What it is:
Harry Markowitz is a famous economist who won the Nobel Prize in in 1990.
How it works (Example):
Born in Chicago in 1927, Markowitz earned his bachelor's degree in efficient frontier.at the University of Chicago and then joined the RAND in 1952, where he worked on the optimization techniques and algorithms that would lead to his famous theory: the
The efficient frontier is a mathematical concept that evaluates the expected returns,and the covariances of a set of securities in order to determine which combinations, or portfolios, generate the maximum expected return for various levels of risk.
In 1952, Markowitz set the efficient frontier idea in motion when he published a formal portfolio selection model in The Journal of Finance. Markowitz continued to develop and publish research on the subject over the next 20 years, and other financial theorists contributed to the work. Markowitz won the 1990 Nobel Prize in for his work on the efficient frontier and for related contributions to modern portfolio theory.
Though his work is complex, Markowitz's principle idea is simple: Different combinations of securities produce different levels of return. The efficient frontier represents the best of these combinations -- those that produce the maximum expected return for a given level of risk.
For every point on the efficient frontier, there is at least one portfolio constructible from thein the universe that has the risk and return corresponding to that point.
An example appears below. standard deviation) taken.
The relationship securities have with each other is an important part of the efficient frontier. Some security prices head the same direction under similar circumstances, but many securities zig when others zag. The more out of sync the securities in the portfolio are (that is, the lower their covariance), the smaller the risk (standard deviation) of the portfolio that combines them. This is why the efficient frontier is curved rather than linear -- diversification makes the risk (standard deviation) of the portfolio lower than the risk (standard deviation) of each individual security.
Why it Matters:
When Markowitz introduced the, it was groundbreaking in many respects. One of its largest contributions was its clear demonstration of the power of .
Investors tend to choose, directly or indirectly, portfolios that generate the largest possible returns with the least amount of risk -- in other words, they tend to seek portfolios on the. However, there is no one , because portfolio managers and investors can edit the number and characteristics of the securities in the universe to conform to specific needs. For example, a client may require the portfolio to have a minimum , or the client may rule out in ethically or politically undesirable industries. Only the remaining securities are included in the calculations.
When he accepted the Nobel Prize, Markowitz said, "The existence of uncertainty is essential to the analysis of rationalbehavior." Ironically, Markowitz's effort to actually compute the investor's optimal portfolio proves to be one of the most controversial aspects of the . Many argue that it reduces to an algorithm involving nothing more than statistical relationships among securities rather than analysis of the underlying companies' fundamental and financial characteristics.