Asset‐Allocation Models Using the Markowitz Approach

This chapter presents the fact that Harry Markowitz developed a theory that became a foundation of financial economics and revolutionized investment practice. He 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 investor's wealth among those securities; it is the problem of portfolio selection. Markowitz developed mean‐variance analysis in the context of selecting a portfolio of common stocks. Over the previous decade, mean‐variance analysis has been increasingly applied to asset allocation. In many respects, asset allocation is a more suitable application of mean‐variance analysis than is stock portfolio selection. The Markowitz model treats expected returns, standard deviations, and correlations as population parameters. However, in practice, population parameters are unavailable. Instead, statistical estimates must be used.