Portfolio Optimization Theory
In 1952 Harry Markowitz changed the world of investing forever when the "Journal of Finance" printed his research article entitled "Portfolio Selection". In his research Markowitz set the groundwork for modern portfolio optimization theory, or as it is more commonly called, modern portfolio management theory (MPT).
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Signifigance
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Some of the common concepts discussed by Markowitz in his research in modern portfolio management theory include the "efficient frontier" and diversification. Years later, Markowitz's work has been improved on by others, but the principles he established are still used today both in classrooms of business schools and in the offices of investment management companies. Nearly every investment sales person uses the concepts of diversification and the efficient frontier when talking with clients about buying mutual funds or other investment vehicles.
Efficient Frontier
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The most important theory that Markowitz espoused was that an investing "efficient frontier" existed. The frontier was a graphical illustration that charted out risk versus reward. This illustrated that in the early stages of adding risk, additional reward is also created, but at a certain point, adding more risk does not further increase the return on investment. Markowitz also showed that achieving any additional return for taking on a given risk could only be accomplished with the use of leverage, that is, borrowing money.
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Asset Allocation
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Asset allocation is a modern application of the efficient frontier. Asset allocation is the process of dividing up investment dollars across a series of assets with varying degrees of risk, in order to achieve an average expected level of risk and a commensurately rewarding level of return. Modern asset allocation typically divides investment dollars into equities (stocks), fixed income (bonds), cash (money market), alternative investments (hedge funds or private equity) and real assets (commodities and real estate).
Diversification
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Even within the context of asset allocation, a major tenet of portfolio optimization is diversification. Asset allocation diversifies investment dollars across a variety of asset classes, but investors should also diversify within a single asset class. In the U.S. alone there are over 5,000 publicly traded common stocks and several thousand mutual funds that combine in a variety of ways. Diversifying in a single asset class means that you do not buy a dozen stocks for the equity portion of your portfolio but instead buy several hundred stocks or a mutual fund that owns hundreds of stocks.
Time Frame
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Within the theories of portfolio optimization and modern portfolio management there is no mention of a holding period for a given investment. It is assumed that investments are made for the long-term (typically measured not in years but in decades). Day trading, that is, quickly buying and selling stocks, has no place in portfolio optimization. Trading is more akin to speculation or gambling than it is to investing.
Theories/Speculation
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Other than Henry Markowitz two other major names in the world of portfolio optimization theory are Tobin and Sharpe. Both men used advanced statistical calculations to build on the work done by Markowitz and even to create some of their own financial principles such as Tobin's Theorem and the Sharpe Ratio.
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References
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