Harry Markowitz, Portfolio Selection.

History

The Modern Portfolio Theory (MPT) was established in 1952 by Harry Markowitz. The most fundamental concept of the MPT was the impact on portfolio diversification due to the number of securities and their covariance relationship within the portfolio. Diversification is the most important concept of the MPT. The portfolio selection theory is based on the normative theory, meaning that investors who shall pursue the constructing of a portfolio shall do it under the standard or norm behaviour.

According to Markowitz(1952, 77-91), they are two stages of selecting a portfolio. The first stage is the observation and experience that leads to the beliefs about future performances of the available securities.  The second stage begins with the relevant beliefs about the future performances that results with the choice of portfolio. The paper focuses on the second stage.

The portfolio selection is solely based on the “expected return-variance of returns” rule also known as the mean-variance analysis.  The idea that a risk averse investor can construct their portfolio to either optimize or maximize their expected return based on a given level of market risk, with the emphasis that the risk taken  is part of the higher reward.

The MPT framework holds assumptions about the market and investors. Namely;

Ø  Investors are rational (seeking to maximize returns while minimizing risk)

Ø  Investors are only willing to accept high amounts of risk if only they will be compensated with high amounts of expected returns.

Ø  Investors timely receive all their pertinent info related to their investment decision.

Ø  Investors have unlimited borrowing and lending of capital amount at a risk-free rate of interest.

Ø  There is perfect market efficiency.

Ø  They are no transaction cost or taxes in the market.

Ø  The selection of securities their individual performance is not dependent on other portfolio performance.

The concept of diversification aims to properly select a weighted collection of investment assets that collectively will result in lower risk factors compared to any individual asset or a set of single class assets. This diversifiable risk is referred to as the unsystematic risk, risk that is usually not connect to other risks and generally impacts certain securities or assets. The investment in stocks, securities or assets that move in opposite directions is one of the mechanisms of achieving diversification.

The variance and or standard deviation is used to calculate or measure risk or volatility.

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