Portfolio Selection
Read the paperopens doi.org in a new tab
What they found
Markowitz formalized the idea that an investor should care about the risk of the whole portfolio, not of each holding in isolation. Because assets that do not move together partially cancel each other's swings, a portfolio's variance depends on correlations as much as on individual volatilities, and there is a frontier of portfolios that offer the highest expected return for each level of risk. The paper introduced mean-variance optimization and the concept of diversification as a quantitative tool, and earned Markowitz the Nobel Prize.
What you can use
- Risk is a property of the portfolio, not of a single trade; two positions that lose together are one big position.
- Diversification only works across things that are not highly correlated, and correlations rise in crises.
- The framework is the foundation for thinking about how much of your capital any one idea should get.
Caveats
Assumes returns are described by mean and variance and that these are known; in practice estimation error makes naive optimization unstable. Theory paper.
Tags: risk, portfolio, diversification, foundations
Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.