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The Markowitz Model

The Markowitz model was first postulated by Harry Markowitz in 1952 and is a minimum variance model that emphasizes diversifying assets to reduce risk. It considers the tradeoff between expected return and risk, measured by standard deviation. The model stresses diversification across uncorrelated or negatively correlated assets to mitigate risk for risk-averse investors. Mathematically, it aims to minimize portfolio variance subject to constraints on expected return and asset weights, using tools like covariances and Lagrangian multipliers to solve for the efficient portfolio. While influential, it has limitations like assuming equal asset weights and sensitivity to changes in highly weighted assets. Overall, it is a pillar of financial theory despite empirical differences from actual investor behavior.

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49 views4 pages

The Markowitz Model

The Markowitz model was first postulated by Harry Markowitz in 1952 and is a minimum variance model that emphasizes diversifying assets to reduce risk. It considers the tradeoff between expected return and risk, measured by standard deviation. The model stresses diversification across uncorrelated or negatively correlated assets to mitigate risk for risk-averse investors. Mathematically, it aims to minimize portfolio variance subject to constraints on expected return and asset weights, using tools like covariances and Lagrangian multipliers to solve for the efficient portfolio. While influential, it has limitations like assuming equal asset weights and sensitivity to changes in highly weighted assets. Overall, it is a pillar of financial theory despite empirical differences from actual investor behavior.

Uploaded by

Sarnalika Das
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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CU REGISTRATION NO:

031-1211-0414-21

CU ROLL NO: 213031-11-0105

TOPIC: MARKOWITZ MODEL

SEMESTER : V
The Markowitz Model
Introduction: What is the Markowitz model?

The Markowitz model was first postulated by Harry Markowitz in


1952. It is a minimum variance model and mainly emphasizes that the
variability in the rate of returns or the risk(uncertainty) on the returns
of a portfolio can be minimized through the diversification of assets.
Diversification of assets results in a wide array of possible outcomes,
distributing the risk among the assets forming the portfolio such that
the risk held in individual assets is reduced.

Moreover, another important aspect of diversification is positively


correlated assets must be avoided while inclusion of assets to
diversify a portfolio. It is so because if the return on one asset falls or
fluctuates invariably, it will subsequently lead to a falter in the returns
of other assets. Thus, negatively correlated assets are preferred for
compensatory purposes. It is important to minimize the interactive
risk among the assets.

Importance: why do we need Markowitz model?

The Markowitz model explicitly takes into account the trade-off


between the expected rate of return and the risk on rate of returns,
typically measured by the standard deviation of the rate of returns
(). The significance of this model is as follows:

1. The model stresses the motto of diversification which is variation


in the assets invested. To mitigate the needs of risk-averse
investors, the model clarifies that the conservative concept of
“keeping all the eggs in the same basket” is not at all efficient and
at times even riskier.

2. Promotes risk management and cautious allocation of funds among


assets.
Mathematical Setup

To theoretically examine the Markowitz model set up, we use certain


mathematical and statistical tools in the following manner:
Suppose there is a portfolio consisting of n assets, with each asset
having an expected rate of return or mean as r1,r2,r3…rn
The covariances among them are of the form ij where i, j= 1,2,…n.
Now since there are n assets, each has its proportion in the total
portfolio which is estimated based on the amount of initial outlay
invested or allocated among them. Thus, there are weights given to
each asset denoted by wi, i= 1 2 3…n.
Naturally, wi = 1 where i = 1 2 3 ….n
Our objective is to find such a portfolio which has a minimum
variance in its rate of return:
Min 1/2(wiwjij) subject to the constraints (wiri) = r and wi = 1

Note the variance of a portfolio is (wiwjij) and ri is r bar which is


the expected rate of return for the ith asset. r is the common
portfolio's expected rate of return

Now using the Lagrangian method we find the solution portfolio as


follows: L = 1/2((wiwjij)) - (wiri – r) - (wi – 1)

We differentiate the Lagrangian function L w.r.t each variable wi and


equate each partial derivative to 0. From there we find n+2 equations
and simultaneously solve to get values of n+2 unknowns ( n weights,
 and ). The equations we get are also known as equations of
efficient sets. After estimating the unknowns, we can estimate the
portfolio having minimum variance.

Merits of the model

1. This model is considered to be one of the most successful


approaches in financial modelling.

2. The model helps in minimizing collective risk and maximise


returns from the portfolio.
3. Provides aid to construct and identify efficient frontiers and their
boundary points.

Limitations of the model

1. The model considers the 1/n rule for asset weightage and not
proper samples for empirical verification.

2. The assets given more weightage are highly sensitive for the
portfolio. A minute change in their data results in a huge impact on
the portfolio’s expected rate of return.

Conclusion
The Markowitz Model is one of the most significant models and acts
as a pillar of financial theory. Even though the empirical behaviour of
the investors tends to differ from the predictions in the model, its
simplicity and relevance makes it popular and a well-known model
among finance pursuers.

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