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From Markowitz to modern risk management

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  • Gordon Alexander

Abstract

Nobel Laureate Harry Markowitz is often referred to as the 'founder of Modern portfolio theory' and deservedly so given his enormous influence on the money management industry.1 However, it is my contention that he should also be referred to as the 'founder of Modern Risk Management' since his contributions to portfolio theory formed the basis for how risk is currently viewed and managed. More specifically, Markowitz argued that a portfolio of securities should be viewed through the lens of statistics where the probability distribution of its rate of return is evaluated in terms of its expected value and standard deviation. Since the ultimate selection of a portfolio involves the evaluation and management of risk as measured by standard deviation, it is clear that Markowitz's process of portfolio selection represents the birth of modern risk management whereby risk is quantified and controlled. In this paper, I will first, introduce value-at-risk as a measure of risk and how it relates to standard deviation, the risk measure at the heart of the model of Markowitz. Second, I will similarly introduce conditional value-at-risk (also known as expected shortfall) as a measure of risk and compare it with VaR. Third, I will briefly introduce stress testing as a supplemental means of controlling risk and will then present my conclusions.2

Suggested Citation

  • Gordon Alexander, 2009. "From Markowitz to modern risk management," The European Journal of Finance, Taylor & Francis Journals, vol. 15(5-6), pages 451-461.
    • Handle: RePEc:taf:eurjfi:v:15:y:2009:i:5-6:p:451-461
    DOI: 10.1080/13518470902853566
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    References listed on IDEAS

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    1. Gordon J. Alexander & Alexandre M. Baptista, 2004. "A Comparison of VaR and CVaR Constraints on Portfolio Selection with the Mean-Variance Model," Management Science, INFORMS, vol. 50(9), pages 1261-1273, September.
    2. Alexander, Gordon J. & Baptista, Alexandre M., 2002. "Economic implications of using a mean-VaR model for portfolio selection: A comparison with mean-variance analysis," Journal of Economic Dynamics and Control, Elsevier, vol. 26(7-8), pages 1159-1193, July.
    3. Alexander, Gordon J. & Baptista, Alexandre M., 2006. "Does the Basle Capital Accord reduce bank fragility? An assessment of the value-at-risk approach," Journal of Monetary Economics, Elsevier, vol. 53(7), pages 1631-1660, October.
    4. Merton, Robert C., 1972. "An Analytic Derivation of the Efficient Portfolio Frontier," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 7(4), pages 1851-1872, September.
    5. Black, Fischer, 1972. "Capital Market Equilibrium with Restricted Borrowing," The Journal of Business, University of Chicago Press, vol. 45(3), pages 444-455, July.
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    Cited by:

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    3. Halim Kazan & Kültigin Uludag, 2014. "Credit Portfolio Selection According to Sectors in Risky Environments: Markowitz Practice," Asian Economic and Financial Review, Asian Economic and Social Society, vol. 4(9), pages 1208-1219, September.
    4. Oikonomou, Ioannis & Platanakis, Emmanouil & Sutcliffe, Charles, 2018. "Socially responsible investment portfolios: Does the optimization process matter?," The British Accounting Review, Elsevier, vol. 50(4), pages 379-401.
    5. Giulio PALOMBA & Luca RICCETTI, 2013. "Asset Management with TEV and VaR;Constraints: the Constrained Efficient;Frontiers," Working Papers 392, Universita' Politecnica delle Marche (I), Dipartimento di Scienze Economiche e Sociali.
    6. Palomba, Giulio & Riccetti, Luca, 2012. "Portfolio frontiers with restrictions to tracking error volatility and value at risk," Journal of Banking & Finance, Elsevier, vol. 36(9), pages 2604-2615.
    7. Robert Durand & John Gould & Ross Maller, 2011. "On the performance of the minimum VaR portfolio," The European Journal of Finance, Taylor & Francis Journals, vol. 17(7), pages 553-576.
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    9. Degiannakis, Stavros & Floros, Christos & Livada, Alexandra, 2012. "Evaluating Value-at-Risk Models before and after the Financial Crisis of 2008: International Evidence," MPRA Paper 80463, University Library of Munich, Germany.

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