Summary of a reading - Outline Example

Summary of a Reading By The short paper en d “Portfolio Selection,” published in the March 1952 issue of the Journal of Finance which turned out to be a landmark in the history of ideas, was written by a 25-year-old graduate student from the University of Chicago named Harry Markowitz. Though Markowitz won a Nobel Prize for his achievements in economic sciences 38 years later, the originality and intellectual density of the article was not appreciated until much later, as the subject itself was of limited interest at that time.

Memories of the crash and depression in the1930s, the scars of World War II, and presence of unscrupulous players in the market coupled with legal restrictions kept the general public away from the stock market in the 1950s. A.D.Roy’s paper titled “Safety First and the Holding of Assets” published three months after Markowitz’s paper appeared in the Journal of Finance, discussed the same lines of arguments, but did not evoke any response.After earning his undergraduate degree in economics, Markowitz continued his graduate work while serving as a Research Associate at the Cowles Commission.

He chose stock market as the subject of his doctoral dissertation in consultation with Jacob Marschak (director of Cowles Commission) and Marshall Ketchum (Dean of the Graduate School of Business). The Theory of Investment Value by John Burr Williams fascinated him, but it struck him that people should consider risk as well as return while making investment decisions. So he applied Tjalling Koopmans’ (Prof. of Economics at Chicago University) linear programming technique for solving problems of resource allocation under constraints, to analyze the choices facing an investor who must decide between seeking high returns and attempting to hold down risk at the same time.

Diversification protects the investor from losing everything in one swoop. At the same time it reduces the opportunity of earning high returns by concentrating investment in one stock which appears to be the best. Markowitz followed the idea of the tension between risk and return and between diversification and concentration down two separate tracks. The first track, the subject of his 1952 article, tells the investor how to apply the trade off between risk and reward in selecting a portfolio, by applying Koopmans’ linear programming.

The second track tells how each investor should go about selecting the single portfolio that most closely conforms to the investor’s goals. This aspect is treated at length in Markowitz’s book, Portfolio Selection: Efficient Diversification of Investment, completed in 1955 as his PhD thesis and published in 1959. Markowitz puts emphasis on right kind of diversification for the right reason and avoiding investment in securities with high covariance among themselves (assets which move up and down in sympathy with one another).

Variance and high risk in stock market is evident from the fact that, from 1925 to 1989, the average return rate was 12.4%, but there were nine good years with 33% yields and five bad years with below -8% yields.Markowitz recommends an efficient portfolio which offers highest expected return for any given degree of risk or has the lowest degree of risk for any given return. According to him, by choosing a portfolio consisting of stocks which have low covariance, the overall variance of a portfolio of highly risky stocks can be reduced.

Even a portfolio of 15 stocks selected at random will have only 5% more variance than a portfolio of 100 stocks, showing that even a little diversification can help reduce risk. Markowitz further updated his theory in his book, Mean-Variance Analysis in Portfolio Choice and Capital Markets published in 1987.For applying Markowitz’s theory, investors need to analyze every possible combination of assets and search for the most efficient among them. Even with computer technology, this is difficult for the average investor.

After arriving at the “efficient frontier,” the investor has to choose the portfolio most appropriate for him considering his risk appetite. Further, market prices, investor expectations and riskiness of assets are dynamic and also constantly interact as new information arrives in the market. As a result, the necessary conditions for an accurate calculation of risk may not prevail. Despite these limitations, there is no denying the fact that Markowitz’s theories formed the foundation for all subsequent theories on how financial markets work, how risk can be quantified and even how corporations should finance themselves.