When Markowitz began to formulate his ideas in the 1950’s, leading investment guides recommended that an investor should find one stock with the highest expected return, invest in it, and ignore all the others. If investing involved no amount of risk, holding investments with the highest expected returns would be a highly profitable idea. The experienced investor knows that investing is full of risk. Risk essentially means that more can happen than will happen, which adds great uncertainty to investment decision-making. People do not expect to be in an auto accident, but they invest in auto insurance because of the unpredictable possibilities. People also do not expect a stock in their portfolio to decrease in price, but it can and will at some point. If an investor’s portfolio is diversified, then the loss incurred from that one stock will be “insured” by other stocks that do not decrease in price. Markowitz knew that in the real world, investors are not only interested in return, but they are concerned with risk as well.
Markowitz concluded that risk is central to the whole process of investing. He then wondered how to measure the appropriate amount of risk to undertake. Markowitz came to realize the cruel truth of investing: investors cannot earn higher returns without taking on greater risk, and the greater the risk, the greater the possibility of loss. He set out to devise ways to help investors apply tradeoffs between risk and return. Using mathematics to solve the puzzle, Markowitz discovered a remarkable new way to build an investment portfolio, which he called the "efficient portfolio.” It offers an investor the highest expected return for any given level of risk, or the lowest level of risk for any given expected return.
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