Markowitz - PERSPECTIVES The Early History of Portfolio...

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Jully/August 1999 5 PERSPECTIVES The Early History of Portfolio Theory: 1600–1960 Harry M. Markowitz iversifcation oF investments was a well-established practice long beFore I published my paper on portFolio selection in 1952. ±or example, A. Wiesenberger’s annual reports in Investment Companies prior to 1952 (beginning 1941) showed that these frms held large numbers oF securities. They were neither the frst to provide diversifcation For their customers (they were modeled on the investment trusts oF Scotland and England, which began in the middle oF the 19th century), nor was diversifcation new then. In the Merchant of Venice , Shakespeare has the merchant Antonio say: My ventures are not in one bottom trusted, Nor to one place; nor is my whole estate Upon the Fortune oF this present year; ThereFore, my merchandise makes me not sad. Act I, Scene 1 Clearly, Shakespeare not only knew about diversi- fcation but, at an intuitive level, understood cova- riance. What was lacking prior to 1952 was an ade- quate theory oF investment that covered the eFFects oF diversiFication when risks are correlated, distin- guished between eFFicient and ineFFicient portFo- lios, and analyzed risk–return trade-oFFs on the portFolio as a whole. This article traces the develop- ment oF portFolio theory in the 1950s (including the contributions oF A.D. Roy, James Tobin, and me) and compares it with theory prior to 1950 (includ- ing the contributions oF J.R. Hicks, J. Marschak, J.B. Williams, and D.H. Leavens). Portfolio Theory: 1952 On the basis oF Markowitz (1952), I am oFten called the Father oF modern portFolio theory (MPT), but Roy (1952) can claim an equal share oF this honor. This section summarizes the contributions oF both. My 1952 article on portFolio selection proposed expected (mean) return, E , and variance oF return, V , oF the portFolio as a whole as criteria For portFolio selection, both as a possible hypothesis about actual behavior and as a maxim For how investors ought to act. The article assumed that “belieFs” or projections about securities Follow the same probability rules that random variables obey. ±rom this assumption, it Follows that (1) the expected return on the portFolio is a weighted average oF the expected returns on individual securities and (2) the variance oF return on the portFolio is a particular Function oF the vari- ances oF, and the covariances between, securities and their weights in the portFolio. Markowitz (1952) distinguished between eFFi- cient and ineFFicient portFolios. Subsequently, someone aptly coined the phrase “eFFicient Fron- tier” For what I reFerred to as the “set oF eFFicient mean–variance combinations.” I had proposed that means, variances, and covariances oF securities be estimated by a combination oF statistical analysis and security analyst judgment. ±rom these esti- mates, the set oF eFFicient mean–variance combina- tions can be derived and presented to the investor For choice oF the desired risk–return combination. I used geometrical analyses oF three- and Four-security examples to illustrate properties oF
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This note was uploaded on 12/10/2011 for the course FNBU 3432 taught by Professor Yang during the Spring '10 term at Bentley.

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Markowitz - PERSPECTIVES The Early History of Portfolio...

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