Portfolio theory (first paper )

Question 1

What was the common approach to portfolio selection before Markowitz (1952)?

Answer 1

Investors focused on picking undervalued individual securities without considering the overall portfolio’s risk or the benefits of diversification.

Question 2

What major flaw did Markowitz identify in traditional portfolio selection?

Answer 2

He argued that selecting predicted “winners” without considering how they interact in terms of risk (i.e., correlations) leads to poor portfolio construction.

Question 3

What is the core principle of Markowitz’s portfolio theory?

Answer 3

Investors should maximize expected utility, balancing expected return against portfolio risk (measured by variance of returns).

Question 4

What is the “efficient set” of portfolios in Markowitz’s theory?

Answer 4

Portfolios that either:

Maximize expected return for a given level of risk, or

Minimize risk for a given level of expected return.

Question 5

What role does diversification play in Markowitz’s theory?

Answer 5

Diversification reduces risk by considering the covariance among securities — it gives formal meaning to risk reduction through portfolio construction.

Question 6

How does Markowitz’s theory apply to corporate finance decisions?

Answer 6

Firms should evaluate investment projects the same way investors evaluate securities — based on risk-return trade-offs.
👉 Corporate diversification alone does not increase value unless it changes expected cash flows (e.g., by reducing bankruptcy risk).