Creating Diversified Portfolios of Uncorrelated Assets
By Dr. David Edward Marcinko MBA CMP™
More than a half century ago, a paper appeared in The Journal of Finance written by a 24-year-old doctoral candidate in economics at the University of Chicago—Harry Markowitz. It was called “Portfolio Selection” and suggested that investors take into account risk in pursuit of the highest return—a concept that we take for granted today [Modern Portfolio Theory].
Markowitz drew a trade-off curve between risk and reward and called it the “efficient frontier.” A rational physician executive or other investor who knew his or her risk tolerance could choose an appropriate portfolio from a point on this curve. Markowitz led investors to diversified portfolios of uncorrelated investments.
Markowitz followed up his dissertation in 1959 with a book entitled Portfolio Selection [Efficient Diversification of Investment]. His many contributions to finance earned him the Nobel Prize in Economic Science in 1990 along with William Sharpe and Merton Miller. He reasoned that diversification is about avoiding the covariance.
If risks are uncorrelated, you can reduce the risk of a portfolio to practically zero by sufficient diversification. This doesn’t work if risks are correlated. If one invests in a very large number of securities that are correlated, risk does not approach zero but rather the average covariance, which is a very substantial amount of risk.
Where It All Started
It was at the RAND Corporation that Markowitz met William [Bill] Sharpe who was working on his PhD at UCLA. Markowitz takes issue with Sharpe’s Capital Asset Pricing Model (CAPM), which claims that the expected return of a security depends only on its beta—ignoring fundamental analysis.
CAPM also implies that the market portfolio is efficient, even though investors in the market may not act rationally. It says that the market portfolio is a mean-variance efficient portfolio. Markowitz disputes this conclusion. He points to Fama and French and others who have found that expected returns are more closely related to book-to-price or size—not to beta.
The still living Markowitz fends off criticism of mean-variance analysis only being valid when probability distributions are normal by stating that he realizes that probability distributions are not normal in the real world.
But, if they are similar to a normal distribution, mean variance does a good job at approximating expected utility. He admits that when they are too dispersed, mean variance doesn’t work well.
Note: Travels along the Efficient Frontier,” an interview with Harry Markowitz by Jonathan Burton, Dow Jones Asset Management, May/June 1997, pp. 21–28, Dow Jones Financial Publishing Corp.
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Filed under: CMP Program, Investing, Portfolio Management | Tagged: Capital Asset Pricing Model, CAPM, CMP, david marcinko, Fama and French, Harry Markowitz, Merton Miller, Modern Portfolio Theory, MPT, William Sharpe, William [Bill] Sharpe, www.certifiedmedicalplanner.com |