What it is:
Harry Markowitz is a famous economist who won the Nobel Prize in Economics in 1990.
How it works (Example):
Born in Chicago in 1927, Markowitz earned his bachelor's degree in economics at the University of Chicago and then joined the RAND Corporation in 1952, where he worked on the optimization techniques and algorithms that would lead to his famous theory: the efficient frontier.
The efficient frontier is a mathematical concept that evaluates the expected returns, standard deviation 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 Economics 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 the investments in the universe that has the risk and return corresponding to that point.
An example appears below. Note how the efficient frontier allows investors to understand how a portfolio's expected returns vary with the amount of risk (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 efficient frontier, it was groundbreaking in many respects. One of its largest contributions was its clear demonstration of the power of diversification.
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 efficient frontier. However, there is no one efficient frontier, because portfolio managers and investors can edit the number and characteristics of the securities in the investing universe to conform to specific needs. For example, a client may require the portfolio to have a minimum dividend yield, or the client may rule out investments in ethically or politically undesirable industries. Only the remaining securities are included in the efficient frontier calculations.
When he accepted the Nobel Prize, Markowitz said, "The existence of uncertainty is essential to the analysis of rational investment behavior." Ironically, Markowitz's effort to actually compute the investor's optimal portfolio proves to be one of the most controversial aspects of the efficient frontier. Many argue that it reduces investment management to an algorithm involving nothing more than statistical relationships among securities rather than analysis of the underlying companies' fundamental and financial characteristics.