Home > Topics > Portfolio Management > Markowitz Model
← PreviousNext →

Markowitz Model 🧠🏛️

Proposed by Harry Markowitz in 1952, the Markowitz Model (also called the Mean-Variance Model) provided the first mathematical framework for diversifying a portfolio. It transformed portfolio management from an art into a science.

1. The Core Objective

The model's goal is to help an investor choose a portfolio that:

  1. Maximizes Return for a given level of risk.
  2. Minimizes Risk for a given level of expected return.

This is known as the Mean-Variance Criterion.

Loading stats…

2. Assumptions of the Model

Like all scientific models, the Markowitz Model makes several assumptions about the world and investors:

  • Rational Investors: Investors want more money and less risk.
  • Risk Aversion: If two portfolios have the same return, the investor will always choose the one with lower risk.
  • Information Availability: All investors have access to the same information at the same time.
  • Efficiency: There are no taxes or brokerage commissions (in the theoretical model).
  • Single Period: Decisions are made for one specific holding period.
  • Quantifiable Risk: Risk is uniquely measured by Variance or Standard Deviation.

3. The Efficient Set

Markowitz proved that out of infinite possible combinations of stocks, only a few are actually "worth holding."

Important

A portfolio is Efficient if no other portfolio exists that has:

  • A higher return with the same risk.
  • A lower risk with the same return.

By plotting these efficient portfolios on a graph, we get the Efficient Frontier.

4. Limitations of the Model

While revolutionary, the Markowitz model has some real-world issues:

  1. Data Intensive: It requires a huge number of inputs (Expected returns, variances, and correlations for every pair of stocks).
  2. Estimation Error: If your "guesses" for future returns are slightly wrong, the whole model fails.
  3. Complexity: It is difficult for individual investors to calculate without software.

Summary

  • The Markowitz Model is based on the Mean-Variance Criterion.
  • It assumes investors are rational and risk-averse.
  • It focuses on finding the Efficient Frontier.
  • Its biggest strength is scientific diversification; its biggest weakness is its heavy data requirement.

Quiz Time! 🎯

Loading quiz…

← PreviousNext →