Harry Max Markowitz (born August 24, 1927) is an American economist who received the
1989 John von Neumann Theory Prize and the 1990 Nobel Memorial Prize in Economic Sciences.
Markowitz is a professor of finance at the Rady School of Management at the University of
California, San Diego (UCSD). He is best known for his pioneering work in modern portfolio
theory, studying the effects of asset risk, return, correlation and diversification on probable
investment portfolio returns.
Markowitz won the Nobel Memorial Prize in Economic Sciences in 1990 while a professor of
finance at Baruch College of the City University of New York. In the preceding year, he received
the John von Neumann Theory Prize from the Operations Research Society of
America (now Institute for Operations Research and the Management Sciences, INFORMS) for
his contributions in the theory of three fields: portfolio theory; sparse matrix methods; and
simulation language programming (SIMSCRIPT).
A Markowitz-efficient portfolio is one where diversification can lower the portfolio's risk for a
given return expectation (alternately, no additional expected return can be gained without
increasing the risk of the portfolio). The Markowitz Efficient Frontier is the set of all portfolios
that will give the highest expected return for each given level of risk. These concepts of efficiency
were essential to the development of the capital asset pricing model.
The efficient frontier theory was introduced by Nobel Laureate Harry Markowitz in 1952 and is a
cornerstone of modern portfolio theory (MPT). 1 The efficient frontier rates portfolios
(investments) on a scale of return (y-axis) versus risk (x-axis).
Harry M. Markowitz, (born August 24, 1927, Chicago, Illinois, U.S.), American finance
and economics educator, cowinner (with Merton H. Miller and William F. Sharpe) of the 1990
Nobel Prize for Economics for theories on evaluating stock-market risk and reward and
on valuing corporate stocks and bonds.
Markowitz studied at the University of Chicago (Ph.B., 1947; M.A., 1950; Ph.D., 1954) and then
was on the research staff of the RAND Corporation in Santa Monica, California (1952–60, 1961–
63), where he met Sharpe. He then held various positions with Consolidated Analysis Centers, Inc.
(1963–68), the University of California, Los Angeles (1968–69), Arbitrage Management
Company, (1969–72), and IBM’s T.J. Watson Research Center (1974–83) before becoming a
professor of finance at Baruch College of the City University of New York. In 1994 he became a
research professor of economics at the University of California, San Diego.
The research that earned Markowitz the Nobel Prize involved his “portfolio theory,” which sought
to prove that a diversified, or “optimal,” portfolio—that is, one that mixes assets so as to maximize
return and minimize risk—could be practical. His techniques for measuring the level of risk
associated with various assets and his methods for mixing assets became
routine investment procedures. He also developed a computer language called Simscript, used to
write economic-analysis programs.
What Is the Efficient Frontier?
The efficient frontier is the set of optimal portfolios that offer the highest expected return for a
defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie
below the efficient frontier are sub-optimal because they do not provide enough return for the
level of risk. Portfolios that cluster to the right of the efficient frontier are sub-optimal because
they have a higher level of risk for the defined rate of return.
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The standard deviation of returns in a portfolio measures investment risk and consistency
in investment earnings.
Lower covariance between portfolio securities results in lower portfolio standard
deviation.
Optimal portfolios that comprise the efficient frontier usually exhibit a higher degree of
diversification.
Understanding the Efficient Frontier
The efficient frontier rates portfolios (investments) on a scale of return (y-axis) versus risk (xaxis). The compound annual growth rate (CAGR) of an investment is commonly used as the
return component while standard deviation (annualized) depicts the risk metric.
The efficient frontier graphically represents portfolios that maximize returns for the risk
assumed. Returns are dependent on the investment combinations that make up the portfolio.
Why Is the Efficient Frontier Important?
The efficient frontier graphically depicts the benefit of diversification and can. The curvature of
the efficient frontier shows how diversification can improve a portfolio's risk versus reward
profile.
 The modern portfolio theory argues that any given investment's risk and return
characteristics should not be viewed alone but should be evaluated by how it affects the
overall portfolio's risk and return.
What Is the Optimal Portfolio?
An optimal portfolio is one designed with a perfect balance of risk and return. The optimal
portfolio looks to balance securities that offer the greatest possible returns with acceptable risk or
the securities with the lowest risk given a certain return.
How Is the Efficient Frontier Constructed?
The efficient frontier rates portfolios on a coordinate plane. Plotted on the x-axis is the risk, while
return is plotted on the y-axis—annualized standard deviation is typically used to measure risk,
while compound annual growth rate (CAGR) is used for return.
What Is Diversification?
Diversification is a risk management strategy that mixes a wide variety of investments within a
portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles in
an attempt at limiting exposure to any single asset or risk.
How Does the Efficient Frontier Work?
Harry Markowitz introduced the efficient frontier theory in 1952. Generally, efficient frontier refer
to a set of portfolios that offer benefits that no other portfolios or investments in the market offer.
Although, they have the same standard deviation attributable to other returns, they offer expected
returns that are higher than the others. The returns offered by efficient frontier are based on the
nature of investments that make up the optimal portfolio. In order to maximise the highest level of
returns for a defined level of risks, investors select securities that offer exceptionally high returns
and low risks to make up the portfolio in the efficient frontier. Using the efficient frontier theory,
investments are highly diversified, that is there is a mix of investments that offer the highest returns
and those that offer the lowest risks in the portfolio. hence, diversification is an attribute of optimal
portfolios that use the efficient frontier principle. Here are some important things you should know
about efficient frontier;
Optimal Portfolio
In the investment market, there is always a belief or an assumption that the higher the benefit of
an investment, the higher the risk that it entails. Also, the lower the risk, the lower the return.
However, Harry Markowitz developed a theory that creates a balance between risk and return and
that is the efficient frontier theory. The efficient theory uses a set of optimal portfolios in creating
a balance between the expected returns of investment and their defined level of risk. This set of
optimal portfolio offer the highest rate of return for a defined level of risk, aloco, they offer the
lowest level of risk for a maximum potential return.
Selecting Investments
It is important to know that the types of investments that an investor selected in a portfolio will
determine whether the portfolio will be an efficient frontier. Basically, securities that have a high
level of risk as well as high expected returns occupy the right end of the efficient frontier. Also,
on the left side of the efficient frontier are securities or investment instruments that have low risks
as well as low potential returns. Investors that have risk-tolerance those that are interested in using
the efficient frontier theory, usually, select from the right side of the efficient frontier. For investors
that want to avert investment risks, selecting from the left side of the efficient frontier is the best
choice.
Limitations
There are many setbacks or limitations on the efficient frontier theory. One of the limitations of
this theory is that it is best as a theory and not in practice. The fact that investments making up the
optimal portfolio in the efficient frontier are selected based on the assumption that returns on assets
usually follow normal distribution is another limitation of this theory. In reality, returns on assets
are said to follow a heavy-tailed distribution and not the normal distribution. Aside from the above
limitations, some underlying assumptions in the efficient theory such as the rationality of investors
and their tendency to avoid risk is debatable. This is because the market generally witness irrational
investors and risk-daring investors who can influence certain decisions in the market.