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Asset Allocation Models Using the Markowitz Approach Revised January 1998. Paul D. Kaplan, PhD, CFA Vice President and Chief Economist 225 North Michigan Avenue, Suite 700 Chicago, IL 60601-7676 Page 1 Introduction A little over forty years ago, a University of Chicago graduate student in economics, while in search of a dissertation topic, ran into a stockbroker who suggested that he study the stock market. Harry Markowitz took that advice and developed a theory that became a foundation of financial economics and revolutionized investment practice.1 His work earned him a share of 1990 Nobel Prize in Economics. A basic premise of economics is that, due to the scarcity of resources, all economic decisions are made in the face of trade-offs. Markowitz identified the trade-off facing the investor: risk versus expected return. The investment decision is not merely which securities to own, but how to divide the investors wealth amongst securities. This is the problem of “Portfolio Selection;” hence the title of Markowitz’s seminal article published in the March 1952 issue of the Journal of Finance. In that article and subsequent works, Markowitz extends the techniques of linear programming to develop the critical line algorithm.2 The critical line algorithm identifies all feasible portfolios that minimize risk (as measured by variance or standard deviation) for a given level of expected return and maximize expected return for a given level of risk. When graphed in standard deviation versus expected return space, these portfolios form the efficient frontier. The efficient frontier represents the trade-off between risk and expected return faced by an investor when forming his portfolio. Most of the efficient frontier represents well diversified portfolios. This is because diversification is a powerful means of achieving risk reduction. Thus, mean-variance analysis gives precise mathematical meaning to the adage “Dont put all of your eggs in one basket.”