Economics: Portfolio Theory Essay

Sometime during the 1980s, investors on the whole concluded that internationally diversified portfolios produced the best risk-adjusted returns, and that it was possible to identify and trade in a sufficient number of international stocks to make this conclusion a reality. Indeed, performance could also be enhanced by investing in a well-selected mix of stocks from other economies. The lasting benefit of all of international investing, however, depended on a key tenant of modern portfolio theory-that overall portfolio risk was lowered through diversification into noncorrelated investments-which has been shown especially to apply to international investments. The key (to the theory) is the lack of correlation between most foreign markets and one’s own. In a perfectly integrated market, on the other hand, the correlation between markets would be quite high and there could be no gain from diversification per se. Harry Markowitz, along with Merton Miller and William Sharpe, won the economics Nobel Prize in 1990 for his â€Å"pioneering work in the theory of financial economics. † Markowitz has applied computer and mathematical techniques to various practical decision-making areas. He is often referred to as the father of modern portfolio theory (MPT). This is based on his contributions to portfolio theory first in the article â€Å"Portfolio Selection, † published in the Journal of Finance in 1952, and then in his book, Portfolio Selection: Efficient Diversification of Investments, first published in 1959. Between these two publications and since the publication of the book, Markowitz has made many other contributions using mathematical programming and computer modeling techniques to address realworld problems to aid in decisionmaking. He got the Nobel Prize for the development of the theory of portfolio choice and contributions to the theory of price formation for financial assets, the so-called Capital Asset Pricing Model (CAMP). Becoming an economist was not a childhood dream of Harry Markowitz. His first two years at the University of Chicago were spent emphasizing the reading of original material where possible. Here again, he was especially interested in the philosophers. When it was time to choose his upper-division major at the University of Chicago, after some consideration. He first went through the basics of macroeconomics, which is the big picture of the economy of a country and its governance. Then he went through microeconomics, which is the economics of individual economic units of business. After going through these basics, he found his true love, the economics of uncertainty. The concepts of expected utility, personal probability, efficiency, and efficient sets, as taught by the outstanding faculty at Chicago, inspired him to pursue his later works. Harry Markowitz tells the story of how he stumbled up on his dissertation topic in the Personal Notes section of the third printing of his first book, The Portfolio Selection: Efficient Diversification of Investments. He was a student in the economics department of the University of Chicago and a research fellow of the Cowles Commission. He was sitting outside Jacob Marschak’s office waiting for the opportunity to discuss suggestions for his Ph. D. dissertation topic. An older man also was waiting outside the Marschak’s office and they began talking. The other man identified himself as a stockbroker and suggested that Markowitz should consider doing a dissertation on the stock market. When he later spoke to Marschak about the idea, he agreed that it was reasonable. Markowitz recalled that Alfred Cowles, the founder of the Cowles Commission, had done work in that area. Markowitz was sent to Marshall Ketchum in the Business School to get a reading list so that he could understand the theories on stock investments as revealed in the literature. The basic concepts of portfolio theory came to him one afternoon in the library while reading John Burr Williams’ The Theory of Investment Value. The dissertation that resulted provided the underpinnings of Modern Portfolio Theory (MPT). In reviewing Williams’ work, as referred to above, Markowitz noted that he recommended that a stock be valued by finding the present value of its future dividends. His treatment of risk involved finding a large number of securities with maximum present value and divide funds among them. This treatment provided no measure of individual securities nor of the resulting portfolio. Markowitz provided the methodology for eliminating that shortcoming. His approach was to use expected return as the positive attribute of a security and the variability of the possible returns around its expected return as a measure of risk or uncertainty, the negative attribute of the security. This provided the missing risk measure for individual securities. However, the problem of the portfolio of securities also needed to be addressed. The question was, when securities are mixed into a portfolio, how will the expected return and the risk measure of the portfolio be determined? This is the next contribution that Markowitz provided in his portfolio theory. The third ingredient needed to put the securities together in a portfolio was a methodology for handling the interaction of the respective variabilities of individual securities when mixed together in a portfolio. Quantification of this key element had been missing in investment theory up to this point. A couple of simple examples to help understand this problem follow. First, visualize taking two securities that have identical variability of returns over time. If we mix these together in a portfolio, the portfolio will look just like the two individual securities looked separately. The result is that we have not diversified away any rise by building that portfolio. Now, think about taking two securities that move in opposite directions in their variability of returns over time. As time passes, the portfolio variability of return will be less than the individual securities variability of returns because of the canceling out of the variability of one security’s deviations by an opposite deviation from the other security. These are two extreme examples to illustrate the concept of diversification. In the real world, we usually have something in between these two extreme examples, but some risk reduction can be achieved by diversification. Accordingly, the portfolio’s risk could be less than any of the individual securities included in the portfolio. A measure of this interaction between securities’ variability is called the correlation of returns variability. The next large contribution provided by Markowitz was that he was able to demonstrate mathematically that given a group of individual securities with their measures of expected returns, individual variabilities, and the correlations of their variability with the variability of each of the other securities, one could determine an efficient set of portfolios of those securities. This efficient set is the set of portfolios that have the highest expected return for any level of portfolio risk. Alternatively, it can be said that this efficient set is the set of portfolios that have the lowest portfolio risk for any level of expected return feasible with those securities. This is the cornerstone of Modern Portfolio Theory. Every textbook on investments used by colleges and universities all over the world includes the Markowitz MPT concepts. In his book, Portfolio Selection: Efficient Diversification of Investments, he also introduced the concept of a one-factor model. This model would reduce greatly the number of measures of correlations needed to determine portfolio risk. During the 1950s, Markowitz, along with others, decided that many practical business problems were beyond analytic solution. This implied that simulation techniques were required. One of the problems with simulation models is the amount of time required to program a detailed simulator. This is the problem that he attacked in his work on SIMSCRIPT. It allowed the programmer to describe the system to be simulated rather than describing the detailed steps the computer must take to accomplish the simulation. SIMSCRIPT, would then take the system description provided by the programmer and translate it into detailed computer actions necessary. This provided a very large time savings in putting together simulation models for many kinds of business situations. Between the two books on SIMSCRIPT Markowitz, with others, published another book on economy-wide production capabilities in 1963. This book is Studies in Process Analysis: Economy-wide Production Capabilities. Later, in 1967, this book was published in Russian.