Each investor must determine how much risk he or she is willing to take in the hopes of achieving a given return. This decision is a personal one based on the financial goals and personality of the individual. However, wouldn’t it be nice to know how to use data to determine what has historically been the perfect investment?
In 1952, Harry Markowitz published an article titled “Portfolio Selection.” Prior to Markowitz, examination of investment alternatives had been primarily focused on individual assets. For example, since 1926, the average annual return of the stock market has been 6.8 percent, the return of gold has been 1.8 percent, and the return of Treasury Bills has been 0.5 percent. Therefore, it would seem logical to conclude that if each of these asset classes had the same level of risk, stocks win and the optimal portfolio would consist of 100 percent stocks and zero percent gold and T-Bills.
Markowitz’s Nobel Prize-winning work demonstrated that asset investment classes should not be considered individually. Instead, investors should look at the combined expected returns and risks of different combinations of asset classes. Markowitz looked at expected returns and risk based on historical data, using volatility as a measure of the “riskiness” of an investment.
Markowitz developed his own mathematical model for determining the expected return and risk of any given combination of asset classes using historical price, correlation, and volatility statistics. After building this model, he could use it to plot data points for risk versus the expected return of different portfolios on a graph such as this one:
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