Portfolio Selection

Abstract

Revolutionary paper that established the foundations of Modern Portfolio Theory (MPT). Markowitz mathematically demonstrated that a diversified portfolio can have lower risk than the sum of its individual parts. Introduced the concept of efficient frontier: the optimal combination of assets that maximizes expected return for a given level of risk. The paper defines risk as variance of returns and uses covariance between assets to optimize. Markowitz won the Nobel Prize in Economics (1990) for this work that transformed investment management from art to science. His quantitative approach allows investors to construct portfolios that systematically balance risk and return based on their personal preferences, revolutionizing how we think about diversification.

Key Ideas

1. 1Diversification reduces risk without necessarily reducing expected return
2. 2Portfolio risk depends on correlation between assets, not just individual risk
3. 3There exists an "efficient frontier" of optimal portfolios for each risk level
4. 4Maximizing expected return and minimizing variance are complementary objectives
5. 5Rational investors only accept more risk if compensated with higher expected return