Mean-Variance Analysis Assumptions

Mean-variance analysis gives investors a framework to assess the tradeoff between risk and
return as mean-variance analysis quantifies the relationship between expected return and
portfolio variance (or standard deviation).

Mean-variance analysis is the theoretical foundation of Modern Portfolio Theory established by

Professor Harry Markowitz and much of the material covered in this module traces its roots
concept.

Mean-Variance Assumptions

The assumptions underlying the mean-variance analysis are summarized below:

 Investors are risk averse in that they prefer higher return for a given level of risk
(variance, standard deviation), or they want to minimize risk for a given level of returns.
The degree of risk aversion may vary from investor to investor
o Example: An investor is presented with two portfolios:
o Portfolio A offers 12% annual return with 25% standard deviation;
o Portfolio B offers 12% annual return with 20% standard deviation;
o A risk averse investor will choose portfolio B.
 Expected returns, variances, and covariances for all assets are known by all investors.
 Investment returns are normally distributed so only returns, variances, and covariances
are needed to derive the optimal portfolio.
 There are no transaction costs and no taxes. So, before-tax and after-tax returns are the
same making all investors equal.

The mean-variance analysis is used to identify optimal/efficient portfolios.