Investment portfolio management
How to build great investment portfolio or all about the Markowitz model.
The Markowitz Portfolio Model, also known as Modern Portfolio Theory (MPT), was developed by Harry Markowitz in 1952 and is a key concept in the field of financial economics. Markowitz received a Nobel Prize in Economics in 1990 for his contributions to this theory. The model provides a framework for investors to make decisions about the allocation of their assets in a way that maximizes expected returns for a given level of risk, or minimizes risk for a given level of expected returns.
Here are the key principles of the Markowitz Portfolio Model:
1. **Diversification:** Markowitz emphasized the importance of diversification in a portfolio. By holding a mix of different assets that are not perfectly correlated with each other, an investor can reduce the overall risk of the portfolio. Diversification helps to mitigate the impact of poor performance in any single asset.
2. **Expected Return and Risk:** The model considers both the expected return and the risk associated with each asset. Expected return is the anticipated gain or loss from holding an investment, while risk is typically measured by the standard deviation of returns. Markowitz suggested that investors should seek to maximize the expected return for a given level of risk or minimize their risk for a given level of expected return.
3. **Efficient Frontier:** The efficient frontier is a key concept in the Markowitz Portfolio Model. It represents a set of optimal portfolios that offer the highest expected return for a defined level of risk, or the lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are considered suboptimal because they do not provide as much return for the level of risk taken.
4. **Risk-Free Rate:** The inclusion of a risk-free rate is another important element in the Markowitz model. Investors can borrow or lend money at the risk-free rate to adjust their level of risk and return. The risk-free rate allows investors to construct a portfolio that lies on the tangent line drawn from the risk-free rate to the efficient frontier.
5. **Capital Market Line (CML):** The CML is the tangent line from the risk-free rate to the efficient frontier. It represents a combination of the risk-free rate and a risky portfolio that provides the maximum return for a given level of risk. The point at which the CML touches the efficient frontier is considered the optimal portfolio for an investor with a specific risk tolerance.
The Markowitz Portfolio Model is a foundational concept in the field of portfolio management, providing a framework for investors to make informed decisions about asset allocation based on their risk preferences and return objectives. It's important to note that the model makes certain assumptions, such as the normal distribution of asset returns and constant correlations, which may not always hold true in real-world markets.