Modern Portfolio Theory and Investment Analysis, 9th Edition

7

The Correlation Structure of Security Returns—the Single-Index Model

In the previous three chapters of this book we outlined the basics of modern portfolio theory. The core of the theory, as described in these chapters, is not new; in fact, it was presented as early as 1956 in Markowitz's pioneering article and subsequent book. The reader, noting that the theory is over 50 years old, might well ask what has happened since the theory was developed. Furthermore, if you had knowledge about the actual practices of financial institutions, you might well ask why the theory took so long to be used by financial institutions. The answers to both these questions are closely related. Most of the research on portfolio management in the last 50 years has concentrated on methods for implementing the basic theory. Many of the breakthroughs in implementation have been quite recent, and it is only with these new contributions that portfolio theory becomes readily applicable to the management of actual portfolios.

In the next three chapters we are concerned with the implementation of portfolio theory. Breakthroughs in implementation fall into two categories: the first concerns a simplification of the amount and type of input data needed to perform portfolio analysis. The second involves a simplification of the computational procedure needed to calculate optimal portfolios. As will soon become clear, these issues are interdependent. Furthermore, their resolution vastly simplifies portfolio analysis. ...