16-Port Selection Mean Var Page 471 Wednesday, February 4, 2004 1:09 PM

CHAPTER

16

Portfolio Selection Using

Mean-Variance Analysis

A

s explained in Chapter 3, a major step in the direction of the quanti-

tative management of portfolios was made in the 1950s by Harry

Markowitz in his paper “Portfolio Selection” published in 1952 in the

Journal of Finance.^1 The ideas introduced in this article have come to

form the foundations of what is now popularly referred to as mean-vari-

ance analysis (M-V analysis) for reasons explained in this chapter, and

Modern Portfolio Theory (MPT). Initially, M-V analysis generated rela-

tively little interest, but with time, the financial community adopted the

thesis, and now 50 years later, financial models based on those very

same principles are constantly being reinvented to incorporate new find-

ings that result from that seminal work.

Though widely applicable, M-V analysis has had the most influence

in the practice of portfolio management. In its simplest form, M-V anal-

ysis provides a framework to construct and select portfolios based on

the expected performance of the investments and the risk appetite of the

investor. M-V analysis also introduced a whole new terminology, which

now has become the norm in the area of investment management.

It may be useful to mention here that the theory of portfolio selec-

tion is a normative theory. A normative theory is one that describes a

standard or norm of behavior that investors should pursue in construct-

ing a portfolio, in contrast to a theory that is actually followed. Asset

(^1) Harry M. Markowitz, “Portfolio Selection,” Journal of Finance (March 1952), pp.
77–91. In 1959 Markowitz expanded his ideas in book form: Harry M. Markowitz,
Portfolio Selection: Efficient Diversification of Investments (New York: John Wiley,
1959).
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