Markowitz portfolio theory

Farhad Amu, Marcus Millegård

February 9, 2009

1 Introduction
Optimizing a portfolio is a major area in nance. The objective is to maximize the yield
and simultaneously minimize the risk. One way of optimizing a portfolio was suggested
by Harry Markowitz (1927-) who published the article Portfolio selection in Journal of
Finance 1952 [1]. In 1990 he received the Nobel Memorial Prize in Economic Sciences
due to his contributions to portfolio theory. There have been extensions and develop-
ments made on Markowitz model and it is still a widely used model.

Our purpose is to explain Markowitz portfolio theory in an understandable and cor-

rect way. In order to do so we need some background knowledge of the concepts of
portfolio theory. We will also discuss an implementation of the Markowitz model called
CAPM.

2 Mean variance portfolio theory

Before we present a model for portfolio theory we must be able to handle the basics of
probability theory, and also be familiar with the notations used in portfolio theory. This
section will therefore mostly consist of denitions and explanation of the theory behind
Markowitz portfolio theory. We work with a single period model and there are no tax
or transaction costs.

2.1 Some important concepts in portfolio theory

An investment instrument that can be bought and thereafter sold is called an asset [2].
The underlying asset could be a stock, currency, option, bond or portfolio. Suppose you
purchase an asset at time zero and sell it at a xed time (T ≥ 0). We are only inter-
ested in this single period and will assume that neither tax nor transaction costs present.

Let X0 be the amount of money invested at time 0, and let XT be the amount of
money you receive when you sell the asset at time T . Then the total return, R, on your
investment is dened as
XT
R= .
X0
The rate of return ,r, (sometimes referred to as return ) is dened as
XT − X0
r= ,
X0

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hence R = 1 + r. Note that to make a prot r has to be greater than zero.

Suppose now that there are n dierent assets, and to each of them corresponds a total
return Ri , i = 1, . . . , n. If we spread out our invested money in these assets, we say that
we form a portfolio (it is called a portfolio even if we don't invest money in all assets).
We select an amount of money X0i in asset i such that ni=1 X0i = X0 , and we restrict
P

ourselves X0i ≥ 0, i = 1, .., n. To make the coming notation simpler we introduce weights
wi , i = 1, . . . , n, such that X0i = wi X0 . Clearly the sum over all weights is equal to one.
Then the amount of money generated at time T by the ith asset is Ri wi X0 , and hence
the total return R of the portfolio is
Pn Pn n n
i=1 Ri wi X0 i=1 (1 + ri )wi X0 X X
R= = = wi + ri wi
X0 X0
i=1 i=1

Since the sum of all wi is one and R = 1 + r, we have

n
X
r= wi ri .
i=1

2.2 Expected value and variance of the return of a portfolio

The return you get when you sell an asset r is uncertain when you buy the asset. In
these cases r is a random variable. Suppose we know the mean for each of the n assets,
call it r¯i , i = 1, . . . , n. Call the variance of asset i σi2 , and the covariance between asset
i and j σij . Then the expected return of a portfolio r̄ is simply
n
X n
X
E[r] = r̄ = wi E[ri ] = wi r¯i .
i=1 i=1

The variance σ 2 of the portfolio return is

n n
2 2
 X X
2 
σ = E[(r − r̄) ] = E wi ri − wi r¯i
i=1 i=1
n n
 X
X

= E wi (ri − r¯i ) wj (rj − r¯j )
i=1 j=1
n
X
 
= E wi wj (ri − r¯i )(rj − r¯j )
i,j=1
n
X
= wi wj σij .
i,j=1

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3 The Markowitz model
The fundamental problem of a portfolio can be formulated in 2 ways, either the investor
wants to minimize the variance with respect to a xed expected return r̄ or maximize
the expected return given a xed variance. This is known as the Markowitz model [2].
To express it mathematically, the problem can be formulated as

• minimize ni,j=1 wi wj σij subject to

P
Pn
wi r¯i = r̄,
Pi=1
n
i=1 wi = 1
if you are risk averse, or

• maximize ni,j=1 wi r¯i subject to

P
Pn
wi wj σij = σ 2 ,
Pi,j=1
n
i=1 wi = 1.

We will mainly concentrate on the rst one, the second one is rather equivalent. The
solution to the Markowitz model is an optimization problem. To be able to solve it and
fully understand it, we need to use Lagrange multipliers.

3.1 Lagrange multipliers

Lagrange multipliers can be used to nd the extremum of a multivariate function

f (x1 , . . . , xn ) subject to the constraint g(x1 , . . . , xn ) = 0, where f and g are func-
tions with continuous rst partial derivatives on the open set containing the curve
g(x1 , . . . , xn ) = 0, and ∇g 6= 0 at any point on the curve g(x1 , . . . , xn ) = 0 (where
∇ is the gradient) [3].

