The Harry Markowitz Model & MPT Assumptions

MPT stands for risk diversification in investing. The core of MPT is selecting a group of assets with lower collective risk than any of the single assets. Therefore, MPT allows to construct a maximum return portfolio for a given risk as well as to create portfolio with minimum risk for given return. Therefore, Modern Portfolio Theory is a strategic tool to diversify Your investments.

The Harry Markowitz Model

MPT - Modern Portfolio Theory - represents the mathematical formulation of risk diversification in investing, that aims at selecting a group of investment assets which have collectively lower risk than any single asset on its own. This becomes possible, since various asset types frequently change in value in opposite directions. Actually investing, being a tradeoff between risk and return, presupposes that risky assets have the highest expected returns.

Markowitz Model & MPT

Thus, MPT shows how to choose a portfolio with the maximum possible expected return for the given amount of risk. It also describes how to choose a portfolio with the minimum possible risk for the given expected return. Therefore, Modern Portfolio Theory is viewed as a form of diversification which explains the way of finding the best possible diversification strategy.

Harry Markowitz model (HM model), also known as Mean-Variance Model because it is based on the expected returns (mean) and the standard deviation (variance) of different portfolios, helps to make the most efficient selection by analyzing various portfolios of the given assets. It shows investors how to reduce their risk in case they have chosen assets not “moving” together.

MPT Assumptions

Modern Portfolio Theory relies on the following assumptions and fundamentals that are the key concepts upon which it has been constructed:

  • For buying and selling securities there are no transaction costs. There is no spread between bidding and asking prices. No tax is paid, its only risk that plays a part in determining which securities an investor will buy.
  • An investor has a chance to take any position of any size and in any security. The market liquidity is infinite and no one can move the market. So that nothing can stop the investor from taking positions of any size in any security.
  • While making investment decisions the investor does not consider taxes and is indifferent towards receiving dividends or capital gains.
  • Investors are generally rational and risk adverse. They are completely aware of all the risk contained in investment and actually take positions based on the risk determination demanding a higher return for accepting greater volatility.
  • The risk-return relationships are viewed over the same time horizon. Both long term speculator and short term speculator share the same motivations, profit target and time horizon.
  • Investors share identical views on risk measurement. All the investors are provided by information and their sale or purchase depends on an identical assessment of the investment and all have the same expectations from the investment. A seller will be motivated to make a sale only because another security has a level of volatility that corresponds to his desired return. A buyer will buy because this security has a level of risk that corresponds to the return he wants.
  • Investors seek to control risk only by the diversification of their holdings.
  • In the market all assets can be bought and sold including human capital.
  • Politics and investor psychology have no influence on market.
  • The risk of portfolio depends directly on the instability of returns from the given portfolio.
  • An investor gives preference to the increase of utilization.
  • An investor either maximizes his return for the minimum risk or maximizes his portfolio return for a given level of risk.
  • Analysis is based on a single period model of investment.

Choosing the Best Portfolio

Two essential decisions are necessary to be made to choose the best portfolio from a number of possible portfolios, each with its risk and return opportunities:

  1. Determine a set of efficient portfolios.
  2. Select the best portfolio out of the efficient set.

Being an important achievement in the financial sphere, the theory has found ground in other fields as well. In 1970s, it was widely applied in the area of regional sciences to derive the relationship between variability and economic growth. Similarly it has been used in the field of social psychology to form the self-concept. Currently, it is used by experts to model project portfolios of both financial and non-financial instruments.