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Concept
Markowitz model
Summary
In finance, the Markowitz model ─ put forward by Harry Markowitz in 1952 ─ is a portfolio optimization model;
it assists in the selection of the most efficient portfolio by analyzing various possible portfolios of the given securities.
Here, by choosing securities that do not 'move' exactly together, the HM model shows investors how to reduce their risk.
The HM model is also called mean-variance model due to the fact that it is based on expected returns (mean) and the standard deviation (variance) of the various portfolios.
It is foundational to Modern portfolio theory.
Markowitz made the following assumptions while developing the HM model:
Risk of a portfolio is based on the variability of returns from said portfolio.
An investor is risk averse.
An investor prefers to increase consumption.
The investor's utility function is concave and increasing, due to their risk aversion and consumption preference.
Analysis is based on single period model of investment.
An investor either maximizes their portfolio return for a given level of risk or minimizes their risk for a given return.
An investor is rational in nature.
To choose the best portfolio from a number of possible portfolios, each with different return and risk, two separate decisions are to be made, detailed in the below sections:
Determination of a set of efficient portfolios.
Selection of the best portfolio out of the efficient set.
A portfolio that gives maximum return for a given risk, or minimum risk for given return is an efficient portfolio. Thus, portfolios are selected as follows:
(a) From the portfolios that have the same return, the investor will prefer the portfolio with lower risk, and
(b) From the portfolios that have the same risk level, an investor will prefer the portfolio with higher rate of return.
As the investor is rational, they would like to have higher return. And as they are risk averse, they want to have lower risk. In Figure 1, the shaded area PVWP includes all the possible securities an investor can invest in.
Official source
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