For an extremum of f to exist on g , the gradient of f must line up with the gradi-
ent of g [3]. If the two gradients are in the same direction, then one is a multiple (−λ)
of the other, so
∇f = −λ∇g.
The two vectors are equal, so all of their components are as well, giving

fx0 i = −λgx0 i

for i = 1, . . . , n.

The extremum is then found by solving the n + 1 equations in n + 1 unknowns

λg(x1 , . . . , xn ) = 0, fx0 i + λgx0 i = 0, (i = 1, . . . , n).

If there are several constraints  for example if there exist 2 functions g1 (x1 , . . . , xn ) = 0
and g2 (x1 , . . . , xn ) = 0, the equations become ∇f + λ∇g1 + µ∇g2 = 0, where µ and λ
are constants.

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3.2 Solution to the Markowitz model using Lagrange multipliers

We can now apply the Lagrange multipliers and get a solution to the Markowitz model.
Using the same notation as in section 3.1, set
n
X
f (w1 , . . . , wn ) = wi wj σij ,
i,j=1

n
X

λg1 (w1 , . . . , wn ) = λ wi r¯i − r̄ ,
i=1
n
X

µg2 (w1 , . . . , wn ) = µ wi − 1 .
i=1

Note that if we want our constraints (namely ni=1 wi r¯i = r̄, ni=1 wi = 1) to be
P P

fullled, g1 = g2 = 0 as we moved the right side over to the left side. Also note that
we already know σij , r¯i and r̄ for every i, j . If we sum the functions above we get the
Lagrangian
n
X n
X n
X



L(w1 , . . . , wn ) = wi wj σij + λ wi r¯i − r̄ + µ wi − 1 .
i,j=1 i=1 i=1

If we dierentiate L with respect to w1 , . . . , wn , set those n equations equal to zero, and

also set λg1 = µg2 = 0, we have n + 2 equations with n + 2 unknown variables. As all
the equations are linear, a solution can be found easily by using linear algebra.

Figure 1: An example of a mean-variance plot. A red dot marks a possible portfolio while
the blue line, called the ecient frontier, consists of the set of all portfolios, either a minimal
variance with subject to a xed expected return, or a maximal expected return subject to
a xed variance.

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4 CAPM
The capital asset pricing model (CAPM) is developed mainly by Sharpe, Lintner
and Mossin, which follows from the Markowitz mean-variance portfolio theory [2]. This
method is applied to investment decision problems. When one chooses to set up a
portfolio the expectation of the return has to be studied carefully. The idea is to get
better understanding of an asset's return and try to diversify the risk. Later on this
result will be input variables in Markowitz model.
The CAPM formula is usually written as

ri = rf + βi (rM − rf )

where
σiM
βi = 2 .
σM

• ri is the expected return on asset i.

• rf is a risk free rate.

• βi is a risk measure of asset i.

• rM is the expected market return.

There are many methods to obtain a risk free asset rf . One can lend money with interest
of rate or buy bond. The market return, rM , describes the market which contains the
asset. For example if we purchase stocks in Ericsson then OMX is our market. We use
the value of these two when calculating the β parameter. β a is relation between the
asset and market return.

5 Conclusions
Markowitz model to minimize risk subject to a given expected return is an optimization
problem. One wants to nd the optimal amount of money wi to invest in each asset i.
The model is quite simple to understand and can be solved by using Lagrange multipli-
ers. A common way of estimating the expected return, r, is made by CAPM but there
are more advanced tools and one is called Arbitrage Pricing Theory (APT). CAPM is a
single factor model since one β is generated while APT has many factors.

It is important to point out that the Markowitz model is just a tool. The most im-
portant part of portfolio theory is the assets and risk factors that one chooses. You have
to have knowledge about your asset since there is no guarantee to prot in the model.
The risk factors should be chosen carefully because of the correlation between the asset
and the risk factor which is not always obvious. A correlation could exist even if the
factor and asset are not in the same area of business.

A lot of extensions can be made to the Markowitz model. In our example we assumed
that there were no transaction costs, this is of course not the case in reality. Braun and
Mitchell show a solution to the portfolio problem when the transaction costs are linear
[4]. Moreover, we concentrated on the original Markowitz model on just a single period

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where a portfolio is created once and then sold at a xed time T ≥ 0. Multiple periods
is discussed further by Luenberger [2].

For further reading, David G Luenberger's Investment Science [2] is generally a good
source. Sources on the internet should be read with care since the quality of them varies.

References
[1] Harry Markowitz. Portfolio selection. Journal of nance ; Vol 7; 77-91.

[2] David G Luenberger. Investment science. Oxford university press 1998.

[3] [downloaded 2009-01-29]. Available: http://mathworld.wolfram.com/LagrangeMultiplier.html.

[4] [downloaded 2009-02-04]. Available: http://www.rpi.edu/ mitchj/papers/exact.pdf.