<br> </i>Does portfolio theory assume asset returns are normally distributed?</td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Sponsored Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" width="75"> <img border="0" src="../images/ad_side_banner_1.jpg" width="103" height="285"></td> <td bgcolor="#FFFFCC" width="99%"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table21"> <tr> <td width="100%" bgcolor="#FFFFFF">  <p align="center"><map name="FPMap0_I1"> <area target="_top" href="http://www.riskglossary.com" shape="rect" coords="0, 0, 164, 102"> </map><img border="0" src="../images/logo.jpg" usemap="#FPMap0_I1" width="165" height="103"></p> <p align="center"><span class="verdana10"> <a href="http://www.riskglossary.com/main/disclaimer.htm" target="_self">Disclaimer</a></span></p> <p align="center">website: <span class="verdana10"> <a target="_top" href="http://www.contingencyanalysis.com">http://www.contingencyanalysis.com</a></span><br> glossary direct link: <span class="verdana10"> <a target="_top" href="http://www.riskglossary.com">http://www.riskglossary.com</a></span><br> copyright © Contingency Analysis, 1996 - current</p> <p align="center"><map name="FPMap1_I1"> <area target="_top" href="http://www.contingencyanalysis.com" shape="rect" coords="0, 0, 240, 88"> </map><img border="0" src="../images/logo_glossary_white.gif" usemap="#FPMap1_I1" width="241" height="89"></p> </td> </tr> </table> </td> </tr> </table> </td> <td>  </td> </tr> </table> </body>