HARRY MARKOWITZ &

T H E D E V E LO P M E N T O F
MODERN PORTFOLIO
THEORY

Understanding the sources of risk and

return in your portfolio, to make better
decisions under uncertainty.
BPV CAPITAL MANAGEMENT | HARRY MARKOWITZ & THE DEVELOPMENT OF MODERN PORTFOLIO THEORY 1
 Harry M. Markowitz
NOBEL LAUREATE
ESTEEMED ADVISOR TO BPV CAPITAL MANAGEMENT

Attended University of Chicago as an undergrad,

In this white paper, we outline
key mathematical concepts
behind mean-variance analysis,
with some valuable insights
from Dr. Markowitz himself.
studying philosophy and physics, then continued on to
the Ph.D. program in Economics
Published his seminal theory of portfolio allocation
under uncertainty in 1952 in the Journal of Finance
Received his Ph.D. from the University of Chicago with
a thesis on portfolio theory in 1955
Published the critical line algorithm in a 1956 paper,
with a subsequent 1959 book on portfolio allocation
Won the Nobel Prize in Economics in 1990, while a
professor of finance at Baruch College of the City
University of New York
Currently serves as Adjunct Professor of Finance at
UC San Diegos Rady School of Management, while
working on volume two of his four volume series
titled Risk-Return Analysis: The Theory and Practice of
Rational Investing, which builds on his 1959 work

Somebody asked me did I realize that I was

going to get a Nobel Prize for that, and I
said, no, but I knew I was going to get a
dissertation; I would get a Ph.D.
- HARRY MARKOWITZ
BPV CAPITAL MANAGEMENT | HARRY MARKOWITZ & THE DEVELOPMENT OF MODERN PORTFOLIO THEORY 2
 BACKGROUND

I n 1990, Harry M. Markowitz won the Nobel

Prize for his seminal theory of portfolio
selection, which was developed in his early
work as a graduate student at the University of
Chicago. This theory, now popularly known as
Modern Portfolio Theory, was first published in
an essay entitled Portfolio Selection (Journal of
Finance, 1952).
Modern Portfolio Theory, or MPT, is based on the
crucial idea that under situations of uncertainty,
an investors portfolio choice is a tradeoff
between the expected return on the portfolio and
the risk of the portfolio. In this white paper, we
outline some of the key mathematical concepts
behind Harrys groundbreaking theories, with help
from Dr. Markowitz himself.

BPV CAPITAL MANAGEMENT | HARRY MARKOWITZ & THE DEVELOPMENT OF MODERN PORTFOLIO THEORY 3
 EXPECTED RETURN OF
A PORTFOLIO
Lets imagine for a minute that you are constructing a portfolio of securities.
One of the main factors you may consider in your security selection is the
expected return of those securities. Mathematically speaking, we can represent
the expected return of a security, or random variable, by the following equation:

In this equation, the E denotes expected return, wi is the weight of the individual
security, and Ri is the anticipated return of the individual security. When only one
security is present, it represents 100% of the expected return of the portfolio.

Now lets imagine that you have a portfolio comprised of multiple securities. In
this case, the expected return of the portfolio would be the sum of the weighted
average expected returns of those securities, or:

Whats interesting here is that in theory, if you purely wanted to maximize the
return of the portfolio, you wouldnt need any more than one security. You could
technically choose the individual security that has the highest expected return
and make that 100% of your portfolio.

BPV CAPITAL MANAGEMENT | HARRY MARKOWITZ & THE DEVELOPMENT OF MODERN PORTFOLIO THEORY 4
 But in practice, we dont maximize the expected return of a portfolio by
maximizing exposure to the stock with the highest expected return. Why?
Because diversification is important; everyone knows you dont put all your
eggs in one basket. We create portfolios that represent a basket of securities,
knowing that some will go up and some will go down during any given time
period.

John Burr Williams understood this when he preached about the importance of
diversification in his Theory of Investment Value, positing that diversification was
the way to eliminate portfolio risk, as measured by variance in portfolio returns.

In His Words:
I was in the business school, in the library of the business school, reading John
Burr Williams Theory of Investment Value, and Williams said that the value of a
stock, is the present value of its future dividends. I figured dividends are uncertain
so he must mean the expected value I figured, if you only are interested in the
expected value of a stock, you must be only interested in the expected value of the
portfolio. The way you maximize the expected value of the portfolio is by putting
all your money into whatever stock has maximum expected value. That is not
right. Everybody knows you are not supposed to put all your eggs in one basket.

- HARRY MARKOWITZ
BPV CAPITAL MANAGEMENT | HARRY MARKOWITZ & THE DEVELOPMENT OF MODERN PORTFOLIO THEORY 5
 MEASURING PORTFOLIO
VARIANCE
Variance (2), like the more commonly understood standard deviation (), is a
measure of dispersion, defined as the average of the squared deviations around
the mean. Standard deviation is the positive square root of the variance. The
equation for variance is below:

Williams believed that when you held an increasing number of securities, you
could slowly diversify away your portfolio risk. It turns out that Markowitz knew
better than Williams: if you diversify, you dont completely eliminate risk. You
can possibly do that if all the assets in the portfolio are uncorrelated.

