True Markowitz or assumptions we break and why it matters

Abstract

Markowitz (1952, 1959) underlies modern corporate finance literature, from modern portfolio theory, option theory, to risk management (especially value at risk type methodologies). From it, Diversify has entered all languages, such is its power. Terms such as “the only free lunch” have become a way to give praise to Markowitz work. And, just as with all fundamental breakthroughs in the literature it has been extended many directions, sometimes not necessarily to the benefit of the original work, which often gets blamed when one rendition or another breaks down. With almost every MBA graduated believing they know what Markowitz optimization or portfolio theory means, it behooves us to step back and look at some of the basics, the assumptions that are made, the costs of breaking assumptions, and the potential disasters that can occur when those basics behind all of the theories dependent upon Markowitz' original work are ignored. This paper lays out many of the basic underlying assumptions behind creation of Markowitz type portfolios, why they matter, and where those assumptions are ignored and/or broken. Breaking model assumptions is common in actual application of theory. Not understanding the implications of broken assumptions is almost a guarantee of failure for a money manager; it is just a matter of time. As one often hears, “Wall Street (or the City if in Europe) is littered with great ideas that do not work in practice.” Some people throw Markowitz and portfolio optimization into that litter bin. We discuss several basic assumptions of modern portfolio theory, when and why they are commonly broken by the best of us in academia and in practice, and discuss the implications for breaking them under trying circumstances.

Millionaire investors: financial advisors, attribution theory and gender differences

“…In order to enable a controlled measure of risk, seven investment portfolios were constructed using varied asset allocations, to reflect differing levels of risk ranging from 1 (very low) to 7 (very high). This approach is consistent with Modern Portfolio Theory (MPT), where investors select a portfolio that balances likely risk and reward (Wilford 2012), and follows methodology used in previous research by De Bondt (1998) and Karabulut (2010). Each portfolio includes a mix of investments, including stocks, bonds and other assets (Marston 2011).…”

A Markowitz‐based alternative model: Hedging market shocks under endowment constraints*

“…Wilford (2012) stated, “from a practical application of MPT in creating efficient portfolios, one must be absolutely cognizant of the basic assumptions of the theory, not just the mathematical models of optimization.” This lack of understanding the basics is likely due to the years of partial digestion of the original work. Inaccurate regurgitation of the theory contributes to the convolution of its fundamental principles.…”

“…Therein, it contributes to two main stands of the literature: Harry Markowitz's portfolio selection and efficient asset allocation, and risk management of regulated portfolios. Within our segments, we formulated our research on the foundation of Markowitz's modern portfolio theory (MPT) and summary issues raised by Wilford (2012) concerning the common misapplication of principles in his work. He points out the implications of so doing by not understanding the fundamental assumptions embedded in traditional mean-variance optimization.…”

Comparing Risk Components of Taxation Systems of Italy and the Russian Federation

“…& Salimi M.H. : 2009;Wilford D. S.: 2012). For the purposes of assessing the risk of investment portfolio we used this approach in the paper (Malkina M. Yu.…”