Markowitz Model
✅ What is the Markowitz Model?
The Markowitz Model, also known as Modern Portfolio Theory (MPT), was introduced by Harry Markowitz, an American economist, in 1952. He later won the Nobel Prize in Economics in 1990 for this work.
The model tells us that investors can build a portfolio (a group of different investments) that gives them the highest return for the lowest possible risk. Instead of picking the stock with the highest return, it focuses on finding the right mix of investments that work well together.
It’s like cooking a perfect dish — you don’t just choose your favorite ingredients; you balance flavors, texture, and nutrition.
🧠 Basic Concept
Let’s say you have ₹1,00,000 to invest.
- You could invest all of it in one company. If it does well, you gain a lot. But if it fails, you could lose everything.
- OR, you could invest ₹20,000 in five different companies across industries. Now even if one company fails, your other investments can save you.
This is called diversification. Diversification means spreading your money across different investments to reduce risk.
Why Does It Work?
Because not all investments move in the same direction at the same time. When some go down, others might go up. This balancing act helps in reducing the total risk of your portfolio.
📈 Key Terms You Should Know
Let’s understand a few important terms used in the Markowitz Model.
1. 📊 Expected Return
The average return an investment is likely to give in the future, based on past performance or analysis.
Example:
If Stock A gave 10%, 12%, and 8% return in the past three years, the average (expected) return is:
(10 + 12 + 8) / 3 = 10%
2. ⚠️ Risk (Standard Deviation)
Risk refers to the uncertainty in your returns. In technical terms, it’s measured by standard deviation — the amount by which returns deviate (go up or down) from the average.
- A stock with stable returns (8%, 9%, 10%) has low risk.
- A stock with highly varying returns (2%, 15%, -5%) has high risk.
3. 🔁 Covariance and Correlation
These measure how two assets move in relation to each other.
- If two stocks move in opposite directions, their correlation is negative, which is good for diversification.
- If two stocks move together, they have positive correlation, which increases overall risk.
So, combining assets with low or negative correlation helps in building a low-risk portfolio.
🧮 How the Markowitz Model Works (Step-by-Step)
Here’s a simplified process of how this model is used:
🔹 Step 1: Identify Possible Assets
Make a list of all the stocks, bonds, or other investments you want to include in your portfolio.
🔹 Step 2: Gather Data
Find the following for each investment:
- Past returns (to calculate expected return)
- Risk (standard deviation)
- Correlation with other assets
🔹 Step 3: Calculate Portfolio Combinations
Try different combinations (ratios) of investments. Example:
- 50% in Stock A and 50% in Stock B
- 70% in bonds and 30% in stocks
- 40% gold, 30% stocks, 30% real estate
Each combination gives a different expected return and risk.
🔹 Step 4: Draw the Efficient Frontier
This is a curve on a graph showing all the best possible combinations.
- On the X-axis = Risk
- On the Y-axis = Return
The topmost curve is the Efficient Frontier. Portfolios on this curve give you the maximum return for a given level of risk.
🚀 What is the Efficient Frontier?
The Efficient Frontier is one of the most important results of the Markowitz Model.
- It shows all the optimal portfolios.
- Any portfolio below the curve is not ideal — you’re taking more risk but not getting enough return.
- You should aim for a portfolio on the curve, depending on your comfort with risk.
Think of it like this: If you’re paying ₹100 for a meal, wouldn’t you want the tastiest and healthiest food possible? The Efficient Frontier gives you the best “deal” for your investment.
💼 Real-Life Application
🏦 Mutual Funds
Mutual fund managers use this model to create diversified portfolios for their clients.
🧑💼 Financial Advisors
They help individuals invest in different asset classes based on this theory.
📉 Risk-Averse Investors
People who want to grow their money but also want safety can use this to build a secure and profitable portfolio.
📈 Efficient Frontier
The Efficient Frontier is a key concept from the Markowitz Model of Modern Portfolio Theory. It shows the best possible investment combinations that offer the maximum expected return for a given level of risk — or in simpler terms, the smartest way to invest your money.
💡 Example
Imagine two portfolios:
- Portfolio A: 8% expected return, 10% risk
- Portfolio B: 8% expected return, 15% risk
Both give the same return, but Portfolio A has less risk, so it’s on the Efficient Frontier.
Portfolio B is below the frontier — you’re taking more risk for nothing extra.
🎯 The Goal of Every Investor
Your goal is to choose a portfolio on the Efficient Frontier based on how much risk you are comfortable taking.
- If you are risk-averse, pick a point on the left side of the curve — lower risk, moderate return.
- If you are okay with more risk, pick a point on the right side of the curve — higher risk, higher return.
🧮 How is it Calculated?
To find the Efficient Frontier, you:
- List all possible portfolios using combinations of available assets.
- Calculate their expected return and risk (standard deviation).
- Plot them on a graph.
- The outermost curve formed by the best portfolios is your Efficient Frontier.
It’s like finding the best combo deals on a menu:
- Some give great taste at a fair price.
- Some are overpriced for what they offer.
You want the best taste for the price you’re willing to pay — that’s the Efficient Frontier.
📘 Real-Life Use
- Mutual fund managers use this to design portfolios for different risk levels.
- Financial advisors use it to help clients invest wisely.
- DIY investors can also use online tools and Excel to simulate and find their own efficient portfolios.
⚠️ Limitations of the Markowitz Model
While the model is powerful, it has some limitations:
- Relies on Historical Data
Future returns may not always match past performance. - Assumes Rational Investors
People don’t always make logical decisions, especially during market panic. - Ignores Market Shocks
Sudden events like COVID-19 or war aren’t predicted in the model. - Needs Accurate Data
The model requires complex calculations and accurate data, which may not always be available.
🧾 Final Thoughts
The Markowitz Model is like a roadmap for smart investing. It shows that you don’t need to chase high returns blindly. Instead, you can build a smart, balanced portfolio that grows over time while keeping risks in check.
