Harry Markowitz was born in Chicago, Illinios on August
24, 1927. He received his bachelor’s degree and Ph.D. in economics
from the University of Chicago. While attending the University of Chicago
he was selected to join the elite Cowles Commission for Research in
Economics. After completing his college career, Markowitz joined the
RAND Corporation in 1952.
A Markowitz Efficient Portfolio is one where no added
diversification can lower the portfolio's risk for a given return expectation
(alternately, no additional expected return can be gained without increasing
the risk of the portfolio). The Markowitz Efficient Frontier is the
set of all portfolios that will give you the highest expected return
for each given level of risk. These concepts of efficiency were essential
to the development of the Capital Asset Pricing Model.
Since 1982, Markowitz has taught economics at Baruch
College at the City University of New York.
The following press release
from the Royal Swedish Academy of Sciences
describes Markowitz’s work:
Financial markets serve
a key purpose in a modern market economy
by allocating productive resources among
various areas of production. It is to a large
extent through financial markets that saving
in different sectors of the economy is transferred
to firms for investments in buildings and
machines. Financial markets also reflect
firms' expected prospects and risks, which
implies that risks can be spread and that
savers and investors can acquire valuable
information for their investment decisions.
The first pioneering contribution in the field of financial
economics was made in the 1950s by Harry Markowitz who developed a theory
for households' and firms' allocation of financial assets under uncertainty,
the so-called theory of portfolio choice. This theory analyzes how wealth
can be optimally invested in assets which differ in regard to their
expected return and risk, and thereby also how risks can be reduced.
A second significant contribution to the theory of
financial economics occurred during the 1960s when a number of researchers,
among whom William Sharpe was the leading figure, used Markowitz's portfolio
theory as a basis for developing a theory of price formation for financial
assets, the so-called Capital Asset Pricing Model, or CAPM.
A third pioneering contribution to financial economics
concerns the theory of corporate finance and the evaluation of firms
on markets. The most important achievements in this field were made
by Merton Miller, initially in collaboration with Franco Modigliani
(who received the Alfred Nobel Memorial Prize in Economic Sciences in
1985 mainly for other contributions). This theory explains the relation
(or lack of one) between firms' capital asset structure and dividend
policy on one hand and their market value on the other.
Harrv M. Markowitz
The contribution for
which Harry Markowitz now receives his
award was first published in an essay entitled "Portfolio Selection"
(1952), and later, more extensively, in his book, Portfolio Selection:
Efficient Diversification (1959). The so-called theory of portfolio
selection that was developed in this early work was originally a normative
theory for investment managers, i.e., a theory for optimal investment
of wealth in assets which differ in regard to their expected return
and risk. On a general level, of course, investment managers and academic
economists have long been aware of the necessity of taking returns as
well as risk into account: "all the eggs should not be placed in
the same basket". Markowitz's primary
contribution consisted of developing a
rigorously formulated, operational theory
for portfolio selection under uncertainty
- a theory which evolved into a foundation
for further research in financial economics.
Markowitz showed that under certain given conditions,
an investor's portfolio choice can be reduced to balancing two dimensions,
i.e., the expected return on the portfolio and its variance. Due to
the possibility of reducing risk through diversification, the risk of
the portfolio, measured as its variance, will depend not only on the
individual variances of the return on different assets, but also on
the pairwise covariances of all assets.
Hence, the essential aspect
pertaining to the risk of an asset is not
the risk of each asset in isolation, but
the contribution of each asset to the risk
of the aggregate portfolio. However, the "law
of large numbers" is not wholly applicable
to the diversification of risks in portfolio
choice because the returns on different
assets are correlated in practice. Thus,
in general, risk cannot be totally eliminated,
regardless of how many types of securities
are represented in a portfolio.
In this way, the complicated and multidimensional problem
of portfolio choice with respect to a large number of different assets,
each with varying properties, is reduced to a conceptually simple two-dimensional
problem - known as mean-variance analysis. In an essay in 1956, Markowitz
also showed how the problem of actually calculating the optimal portfolio
could be solved. (In technical terms, this means that the analysis is
formulated as a quadratic programming problem; the building blocks are
a quadratic utility function, expected returns on the different assets,
the variance and covariance of the assets and the investor's budget
restrictions.) The model has won wide acclaim due to its algebraic simplicity
and suitability for empirical applications.
Generally speaking, Markowitz's work on portfolio theory
may be regarded as having established financial micro analysis as a
respectable research area in economic analysis.