Harry Markowitz and modern portfolio theory

In the 1950s, a new crop of statisticians at Bell Laboratories, the RAND Corporation, and
several universities wanted to use burgeoning computer power for analysis. They found that
stock market data was comprehensive enough to analyze thoroughly, and they set off a
revolution in finance.

In 1952, Harry Markowitz published a paper called “Portfolio Selection” in The Journal of
Finance, setting out what he called the modern portfolio theory (MPT). It caught on, inspired
other groundbreaking research, and was eventually renamed Markowitz portfolio theory in
his honor. (It helped that the acronym stayed the same.) He won the Nobel Prize for his work
in 1990.

Key Points
 Modern portfolio theory focuses on diversification as a means to build wealth.
 The theory encourages investors to choose investments that match how much risk
they’re willing to take.
 MPT helps investors build portfolios that align their savings objectives with their risk
tolerance.
Whether you refer to it as Markowitz portfolio theory or modern portfolio theory, MPT
introduced a systematic approach to building and managing investment portfolios. Instead of
choosing individual investments, MPT urges investors to consider their risk preferences first.

Diversification and the efficient frontier

At the heart of modern portfolio theory is the concept of diversification. Diversification
involves spreading investments across a range of assets to reduce risk, including stocks,
bonds, and alternative assets. MPT argues that by holding a well-diversified portfolio, you
can achieve a more favorable risk-return trade-off than you could by concentrating your
investments in a single asset or asset class.

Markowitz raised key points that continue to matter both in academic finance and the real
world:

 Risk is defined in terms of standard deviations, a measure of the volatility or

variability of an investment’s returns.
 Some investors are willing to accept greater risk in search of a higher return.
 Once you determine your risk tolerance, you can construct a fully diversified portfolio
that optimizes the potential return for the amount of risk that you decide to take.
 Markowitz defines the efficient frontier as the highest expected return for a given
level of risk, or the lowest risk for a given expected return.
 The efficient frontier illustrates the trade-offs between risk and return, helping
investors identify portfolios that align with their risk tolerance and investment goals.
ON A TANGENT. To find your ideal portfolio, look for a mix of securities that give you the
best expected return for a given level of risk. According to modern portfolio theory (MPT),
that point is where the efficient frontier meets the capital market line (CML).

To determine your optimal portfolio, compare your efficient frontier arc with the capital
market line (CML). This comparison illustrates the trade-off between the standard deviation
(what we now call market volatility) of returns and expected return when combining a risk-
free asset (such as U.S. Treasury bonds) with a diversified portfolio of risky assets (such as
stocks and alternative investments).

The CML slopes upward because the expected return (over and above the risk-free rate)
should theoretically be commensurate with the risk an investor is willing to take. The optimal
portfolio, then, is the point at which your efficient frontier touches (i.e., is tangent to) the
CML.

In theory: The CML helps investors determine the optimal allocation between risk-free and
risky assets based on their risk preferences. The optimal portfolio is tangent to this line.

In practice: You probably won’t calculate your optimal portfolio return like this. The lesson
from Markowitz that has carried into the 21st century is that investors can expect the best
risk-adjusted return through diversification. That’s why index funds, which track the
performance of a broad-based stock index such as the S&P 500, can be a core component of a
diversified portfolio, along with Treasuries and other fixed-income securities.

Criticisms and limitations of MPT

Despite its profound impact on investment practice, MPT is not without criticism. Detractors
argue that the theory makes simplifying assumptions about market behavior, such as the
normal distribution of asset returns and constant correlations, which may not hold in the real
world.

One issue is using the standard deviation as a measure of risk. This benchmark considers a
return greater than expected to be as risky as getting a return that’s less than expected, but
most rational investors would disagree.

Many of the limitations reflect the revolutionary nature of Markowitz’s theory. Several
economists looked at MPT, saw the benefits of the basic framework, and used it as the
starting point for such fundamental financial concepts as the efficient market hypothesis
(EMH) and the capital asset pricing model (CAPM). Without MPT, their work might have
taken longer to emerge, if it emerged at all.

