Harry Markowitz, Merton Miller and William Sharpe were largely responsible for the work that collectively became known as modern portfolio theory (MPT). Their theories break down into three major parts: the efficient market hypothesis, the efficient capital markets theory and the capital asset pricing theory.

Dr Harry Markowitz started the research with his paper entitled ‘Portfolio selection’ published in the Journal of Finance in 1952. Within this paper, Markowitz demonstrated that diversification in a portfolio is only actually achieved when each part of the portfolio works differently from all the others. In 1959, he followed this work up with ‘Portfolio selection: efficient diversification of investments’, in which he elaborated on his theories of diversification.

The arguments central to Markowitz’s work are that for portfolios to work efficiently, the investment manager needs to look at the composition of the whole portfolio rather than the careful selection of each part. Using a series of equations, Markowitz showed that a portfolio was diversified effectively only if each element within that portfolio was negatively correlated with the others.

Markowitz also debated the fact that investors are rational beings who know that they must make decisions with regard to the assumption of risk and expected reward. Investors, according to Markowitz, work with one of two objectives; either to maximise returns or to minimise risk. His work then turned to demonstrating that portfolios have theoretical levels of efficiency or natural points of balance. For any particular level of risk, he showed that there is a point where the yield could be optimized.

These theories produced what later became known as the portfolio’s efficient frontier. Once the investor’s preferences as a rational being have been quantified and slotted into a mathematical model, it is a simple step from that to identify the investor’s optimal portfolios, as a point along the line that constitutes the efficient frontier.

This, propounded at a time when a clever investor was someone who could pick the right stocks, was revolutionary thinking. For the first time, someone was analysing risk in a portfolio, and beyond that showing that risk can be measured and managed effectively through prudent allocation of assets.

Markowitz’s original work concentrated on equities and bonds and it was a long while before the MPT theories were applied to other investment classes.

Possibly related posts: (automatically generated)
Modern Managed Futures Portfolio Theory

• Basket options
• The Outlook for Managed Futures Funds (continue)
• The Origins of the Futures Industry (part 2)
• Where Do You Look for the Next Paul Tudor Jones? Part 4
• The Case Against Managed Futures
• Managed Futures
• Managed Futures—Prudent Access to the Futures Markets
• The Origins of the Futures Industry (part 1)
• Immunizing bond portfolios using bond futures
• How Does Performance Compare to Other Investments?