Portfolio Selection

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Submitted By Dizzle
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Disadvantages of Markowitz approach:
The Markowitz method is very sensitive to small changes in the initial conditions, that is in the choice of the data period. Sometimes even changing the analysed period by a few days will greatly alter the composition of the portfolio. Therefore, there is no certainty that the used parameters are stable enough over time.
Markowitz’ optimizers maximize errors. It is not possible to estimate exactly the expected returns, variances and covariances. It is assumed that the returns of the optimised assets follow a normal distribution, which in practice does not hold in all cases. Therefore, estimation errors are inevitable. This is especially true when the number of stocks under consideration is large when compared to the return history in the sample - which is the typical situation in practice. As a result, the investor is suggested to invest in extremely under-diversified portfolios or in the portfolios which contain large short positions - which can be seen inVariance is a method of risk calculation through measuring variance around the expected return. However, only losses represent a real risk – therefore it is questionable, if variance is a proper risk-measuring tool.
In Markowitz approach, only the expected return is taken into account when modelling the future expected uncertainties. It is a great simplification, as in fact many more factors are relevant – such as the employment rate, economic growth etc.
In times of economic crisis the correlations between all risky assets increase. Therefore, diversification benefit decreases and forecasting future expected returns with Markowitz approach will be inadequate.
The investor may have different risk preferences depending on the investment objective.
As it has already been pointed out by Maynard Keynes, using the historical data in economics is problematic. Using the Markowitz…...

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