The foundation of Modern Portfolio Theory was laid by
Markowitz in 1951. He began with the premise that since
almost all investors invest in multiple securities,
rather than one, there must be some benefit in investing in a portfolio
of securities. He measured riskiness of a portfolio through variability
of returns and showed that investment in several securities
reduced the risk of the investment. His work won him the Nobel Prize
for Economics in 1990. Markowitz's work was extended by Sharpe
in 1964, Lintner in 1965 and Mossin in 1966. Sharpe shared the
Nobel Prize for Economics in 1990 with Markowitz and Miller for
his contribution to the Capital Asset Pricing Model (CAPM).
The Single Index Model has been criticized because of its assumption that stock prices
move together only because of common co-movement with the market. Many researchers have found
that there are other factors beyond the market, like industry-related factors, that cause security prices
to move together. Empirical evidence, however, reveals that the more complex models have not
been able to consistently outperform the Single Index Model in terms of their ability to predict ex ante (future) co-variances between stock returns.
Grover, Jeff and Lavin, Angeline M (2007) in their paper, "Modern Portfolio Optimization:
Practical Approach Using Excel Solver Single-Index Model", presented a practical solution to the
strategic asset allocation problem that investors face when attempting to construct an optimal portfolio
from a given set of available stocks. The optimization model, developed in Excel, uses the Capital
Asset Pricing Model (CAPM) principles to determine security (fund) valuation and the Sharpe Ratio
to identify an optimal or efficient combination of the available stocks (funds). |
