What it means
Before Markowitz published his paper "Portfolio Selection" in 1952, investors mostly hunted for the single best stock and held it. He argued that this misses the point, because what matters is how investments behave together.
Two risky assets that do not move in lockstep can combine into a portfolio that is calmer than either one alone. The key measure is correlation (how closely two investments move together, from -1 for opposites to +1 for identical movement).
When correlation is below 1, losses in one holding are partly cushioned by gains or smaller losses in another. That cushioning is what people mean by diversification, and Markowitz gave it a mathematical backbone.
His second contribution is the efficient frontier, a curve that shows the highest expected return available for each level of risk. A portfolio sitting below the curve is wasteful, since you could earn more for the same risk or take less risk for the same return.
Choosing a point on the curve is then a personal decision about how much risk you can stomach. For a business, the same logic applies well beyond the stock market.
A company with several product lines, customers in different industries or revenue in different currencies is running a portfolio, and a finance team can ask whether its sources of income rise and fall together. Pension funds, insurers and treasury teams use portfolio models descended from his work every day.
The approach has well-known limits. It relies on estimates of future returns, risks and correlations, and those estimates are uncertain; correlations also tend to rise sharply in a crisis, just when diversification is needed most.
Critics also point out that using variance as the only measure of risk treats pleasant surprises and unpleasant ones as equally bad.
In practice
Real-world examples.
Example
A pension fund holds shares, government bonds and property. Its investment committee plots the efficient frontier and picks the mix that meets its return target with the least swing in annual funding levels. The chosen mix looks less exciting than an all-shares portfolio but is far steadier.
Example
A founder-led software company earns 85% of revenue from one large customer in the retail sector. Her CFO uses Markowitz-style thinking to argue for winning customers in healthcare and logistics, whose spending cycles do not move with retail. Even at equal average growth, the combined revenue line becomes much more predictable.
Example
A family business owner has most of his wealth in his own factory and the local property market. His adviser points out that the two are highly correlated, since both suffer in a regional downturn, and recommends putting new savings into global bonds and shares instead.
Formula
Calculation
Portfolio variance for two assets = (w1^2 x s1^2) + (w2^2 x s2^2) + (2 x w1 x w2 x correlation x s1 x s2)
Here w is the weight of each asset in the portfolio and s is its standard deviation (the usual measure of how much returns swing). Portfolio risk is the square root of the variance.
Suppose a $1,000,000 portfolio holds 60% in shares (standard deviation 20%) and 40% in bonds (standard deviation 10%), with a correlation of 0.3 between them.
Shares term: 0.6 x 0.6 x 0.20 x 0.20 = 0.36 x 0.04 = 0.0144.
Bonds term: 0.4 x 0.4 x 0.10 x 0.10 = 0.16 x 0.01 = 0.0016.
Interaction term: 2 x 0.6 x 0.4 x 0.3 x 0.20 x 0.10 = 0.144 x 0.02 = 0.00288.
Variance = 0.0144 + 0.0016 + 0.00288 = 0.01888, and the square root is about 0.1374, or 13.7%. The simple weighted average of the two risks would be (0.6 x 20%) + (0.4 x 10%) = 16%, so diversification has cut risk by about 2.3 percentage points, which is roughly $23,000 of annual swing on a $1,000,000 portfolio.Case study
Seen in the real world.
Crestline Dairy is a fictional regional food producer whose treasury team held all of its $6,000,000 cash reserve in one bank's deposits. After a review inspired by portfolio theory, the finance director split the reserve across government securities, deposits at three banks and a short-term bond fund.
The expected return barely changed, but the risk of a single institution's problems affecting the whole reserve fell sharply. The board accepted a small loss of convenience in exchange for much lower concentration, and the illustrative lesson was that the combination of assets mattered more than the choice of any single one.
Watch out
Common mistakes.
- Believing that diversification removes all risk, when it only reduces the risk specific to individual holdings and leaves market-wide risk in place.
- Assuming that correlations stay fixed, when they often climb towards 1 in a market panic and weaken the benefit of holding many assets.
- Counting the number of holdings instead of looking at how they move together, so that ten similar technology shares are mistaken for a diversified portfolio.
Questions
People also ask.
What is the efficient frontier?
It is the curve showing the best expected return available for each level of risk, and any portfolio below the curve could be improved without taking extra risk.
Did Markowitz win a Nobel Prize?
Yes, he shared the 1990 Nobel Memorial Prize in Economic Sciences with Merton Miller and William Sharpe for work on financial economics.
Is his model still used today?
Yes, in adapted forms; most asset managers and pension funds use portfolio optimisation tools that descend from his framework, usually with extra constraints and more careful estimates.
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