This seminar paper explains Markowitz's Portfolio Theory in a consolidated and understandable way.
The principles of the Portfolio Theory are connected to the Financial Crisis that started as a bursting real-estate bubble in 2006. In this connection, it is shown that on the one hand the basic principles of Markowitz apply and might have helped to lower the extent of the crisis. On the other hand, the Risk-Return-Paradoxon which supported the evolution of the crisis is discussed.
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
Research Objectives and Topics
This paper aims to examine the fundamental principles of Harry M. Markowitz's Portfolio Theory and analyze their relevance and applicability in the context of the 2006 financial crisis, exploring why traditional risk-return assessments failed during this period.
- Biography and scientific contributions of Harry M. Markowitz
- Core mechanisms of Portfolio Theory: Risk, Return, and Volatility
- The principle of diversification and its impact on portfolio stability
- Critical analysis of the 2006 financial crisis through the lens of Portfolio Theory
- Examination of rational vs. irrational investment behavior and incentive schemes
Excerpt from the Book
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.
Summary of Chapters
1 Introductory Biography of Harry M. Markowitz: Provides a biographical overview of Harry M. Markowitz, detailing his academic path, his tenure at the RAND Corporation, and his Nobel Prize-winning contributions to economics.
2 The Portfolio Theory: Explains the core tenets of the theory, focusing on the relationship between risk and return as well as the mechanics of diversification.
2.1 Risk and Return: Defines how risk is quantified through standard deviation and volatility, and how investors weigh these factors against expected returns.
2.2 Diversification: Discusses the strategy of combining different assets to minimize portfolio risk, emphasizing the importance of low correlations between securities.
3 Relation to the Financial Crisis: Analyzes the 2006 financial crisis, arguing that a disregard for the principles of diversification and a misjudgment of risk led to widespread institutional failures.
4 Literature: Lists the academic and journalistic sources utilized for the research paper.
Keywords
Harry M. Markowitz, Portfolio Theory, Financial Crisis, Diversification, Risk, Return, Volatility, Asset Allocation, Subprime Credits, Investment Decision, Standard Deviation, Market Correlation, Economic Uncertainty, Financial Instruments, Risk Aversion
Frequently Asked Questions
What is the primary focus of this paper?
The paper examines the foundational concepts of Harry M. Markowitz's Portfolio Theory and applies these theoretical frameworks to explain the root causes of the 2006 financial crisis.
What are the central themes discussed in the work?
The central themes include the risk-return trade-off, the mathematical foundations of security variance, the role of diversification, and the behavioral factors that contribute to market instability.
What is the core objective of the research?
The objective is to determine whether the financial crisis could have been mitigated or avoided had financial institutions adhered to the risk management principles defined by Markowitz.
Which scientific methods are employed?
The work utilizes a literature-based analytical method, applying established economic theory to historical financial events and data simulations, such as the Perlitz and Löbler survey.
What does the main body of the text cover?
It covers the biography of the author of the theory, the mechanics of portfolio selection, and a critical analysis of how institutional greed and ignorance of diversification led to the 2006 crash.
Which keywords best describe the research?
Key terms include Portfolio Theory, Diversification, Financial Crisis, Risk, Return, Volatility, and Asset Allocation.
How does Markowitz define risk in his theory?
Markowitz defines risk as the standard deviation of returns, which represents the variance of actual returns from the expected value.
Why did diversification fail during the financial crisis?
Diversification failed because many financial instruments became too highly correlated, and market participants ignored the risk-return relationship in favor of short-term profit incentives.
What is the "Risk-Return-Paradoxon" mentioned in the text?
It refers to a phenomenon where individuals in a crisis-situation exhibit a higher willingness to take risks, even if the expected outcome is lower, contrary to standard theory.
- 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