The bottom line

Harry Markowitz truly created modern finance, and the MPT remains the cornerstone of
investment theory. The principle of managing risk preferences holds to this day. Consider two
key ways to apply MPT to your investments:

Periodically review and rebalance your portfolio so your risk preferences continue to be met.
Sell assets that are overweighted (usually the assets that performed well) and use the proceeds
to buy underweighted assets (usually assets that are inexpensive because they have
underperformed).
Adjust your portfolio as your risk preferences change. Early in your career, for example, you
can probably take on more risk than you can later in life, as you near and enter your
retirement years.
As with most investing concepts, MPT works best as a framework for understanding how the
world works—theoretically (hence the name). But you must adapt the theory to your reality
to find the portfolio structure that works best for you.
 Optimal portfolio
In investment, it’s a common assumption that more risk entails higher potential rewards.
According to the theories behind the efficient frontier and optimal portfolios, there is an ideal
balance between risk and return. The theory is predicated on investors wanting portfolios
with the highest potential return and the lowest degree of associated risk. These make up the
so-called efficient frontier curve and are called optimal portfolios.

What is an optimal portfolio?

A portfolio that gives the maximum projected return for a specific amount of risk is referred
to as an optimal portfolio. Its basis is the idea of diversification, which seeks to lower risk by
investing in several assets with various risk and return attributes. Building an optimal
portfolio aims to maximise profits while reducing risk.

Understanding an optimal portfolio

To fully understand the concept of an optimal portfolio, one must first comprehend the
relationship between risk and return. Higher returns are often connected with higher levels of
risk. However, by diversifying their assets across asset classes such as equities, real estate,
and bonds, investors might minimise their portfolio’s total risk while still generating good
returns.

Consideration must be given to the preferences and objectives of the investor to ascertain if a
portfolio is optimal. Assessing the investor’s essential attitude toward finances, in general, is
frequently included in this.

Buying assets with a high volatility rate may cause extreme discomfort for someone who is
extremely frugal with his money. When this is the case, acquiring less risky assets while still
providing the most significant return feasible given the volatility will result in the optimum
portfolio design.

It is crucial to remember that the concept of an optimal portfolio is dynamic and will alter as
market circumstances and investor inclinations change. It must be regularly monitored and
rebalanced to ensure the portfolio stays in line with the investor’s goals.
Benefits of an optimal portfolio
The optimum portfolio can limit the influence of any one investment on overall performance
by spreading investments across asset types such as stocks, bonds, and commodities. This
diversification spreads risk and increases the possibility of earning favourable results.

Furthermore, using current portfolio theory and complex mathematical models, the optimum
portfolio considers many characteristics, such as historical returns, volatility, and asset
correlation, to develop a well-balanced and efficient investment plan. This enables investors
to reach their financial objectives.

Limitations of an optimal portfolio

Assumption of investor rationality
The assumption of investor rationality is a significant drawback for an optimum portfolio.
According to the optimum portfolio theory, rational investors always choose investments that
maximise their profits. Investors are susceptible to biases, emotions, and other psychological
influences that might cause them to act irrationally. Lower returns and less-than-ideal
portfolio allocations may arise from this.

Assumption of market efficiency

The assumption of market efficiency is another drawback of the optimal portfolio theory.
According to the concept, it is difficult to continually beat the market since securities prices
are assumed to represent all available information. However, in practice, markets are only
sometimes efficient, and knowledgeable investors may have the opportunity to spot mispriced
assets. For individuals who can take advantage of these inefficiencies, this may result in
potential deviations from the ideal portfolio and better returns.

Heavily dependent on statistical models and historical data

The optimum portfolio theory also extensively depends on statistical models and historical
data to calculate risk and return. These models, however, are predicated on assumptions that
would only be true in some market circumstances. For instance, previous data might not be a
reliable indicator of future risk and return attributes during significant volatility or market
disruptions. Investor losses may occur from this and inefficient portfolio allocations.
Additionally, according to the optimal portfolio theory, investors should have access to
various investments with a range of risk and return profiles. However, some investors may
only have restricted access to particular asset classes or investment options due to limitations
like legal restrictions or a need for more financial resources. This may make it more
challenging to assemble an ideal portfolio and lead to less-than-ideal outcomes.

Example of optimal portfolio

For instance, the ideal investment strategy for a retiree with a low-risk tolerance may consist
of a combination of fixed-income instruments, such as debentures and bonds, and lower stock
exposure. This portfolio aims to produce a consistent income stream while reducing volatility.

Conversely, a young investor with a high-risk tolerance can benefit from a more significant
allocation to stocks and growth-oriented investments like real estate or commodities. This
portfolio’s objective would be to maximise profits over the long term while taking on more
risk.

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