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The Markowitz mean-variance diagram

Article · January 2010

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Markowitz Mean-Variance Diagram

The Markowitz mean-variance diagram plays a central role in the development of

theoretical finance. In setting the foundation for the capital asset pricing model, it
represents the beginning of modern portfolio theory. Prior to Harry Markowitz’s
contribution, the field of finance relied less on mathematical technique. Contributions to
the literature tended to be descriptive, or involved only simple operations applied to
accounting data. The principle of diversification, while accepted as a rule of thumb, was
not well understood. Markowitz’s mean-variance paradigm, summed up succinctly in his
famous diagram, set finance on the path to becoming a technical scientific discipline,
more a branch of economics than of business administration.

The Markowitz diagram is based on the idea that all the information about a portfolio of
risky assets that is relevant to a risk averse investor can be summed up in the values of
two parameters: the standard deviation and the expected value of the portfolio’s return,
briefly stated as the risk and return. The diagram, presented in Figure 1, contains four
essential features: i) the set of parameter pairs of feasible portfolios represented by the
shaded area, ii) the efficient frontier along the upper edge of the feasible set, iii) the linear
asset allocation line running from the point on the vertical axis at the rate of return on the
risk-free asset and tangent to the efficient frontier, and iv) the super-efficient portfolio
parameter pair located at the point of tangency. The feasible portfolios are constructed
by considering an initial endowment that can be spread across different risky assets in a
multitude of ways. The efficient frontier represents those portfolios for which the
expected return is the highest for any level of risk, and for which the risk is the lowest for
any level of expected return. Its curvature, in bending towards the vertical axis, is the
result of the benefit of diversifying among assets that are not perfectly correlated.
Figure 1. The shaded area is the feasible set and the upper boundary is the efficient
frontier. P* marks the super-efficient portfolio located at the point of tangency between
the asset allocation line and the efficient frontier. R RF represents the risk-free rate of
return.

Points on the asset allocation line represent the parameter pairs associated with portfolios
made up of a combination of the super-efficient portfolio and the risk-free asset. Points
on the line to the left of the efficient frontier are associated with portfolios that combine
long positions in both the super-efficient portfolio and the risk-free asset, while points to
the right are associated with a leveraged long position in risky assets created through
borrowing at the risk-free rate. If investors have access to risk-free borrowing and
lending, the optimal portfolio will lie along the asset allocation line, since portfolios
below and to the right will be inefficient and portfolios above and to the left will not be
feasible.
The origin of the mean-variance paradigm is recounted in vivid detail by Markowitz
(1999)1. As a Ph.D. student in economics at the University of Chicago, he went to see
Jacob Marschak for advice on a topic for his dissertation. While waiting in the ante
room, he happened to meet a stockbroker, also waiting to see Marschak, who suggested
that he write his dissertation on the stockmarket. Markowitz relayed the suggestion to
Marschak and found him receptive to the idea. Both men were members of the Cowles
Commission, as it was called at the time, and econometric investigations of the
stockmarket was of special interest to their benefactor, Alfred Cowles. Marschak sent
Markowitz to a professor in the business school for advice on background reading in the
current literature on investments.

Markowitz recalls that it was sometime in 1950, while going through the books on
investments suggested by the business school professor, that he hit on his seminal idea
regarding diversification. The presumption of previous writers had been that, through the
law of large numbers, diversification could eliminate all risk as long as one had a large
enough number of stocks in one’s portfolio. The advice that followed was to invest in
those assets with the highest expected return. Markowitz recognized the error in the
implicit assumption that stock returns were uncorrelated and sought to discover a
measure of risk for a portfolio of assets with imperfectly correlated returns. The idea of
using variance as a measure of risk came to him independently, although Irving Fisher
and others had previously thought of it. Next, he found the formula for the variance of
the returns of a portfolio of risky assets in a book on probability.
On examining the formula for the variance of a weighted sum of random variables
(found in Uspensky 1937 on the library shelf), I was elated to see the way
covariances entered. … Dealing with two quantities—mean and variance—and
being an economics student, I naturally drew a trade-off curve. Being, more
specifically, a student of T. C. Koopmans …, I labeled dominated EV
combinations “inefficient” and the undominated ones “efficient.” (Markowitz
1999, p. 8)

1
See also Bernstein (1992) and Buser (2008).
 By a curious coincidence, in April of the same year that Markowitz made his original
sketch in the library at the University of Chicago, an article by Marschak appeared in
Econometrica , that while not actually showing the diagram, sketches out some of the
essential details. In summarizing, the state of the art in the “theory of assets”,
Marschak writes:

“[I]f more than one commodity or time-point is considered, say γ(τ + 1) = ε

quantities, each prospect may be characterized by ε means, ε variances, ε(ε – 1)/ 2
correlations, etc. Each distribution parameter was regarded as being a “good” (or
possibly a “bad”) in the eyes of the man. … Tastes were described by indifference
surfaces drawn in parameter space P, and the empirical properties of these
surfaces were discussed. For example, the risk-aversion (risk-discount), i.e., the
rate of substitution between the mean and the variance of income, expressed by
the relevant slope of an indifference surface, was stated to be positive.”
(Marschak 1950, p. 118-19)

Markowitz’s diagram of the efficient frontier first appeared in print in the Journal of
Finance in 1952. Unlike the now standard depiction presented in Figure 1, Markowitz’s
construction had the axes reversed and used variance rather than standard deviation as the
measure of risk.

