Chapter 25: The Markowitz Mean-variance Diagram
Fiona Maclachlan 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 Markowitz’s 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. Markowitz’s 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 portfolio’s return, briefly stated as the risk and return. The diagram, presented in Figure 25.1, 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...
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