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Computerized Investing > Third Quarter 2011

Mean Variance Optimization

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by Wayne A. Thorp, CFA

Modern portfolio theory (MPT) dates back to the 1950s and Harry Markowitz’s portfolio selection technique. It was the first time investors had a formal model quantifying the impact of portfolio diversification. Markowitz’s work was so revolutionary that he eventually was awarded the Nobel Prize in economics. Markowitz’s work showed that you could lower the risk of an investment portfolio by adding risky assets to the mix. Just as important, however, was that you could lower the total risk of a portfolio without sacrificing its expected return.

Prior to Markowitz’s research, investment strategies focused on individual asset selection using anecdotal observations of past performance of companies and their industries. As a result, you could very well end up with a portfolio that looked conservative, yet was not really diversified. Markowitz placed portfolio return and risk on equal footing and illustrated that, through an understanding of how individual securities are correlated, you could lower the risk of the overall portfolio without having an adverse impact on return. The key to building a portfolio is to look beyond the risk-reward characteristics of the individual securities and examine how the securities interact together.

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