The story of the history of the diagram is complicated by the appearance of a competing
diagram, also in 1952, in an Econometrica article by Cambridge economist A. D. Roy.
Roy’s diagram has the axes orientated in their now usual fashion, and has the standard
deviation rather than variance as the risk measure. Moreover, he identifies the boundary
of the feasible set as an envelope curve and, presaging the capital market line and the
super-efficient portfolio, he draws a ray from a point on the vertical axis tangent to the
efficient frontier, albeit giving it a different interpretation from that of the capital market
line. The point of tangency in Roy’s diagram coincides with the portfolio that maximizes
the probability that the portfolio return will be above the level at which the line meets the
vertical axis.
Roy includes Marschak (1950) in his list of references so it is plausible that he was
following up on the hints provided in that article. Given that Marschak was Markowitz’s
dissertation advisor, it would be ironic if his competitor for claims of primacy for the
diagram was given an edge from reading Marschak’s article. Markowitz (1999, p. 5)
notes that Roy should share with him the honor as the father of modern portfolio theory
but, in truth, Roy’s contribution remained obscure and did not inspire further
developments, despite his writing an additional article on the topic in 1956.

Markowitz, on the other hand, teamed up with William Sharpe who went on to make
major strides in theoretical finance. Markowitz served as Sharpe’s unofficial dissertation
advisor in the early sixties. A key innovation introduced by Sharpe (1964) was to
recognize that in world with a risk-free asset, the investor’s optimal portfolio would lie,
not necessarily on the efficient frontier, but instead on a line tangent to the efficient
frontier and intersecting the vertical axis at the risk-free rate of return. The portfolio
corresponding to the point of tangency is known as the super-efficient portfolio, and the
optimal risk return combination for an investor could be achieved by combining an
investment in the super-efficient portfolio with a position in the risk-free asset. The
position in the risk-free asset could be long or short depending on one’s risk preferences.
The idea of the asset allocation line comes from the Tobin (1958) separation theorem that
states that one can think of a portfolio in two parts: one part invested in risky assets and
one part invested in the risk-free asset. The decision regarding the best combination of
risky assets can be made separately from the decision regarding one’s level of investment
in the risk-free asset.

Once all the pieces of the Markowitz mean-variance diagram were in place, Sharpe
(1964) was able to draw out the full economic implications in his formulation of the
capital asset pricing model, for which he, along with Markowitz, was awarded the Nobel
prize in economics in 1990. It is a good example of the power of a simple diagram to
illuminate the way to an important discovery.
When Markowitz had defended his dissertation on portfolio diversification at the
University of Chicago in 1955, Milton Friedman had given him a hard time claiming that
his contribution was not economics and that the university could not grant a Ph.D. in
economics for a dissertation that was not economics. Markowitz recalls: “he kept
repeating that for the next hour and a half. My palms began to sweat. At one point he
says, you have a problem. It’s not economics, it’s not mathematics, it’s not business
administration” (Buser 2008, p. 5). Friedman who was committed to the stance he had
recently taken in his famous essay on the methodology of positive economics, could not
see how the discovery of a new paradigm for analyzing investment decisions could
qualify as a contribution to the discipline. Fortunately though, Markowitz was ultimately
successful in his defense, much to the benefit of the field of financial economics.

References
Bernstein, P. (1992), ‘Capital Ideas: The Improbable Origins of Modern Wall Street’,
New York, NY: The Free Press.

Buser, S. (2008), ‘Markowitz: Interview at Rady School of Management at the University

of California San Diego’, History of Finance, American Finance Association,
http://www.afajof.org/association/historyfinance.asp

Marschak, J. (1950), ‘Rational Behavior, Uncertain Prospects, and Measurable Utility’,

Econometrica, 18 (2): 111-141.

Markowitz, H. (1952), ‘Portfolio Selection’, Journal of Finance, 7(1), 77-91.

---------------- (1959), Portfolio Selection: Efficient Diversification of Investments, New

York: John Wiley & Sons.

---------------- (1999), ‘The Early History of Portfolio Theory: 1600–1960’,

Financial Analysts Journal, 55( 4): 5-16
 Roy, A. D. (1952), ‘Safety First and the Holding of Assets’, Econometrica, 20 (3): 431-
449.

------------ (1956), ‘Risk and Rank or Safety First Generalised’, Economica, 23 (91): 214-
228.

Sharpe, W. (1964), ‘Capital Asset Prices: A Theory of Market Equilibrium Under

Conditions of Risk’, Journal of Finance, 19 (3): 425-442.

Tobin, J. (1958). "Liquidity Preference as Behavior Towards Risk". The Review of

Economic Studies, 25(1): 65–86.

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