Beyond Markowitz

Abstract

In sharp contrast to the recommendations of Modern Portfolio Theory, a vast majority of investors are not well diversified. The author attempts to provide a solution to this diversification paradox, by expanding the Markowitz framework of diversifying market risk to also include the concepts of personal risk and aspirational goals. The wealth allocation framework enables individual investors to construct appropriate portfolios using all their assets, such as their home, mortgage, market investments, and human capital. The investor may choose to accept a slightly lower average rate of return in exchange for downside protection and upside potential. The resulting portfolios are designed to meet individual investors' needs and preferences, as well as to protect individuals from personal, market, and aspirational risk factors. A major conclusion of this work is that, for the individual investor, risk allocation should precede asset allocation.