Markowitz Mean-Variance Diagram

The Markowitz mean-variance diagram plays a central role in the development of theoretical finance. In setting the foundation for the capital asset pricing model, it represents the beginning of modern portfolio theory. Prior to Harry Markowitzs contribution, the field of finance relied much less on mathematical technique. Contributions to the literature tended to be descriptive, or involved only simple operations applied to accounting data. The principle of diversification, while accepted as a rule of thumb, was not well understood. Markowitzs mean-variance paradigm, summed up succinctly in his famous diagram, set finance on the path to becoming a technical scientific discipline, more a branch of economics than of business administration. The Markowitz diagram is based on the idea that all the information about a portfolio of risky assets that is relevant to a risk averse investor can be summed up in the values of two parameters: the standard deviation and the expected value of the portfolios return, briefly stated as the risk and return. The diagram, presented in Figure 1, contains four essential features: i) the set of parameter pairs of feasible portfolios represented by the shaded area, ii) the efficient frontier along the upper edge of the feasible set, iii) the linear asset allocation line running from the point on the vertical axis at the rate of return on the risk-free asset and tangent to the efficient frontier, and iv) the super-efficient portfolio parameter pair located at the point of tangency. The feasible portfolios are constructed by considering an initial endowment that can be spread across different risky assets in a multitude of ways. The efficient frontier represents those portfolios for which the expected return is the highest for any level of risk, and for which the risk is the lowest for any level of expected return. Its curvature, in bending towards the vertical axis, is the result of the benefit of diversifying among assets whose returns are not perfectly correlated.

Figure 1. The shaded area is the feasible set and the upper boundary is the efficient frontier. P* marks the super-efficient portfolio located at the point of tangency between the asset allocation line and the efficient frontier. R RF represents the risk-free rate of return. Points on the asset allocation line represent the parameter pairs associated with portfolios made up of a combination of the super-efficient portfolio and the risk-free asset. Points on the line to the left of the efficient frontier are associated with portfolios that combine long positions in both the super-efficient portfolio and the risk-free asset, while points to the right are associated with a leveraged long position in risky assets created through borrowing at the risk-free rate. If investors have access to risk-free borrowing and lending, the optimal portfolio will lie along the asset allocation line, since portfolios below and to the right will be inefficient and portfolios above and to the left will not be feasible. The origin of the mean-variance paradigm is recounted in vivid detail by Markowitz (1999) . As a Ph.D. student in economics at the University of Chicago, he went to see Jacob Marschak for advice on a topic for his dissertation. While waiting in the ante room, he happened to meet a stockbroker, also waiting to see Marschak, who suggested that he write his dissertation on the stockmarket. Markowitz relayed the suggestion to Marschak and found him receptive to the idea. Both men were members of the Cowles Commission, as it was called at the time, and econometric investigations of the stockmarket was of special interest to their benefactor, Alfred Cowles. Marschak sent Markowitz to a professor in the business school for advice on background reading in the current literature on investments.
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Markowitz recalls that it was sometime in 1950, while going through the books on investments suggested by the business school professor, that he hit on his seminal idea regarding diversification. The presumption of previous writers had been that, through the law of large numbers, diversification could eliminate all risk as long as one had a large enough number of stocks in ones portfolio. The advice that followed was to invest in those assets with the highest expected return. Markowitz recognized the error in the implicit assumption that stock returns were uncorrelated and sought to discover a measure of risk for a portfolio of assets with imperfectly correlated returns. The idea of using variance as a measure of risk came to him independently, although Irving Fisher and others had previously thought of it. Next, he found the formula for the variance of the returns of a portfolio of risky assets in a book on probability. On examining the formula for the variance of a weighted sum of random variables (found in Uspensky 1937 on the library shelf), I was elated to see the way covariances entered. Dealing with two quantitiesmean and varianceand being an economics student, I naturally drew a trade-off curve. Being, more specifically, a student of T. C. Koopmans , I labeled dominated EV combinations inefficient and the undominated ones efficient. (Markowitz 1999, p. 8) By a curious coincidence, in April of the same year that Markowitz made his original sketch in the library at the University of Chicago, an article by Marschak appeared in Econometrica , that while not actually showing the diagram, sketches out some of the essential details. In summarizing, the state of the art in the theory of assets, Marschak writes: [I]f more than one commodity or time-point is considered, say ( + 1) = quantities, each prospect may be characterized by means, variances, ( 1)/ 2 correlations, etc. Each distribution parameter was regarded as being a good (or possibly a bad) in the eyes of the man. Tastes were described by indifference surfaces drawn in parameter space P, and the empirical properties of these surfaces were discussed. For example, the risk-aversion (risk-discount), i.e., the rate of substitution between the mean and the variance of income, expressed by the relevant slope of an indifference surface, was stated to be positive. (Marschak 1950, p. 118-19) Markowitzs diagram of the efficient frontier first appeared in print in the Journal of Finance in 1952. Unlike the now standard depiction presented in Figure 1, Markowitzs construction had the axes reversed and used variance rather than standard deviation as the measure of risk. The story of the history of the diagram is complicated by the appearance of a competing diagram, also in 1952, in an Econometrica article by Cambridge economist A. D. Roy. Roys diagram has the axes orientated in their now usual fashion, and has the standard deviation rather than variance as the risk measure. Moreover, he identifies the boundary of the feasible set as an envelope curve and, presaging the capital market line and the super-efficient portfolio, he draws a ray from a point on the vertical axis tangent to the efficient frontier, albeit giving it a different interpretation from that of the capital market line. The point of tangency in Roys diagram coincides with the portfolio that maximizes the probability that the portfolio return will be above the level at which the line meets the vertical axis.