As discussed in the previous section, when you calculate the expected return
on a portfolio, you can take a simple weighted average of the expected returns
of the securities. But when you calculate the expected risk or variance of the
portfolio, you need more than just the variances of the individual securities; you
need to know how those securities tend to move together. For example, if you
have a set of perfectly correlated assets that all tend to move together, buying
more of those assets wont decrease the risk of your portfolio.

In His Words:
Lets go back to John Burr Williams. Later, he says that... you should invest
according to the mean value, the expected value, and he says that it would
seem like there is riskiness, but if you diversify sufficiently, you can eliminate all
risk, and you will, in fact, get the expected value. That is true if there is zero
correlation. (But) according to chapter 5 of my 1959 book, if you diversify,
more and more and more, in correlated risks, the variance of your portfolio
doesnt approach zero. It approaches the average covariance Somehow my
contribution was not diversification. It was a theory which took into account
correlation John Burr Williams thought that you could eliminate risk. You
only needed to invest according to expected return and then diversify enough,
and risk would go away. It will not. That depends on covariance correlation.

- HARRY MARKOWITZ
BPV CAPITAL MANAGEMENT | HARRY MARKOWITZ & THE DEVELOPMENT OF MODERN PORTFOLIO THEORY 6
 The way that securities move together is known as covariance, which is
extremely similar to correlation. Both covariance and correlation describe the
way that variables move together; however, correlation serves as a standardized
form of covariance, while covariance is expressed in units obtained by
multiplying the units of the two variables in question.

This brings us to one final equation, that of the variance of returns on the
portfolio:

While the equation itself appears daunting, it simply states that the variance of
returns on a portfolio is comprised of the individual variances of each security,
as well the covariances of each pair of securities in the portfolio. For example,
a portfolio of 3 securities will have 3 variances and 3(3)-3=6 covariances. A
portfolio of 8 securities will have 8 variances and 8(8)-8=56 covariances.

Therefore, the larger the portfolio is, the more complex the notion of portfolio
risk becomes. It also means that when you have more securities, you have vastly
more covariances to consider, such that simple variance becomes less and less
important as you add securities to the basket.

On a practical level, no one would calculate all this by hand; there are far too
many programs and models designed to efficiently run this sort of analysis.
However, we believe its important to understand the mechanism behind the
risk-return tradeoff in a diversified portfolio.

In His Words:
I would take a book off the shelf, Uspenksys Introduction to Mathematical
Probability, something like that, and look for the formula for the expected
variance of a weighted sum, and there it is, all these covariances or correlations.
I think, ah-ha, thats it...Thats ah-ha moment. Somebody asked me did I realize
that I was going to get a Nobel Prize for that, and I said, no, but I knew I was
going to get a dissertation, I would get a Ph.D. That was the ah-ha moment.

- HARRY MARKOWITZ
BPV CAPITAL MANAGEMENT | HARRY MARKOWITZ & THE DEVELOPMENT OF MODERN PORTFOLIO THEORY 7
 GOING BEYOND MEAN
VARIANCE ANALYSIS
At this point in time, mean variance analysis is nowhere near new, and since
then, a number of other important portfolio valuation and analysis techniques
have popped up. What makes this one particularly significant is that it essentially
breaks down the difficult and multifaceted task of portfolio analysis into two key
factors: risk and return.

In a 1959 book, Markowitz honed this theory into an explanation of how to

calculate the optimal portfolio using quadratic programming, such that the
problem of portfolio choice could actually be mathematically solved. This
model is still frequently used today, over half a century later, due to its ability to
make a complex problem into a relatively simple one.

BPV CAPITAL MANAGEMENT | HARRY MARKOWITZ & THE DEVELOPMENT OF MODERN PORTFOLIO THEORY 8
 SOURCES
Markowitz, Harry M. (July 21, 2015). Personal interview with Steven Turi.

Harry Markowitz. UC San Diego. Web. September 10, 2015. http://rady.

ucsd.edu/faculty/directory/markowitz/

Harry M. Markowitz - Facts. Nobelprize.org. Nobel Media AB 2014. Web.

September 10, 2015. http://www.nobelprize.org/nobel_prizes/
economic-sciences/laureates/1990/markowitz-facts.html

Institute, CFA. CFA Institute Level I 2014 Volume 1 Ethical and Professional
Standards and Quantitative Methods. Wiley Global Finance, 2013-
07-12. VitalBook file.

The Prize in Economics 1990 - Press Release. Nobelprize.org. Nobel Media

AB 2014. Web. 10 Sep 2015. http://www.nobelprize.org/nobel_
prizes/economic-sciences/laureates/1990/press.html

Weisstein, Eric W. Covariance. From MathWorld--A Wolfram Web

Resource. http://mathworld.wolfram.com/Covariance.html

BPV CAPITAL MANAGEMENT | HARRY MARKOWITZ & THE DEVELOPMENT OF 9

MODERN PORTFOLIO THEORY
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