Portfolio choice Modern portfolio theory
More than 60 years ago Harry Markowitz established a whole new concept for optimizing portfolios, by focusing on a holistic approach of several assets to build a portfolio rather than to restrict the investment to a single seemingly profitable asset. In his article “Portfolio selection” from 1952, he derived a normative decision rule to build efficient portfolios. With this decision rule, he laid the foundation for a theory, which was later called the modern portfolio theory. About 40 years later in 1990 Harry Markowitz won the Nobel prize together with Merton H. Miller and William F. Sharpe for their pioneering work in the theory of financial economics.
According to Markowitz, when selecting the optimal portfolio an investor should focus on the two main elements portfolio return and portfolio risk, whereby risk is defined as fluctuations in returns. Each investor has different interests when choosing a portfolio, but every investor pursues the goal to achieve high returns at low risk: “It seemed obvious that investors are concerned with risk and return, and that these should be measured for the portfolio as a whole” (Markowitz, 1952). In the
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Besides the key assumption that investors seek to maximize returns while minimizing risk, Markowitz assumes that markets are efficient, that investors are expected utility maximizers according to Bernoulli and that they make their decisions based on an individual risk function, which leads to a maximization of the expected utility taking expectations about risk and return of a specific investment into consideration. Furthermore, the planning horizon in the modern portfolio theory covers only one period, at the end of each period the investor has to make a new decision about the reallocation of his capital. This makes the asset allocation a static decision with a short-term