Excerpt

## Table of Contents

1 Introductory Biography of Harry M. Markowitz

2 The Portfolio Theory

2.1 Risk and Return

2.2 Diversification

3 Relation to the Financial Crisis

4 Literature

**List of Figures**

Figure 1: Investment decisions

Figure 2: Portfolio compositions

Figure 3: Efficient portfolios

## 1 Introductory Biography of Harry M. Markowitz

Harry Max Markowitz was born on August 24, 1927 in Chicago, Illinois. In high school he played the violin and developed interest in physics and philosophy. In that time he was influenced by the works of David Hume and Charles Darwin. After finishing the Bachelor’s program at the University of Chicago, Markowitz decided to continue his studies specialising in economics. He was particularly interested in the "Economics of Uncertainty", e.g. the theories of Neumann-Morgenstern and Friedman-Savage. While studying, Markowitz joined the Cowles Commission for Research in Economics. He left the University of Chicago in 1952 and started working at the RAND (research and development) Corporation. In the same year, Markowitz’s article “Portfolio Selection” was published by The Journal of Finance. He received a Ph.D. from the University of Chicago with his thesis on portfolio theory in 1955.

Furthermore Harry Markowitz and Herb Karr helped to develop SIMSCRIPT, the first simulation programming language, at RAND Corporation. In 1962 they founded the California Analysis Center Inc., which later turned into CACI International, to support and train the computer language.

In the following years Markowitz was working at the University of California (1968â€‘1969), the Arbitrage Management Company (1969â€‘1972), as well as IBM’s T.J. Watson Research Center (1974â€‘1983). In 1989, he received the Von Neumann Prize in Operations Research Theory by the Operations Research Society of America and The Institute of Management Sciences for his contributions in the areas of portfolio theory, sparse matrix techniques and the SIMSCRIPT programming language. Harry Markowitz was honoured with the Nobel Prize in Economics for his portfolio theory together with William F. Sharpe and Merton M. Miller in 1990. Today, at age 82, he is teaching as an adjunct professor at the Rady School of Management at the University of California, San Diego. Also, he is working as a consultant for several investment firms.

## 2 The Portfolio Theory

### 2.1 Risk and Return

The basic assumption of Markowitz’s theory is that profits and risk of a security are inseparably connected. To illustrate this, Markowitz plotted the distribution of returns of various securities over an 18 year period. It became apparent that securities with a higher variance tend to have a higher mean value.

These insights from past data are applicable to future decisions, as according to Markowitz, the relationships which apply to objective probabilities of random variables also apply to consistent subjective probability beliefs (cf. Markowitz, 1991, p. 38). In this connection, the returns of a security are determined by the expected value (of its future dividends).^{[1]} The risk is measured by the standard deviation. Mathematically the standard deviation describes the square root of the variance, which is the average squared deviation of the actual from the expected returns. It provides a preferable measure compared to e.g. the maximum loss, as it includes the frequency of losses (cf. Markowitz, 1991, p. 17). The standard deviation is called volatility when referring to stocks (cf. Weber, 2007, p. 108).

Consecutively an example to clarify the role of risk and return in the investment decision process is given. Figure 1 presents two companies the SAVE Ltd. and the RISKY Ltd. which both have a stock value of 100$. For the upcoming year two scenarios presuming fixed probabilities are considered:

illustration not visible in this excerpt

**Figure 1: Investment decisions**

Each company will succeed with a 50% chance, whereat SAVE can increase its value to 120$ and RISKY to even 210$. In the equiprobable pessimistic scenario SAVE stays at 100$, but RISKY will drop to 10$. The expected returns are calculated by summing up the possible outcomes weighed by their probabilities of occurrence. Thus both companies have an expected return of 110$. Empirical studies showed that investors generally prefer the secure company over the risky company, because of its lower standard deviation. The behaviour of avoiding risk, given equivalent outcomes, is called risk aversion (cf. Weber, 2007, p. 106 et seq.).

**[...]**

^{[1]} The terms average, mean value and expected value are used synonymously. All measures describe a weighed average using frequencies or probabilities as weights.

- Quote paper
- Dipl. Kfm. Peter Weyel (Author), 2009, Harry M. Markowitz - Portfolio Theory and the Financial Crisis, Munich, GRIN Verlag, https://www.grin.com/document/170556

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