Modern Portfolio Theory and Markowitz Efficient Frontier

2. Literature Review

This chapter will explore the theories associated with the Modern Portfolio Theory and Markowitz efficient frontier. The understanding and role of alternative investments and emotional assets in the financial world are also exemplified. The chapter will then conclude by analysing the importance of alternative investments and emotional assets to a portfolio using existing academic literature.

2.1 Introduction

In portfolio optimisation, investors should keep in mind that diversification is key to balance risk and return. Malkiel (2010), reminded investors that the best investment is a well-diversified portfolio, being re-balanced appropriately while adopting a buy-and-hold strategy. A reduction in portfolio volatility can be achieved by diversifying in several securities. However, even with a large number of assets, risk cannot be reduced to zero since portfolios are affected by macroeconomic factors which influence the market (Bodie et Al., 2004). In addition, portfolio returns can never be guaranteed as the future is unpredictable. A famous quote by a Chinese philosopher sums this up:

“To know is to know that you know nothing. That is the meaning of true knowledge.”

- Confucius.

2.2 Modern Portfolio Theory

Investors familiar with the saying “don’t put all your eggs in one basket”, can comprehend the rationale behind the modern portfolio theory, pioneered by Harry Markowitz (1952). This is one of the most significant and influential economic theories in investment and finance. The theory was further developed by William Sharpe (1966) who along with Merton Miller, the three were awarded the Nobel Prize in Financial Economics in 1990.

In simple terms, modern portfolio theory is a framework for evaluating risk...

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...rn similar to the risk-free rate. However, Krasker’s study had a lot of flaws and can be considered insignificant. The first real contribution was presented by Weil (1993), calculating wine returns between the 1977-1992 periods. The results suggest that returns from holding wine averaged 9.5% per year and compared unfavourably to stocks.

Masset, Henderson and Weisskopf (2009) made the most recent analysis on wine returns ranging data from 1996 to 2009. The data was stretched till 2009 to show that wine still is an attractive proposition in an economic downfall. Their findings suggested that over the 14-year period, wine yielded a mean rate of return (7.3%) and a low volatility (8.23%). These results showed that wine performed better than stocks. In addition, during the 2008 financial crisis, wine prices dropped by 17% while most stock indices lost half their value.