Markowitz: Portfolio Selection

FRM

Markowitz: Portfolio Selection

Markowitz provided a comprehensive theoretical framework for analysis of the investment portfolio Harry M. Markowitz, Portfolio Selection, The Journal of Finance, March, 1952, pp. 77 - 91

Markowitz: Portfolio Selection

Portfolio of securities is an integrated whole, each security complementing the other

Markowitz: Portfolio Selection

Consider both the characteristics of the individual securities and the relationships between those securities

Markowitz: Portfolio Selection

Investors like return and dislike risk

Markowitz: Portfolio Selection

Find the set of portfolios that

Provides the minimum risk for every possible level of return The efficient set Investor selects from the efficient set the single portfolio that meets his/her needs

Markowitz: Portfolio Selection

Maximize the expected return E(R) Minimize the variance V(R)

Markowitz: Portfolio Selection

Expected return of a portfolio is the weighted sum of the expected return from each of those securties

E ( R) =

i =1

xi ei

Markowitz: Portfolio Selection

To compute the variance of a portfolio, we need to know more than the variance of the individual investments We need to know the covariances

Markowitz: Portfolio Selection

Xi is the proportion invested in the ith stock Vi is the variance of the ith stock Cij is the covariance between the ith and jth stocks

Markowitz: Portfolio Selection

V ( R) =

2 xi v i

x x c , i j
i j ij i =1 j =1

cij = i j ij

vi =

2 i

Markowitz: Portfolio Selection

Minimize

( R ) =
Subject to

2 2 xi i

x x
i j ij i i =1 j =1

x
i =1

=1

xi 0

e x
i =1

i i

(k is a minimum acceptable expected return)

Markowitz: Portfolio Selection

Limitations

Assumes that deviations both above and below the level of expected return are equally undesirable

Markowitz: Portfolio Selection

Assumes that the only investment objectives are the acquisition of return and the avoidance of risk

Type of returns (dividends vs. capital gains) are important Timing of realization of income is important

Markowitz: Portfolio Selection

Assumes that historical returns will be repeated in the future

The decision is how long a time period to include in the data set is an important one