Modern portfolio theory of Markowitz

"Until Dr. Markowitz came along, the investment world assumed that the best stock-market strategy was simply to choose the shares of a group of companies that were thought to have the best prospects.

But in 1952, he published his dissertation, “Portfolio Selection,” which overturned this common sense approach with what became known as modern portfolio theory, widely referred to as M.P.T.

The heart of his research was grounded in the basic relationship between risk and reward. He showed that the risk in any portfolio is less dependent on the riskiness of its component stocks and other assets than how they relate to one another. It was the first time that the benefits of diversification had been codified and quantified, using advanced mathematics to calculate correlations and variations from the mean.

This breakthrough insight and its corollaries have now permeated all aspects of money management, with few professionals unfamiliar with his work.

“Williams proposed that the value of a stock should equal the present value of its future dividends,” Dr. Markowitz wrote in a brief autobiography for the Nobel committee. “Since future dividends are uncertain, I interpreted Williams’s proposal to be to value a stock by its expected future dividends.”

But if investors were interested only in the expected values of securities, he figured, then that implied that the best, or maximized, portfolio would consist of the single most appealing stock.

“This, I knew, was not the way investors did or should act,” he concluded. “Investors diversify because they are concerned with risk as well as return.”

He set out to measure the relationships among a diverse assortment of stocks to construct the most efficient portfolio, and to chart what he called a “frontier,” where no additional return can be obtained without also increasing risk."