Harry Markowitz: Founder of Portfolio Theory

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Introduction

Harry Markowitz’s “Portfolio Selection” Journal of Finance article (1952) set the stage for modern portfolio theory
The first major publication indicating the important of security return correlation in the construction of stock portfolios
Markowitz showed that for a given level of expected return and for a given security universe, knowledge of the covariance and correlation matrices are required

Terminology

Security Universe
Efficient frontier
Capital market line and the market portfolio
Security market line
Expansion of the SML to four quadrants
Corner portfolio

Security Universe

The security universe is the collection of all possible investments
For some institutions, only certain investments may be eligible
E.g., the manager of a small cap stock mutual fund would not include large cap stocks

Efficient Frontier

Construct a risk/return plot of all possible portfolios
Those portfolios that are not dominated constitute the efficient frontier
The farther you move to the left on the efficient frontier, the greater the number of securities in the portfolio
When a risk-free investment is available, the shape of the efficient frontier changes
The expected return and variance of a risk-free rate/stock return combination are simply a weighted average of the two expected returns and variance
The risk-free rate has a variance of zero

Capital Market Line and the Market Portfolio

The tangent line passing from the risk-free rate through point B is the capital market line (CML)
When the security universe includes all possible investments, point B is the market portfolio
It contains every risky assets in the proportion of its market value to the aggregate market value of all assets
It is the only risky assets risk-averse investors will hold
Implication for investors:
Regardless of the level of risk-aversion, all investors should hold only two securities:
The market portfolio
The risk-free rate
Conservative investors will choose a point near the lower left of the CML
Growth-oriented investors will stay near the market portfolio