Fin 4980-01

Dr. Alex

2/18/2013

Project 1: “Foundations of Portfolio Theory” by. H.M. Markowitz (1991)

Foundations of Portfolio Theory by H.M. Markowitz is based on a two part lesson of microeconomics of capital markets. Part one being that taught by Markowitz, which is solely geared toward portfolio theory and how an optimizing investor would behave, whereas part two focuses on the Capital Asset Pricing Model (CAPM) which is the work done by Sharpe and Lintner. In this article Markowitz speaks strictly on portfolio theory.

He states that there are three major ways in which portfolio theory differs from the theory of the firm and the theory of the consumer, which he was taught. The first way is concerned with investors; the second is concerned with economic factors that act under uncertainty. The third way is a theory where it can be directly used by large investors with adequate computer and database resources. With the first theory being pretty much self-explanatory Markowitz focuses more on expanding on the second and third theories.

When speaking about uncertainty he begins to relate it to his microeconomics course where the theory of the producer assumes that the competitive firm knows the price at which it will sell the goods or items it produces before there even produced. But in reality as we know that’s not the case. Markowitz states that in reality there is a delay between the decision to produce the goods, the time of production and the time of sale. As you can conclude with this analogy the price at which was set for the goods to be sold initially can and always usually differs from the price that it sells for after it’s produced and that’s because with economic factors always shifting it provides great uncertainty for a price to be determined and placed on something that isn’t ready to be sold.

With that said you shouldn’t count out uncertainty when you are trying to analyze the optimization of investor behavior. If the world was perfect and an investor knew the future returns on security with certainty he or she would invest in only one i.e. the one with the highest return and nothing else holding these factors constant. But as stated by Markowitz “diversification is a common and reasonable investment practice.” For the reason that in the real world certainty is never a factor in investments and with diversification it tends to reduce uncertainty.

Markowitz basic principles for portfolio theory came to him when reading John Burr Williams, The Theory of Investment Value. It came specifically when Williams said that the value of a stock should equal the present value of its future dividend stream. But dividends are clearly uncertain. With understanding that, Markowitz took Williams’ statement as to value a stock as the expected value of its discounted future dividend stream. Markowitz states that investors are only concerned with risk and returns, and that they should be measured for the whole value of the portfolio. Variance is stated to come to mind when risk of the portfolio is being measured. Markowitz says that because variance of a portfolio meaning the weighted sum involved all covariance terms added to the conclusion of the approach. Its also stated that since there were two criteria expected return and risk the natural approach for student is to imagine the investor selecting a point from the return combinations on the efficient frontier. These are considered to be Markowitz basic elements of portfolio theory.

As Markowitz began to explain the third theory he switches to a more technical quantitative standpoint. He says that being equipped with databases, computer algorithms and methods of estimation allows portfolio theorists to be able to trace out mean-variance frontiers for large quantities of securities. But he poses to questions with asking is this right for the investor, and are mean and variance proper and sufficient criteria for portfolio choice? With answering...