Roy includes Marschak (1950) in his list of references so it is plausible that he was following up on the hints provided in that article. Given that Marschak was Markowitzs dissertation advisor, it would be ironic if his competitor for claims of primacy for the diagram was given an edge from reading Marschaks article. Markowitz (1999, p. 5) notes that Roy should share with him the honor as the father of modern portfolio theory but, in truth, Roys contribution remained obscure and did not inspire further developments, despite his writing an additional article on the topic in 1956. Markowitz, on the other hand, teamed up with William Sharpe who went on to make major strides in theoretical finance. Markowitz served as Sharpes unofficial dissertation advisor in the early sixties. A key innovation introduced by Sharpe (1964) was to recognize that in world with a risk-free asset, the investors optimal portfolio would lie, not necessarily on the efficient frontier, but instead on a line tangent to the efficient frontier and intersecting the vertical axis at the risk-free rate of return. The portfolio corresponding to the point of tangency is known as the super-efficient portfolio, and the optimal risk return combination for an investor could be achieved by combining an investment in the super-efficient portfolio with a position in the riskfree asset. The position in the risk-free asset could be long or short depending on ones risk preferences. The idea of the asset allocation line comes from the Tobin (1958) separation theorem that states that one can think of a portfolio in two parts: one part invested in risky assets and one part invested in the risk-free asset. The decision regarding the best combination of risky assets can be made separately from the decision regarding ones level of investment in the riskfree asset. Once all the pieces of the Markowitz mean-variance diagram were in place, Sharpe (1964) was able to draw out the full economic implications in his formulation of the capital asset pricing model, for which he, along with Markowitz, was awarded the Nobel prize in economics in 1990. It is a good example of the power of a simple diagram to illuminate the way to an important discovery. When Markowitz had defended his dissertation on portfolio diversification at the University of Chicago in 1955, Milton Friedman had given him a hard time claiming that his contribution was not economics and that the university could not grant a Ph.D. in economics for a dissertation that was not economics. Markowitz recalls: he kept repeating that for the next hour and a half. My palms began to sweat. At one point he says, you have a problem. Its not economics, its not mathematics, its not business administration (Buser 2008, p. 5). Friedman who was committed to the stance he had recently taken in his famous essay on the methodology of positive economics, could not see how the discovery of a new paradigm for analyzing investment decisions could qualify as a contribution to the discipline. Fortunately though, Markowitz was ultimately successful in his defense, much to the benefit of the field of financial economics. References Bernstein, P. (1992), Capital Ideas: The Improbable Origins of Modern Wall Street, New York, NY: The Free Press.

Buser, S. (2008), Markowitz: Interview at Rady School of Management at the University of California San Diego, History of Finance, American Finance Association, http://www.afajof.org/association/historyfinance.asp Marschak, J. (1950), Rational Behavior, Uncertain Prospects, and Measurable Utility, Econometrica, 18 (2): 111-141. Markowitz, H. (1952), Portfolio Selection, Journal of Finance, 7(1), 77-91. ---------------- (1959), Portfolio Selection: Efficient Diversification of Investments, New York: John Wiley & Sons. ---------------- (1999), The Early History of Portfolio Theory: 16001960, Financial Analysts Journal, 55( 4): 5-16 Roy, A. D. (1952), Safety First and the Holding of Assets, Econometrica, 20 (3): 431-449. ------------ (1956), Risk and Rank or Safety First Generalised, Economica, 23 (91): 214-228. Sharpe, W. (1964), Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk, Journal of Finance, 19 (3): 425-442. Tobin, J. (1958). "Liquidity Preference as Behavior Towards Risk". The Review of Economic Studies, 25(1): 6586. 1 See also Bernstein (1992) and Buser (2008).