Harry Markowitz's Theory Of Portfolio Theory And Mean-Pricing Model

The modern portfolio theory was based on risk and return trade-offs and was developed in earlier works of Harry Markowitz (1952, 1959) and Roy (1952). According to Markowitz (1952), risk can be eliminated through diversification by spreading the wealth across the assets. In his work, Markowitz (1959) implemented the theory of mean-variance of market portfolio which provided the initial foundation for capital asset pricing model. His model was a static model which assumed that investors tend to invest in a portfolio at time t-1, and gave stochastic return in the period t. One of the main assumptions in Markowitz’s efficient-set algorithm is that any portfolio can be evaluated in terms of two parameters: standard deviation of the portfolio and expected return of the portfolio (Blume, 1992). The model of Markowitz …show more content…
Some of these assumptions are described as follows: 1) All investors are single period wealth maximizers who purchase securities based on mean, variance of expected return; 2) Unrestricted borrowing and lending of riskless assets including unlimited short sales of risky assets 3) The financial market is perfectly competitive and all investors are price takes; 4) The quantity of securities is fixed; 5) All securities have perfect liquidity, i.e., there are no significant transaction costs and taxes are neutral; 6) There are no inflation or interest rate changes (Naylor and Tapon, 1982). When we consider these assumptions, all investors will hold the same portfolio, likewise, the CAPM will simply follow Markowitz mathematics (Blume, 1992). However, there are plenty of studies that have been criticizing the CAPM for its unrealistic assumptions. More detailed interpretation and critique of those unrealistic assumptions will be given in the following Section