The Finance Professionals’ Post educates readers in the finance and banking sectors on the forces that shape their business. The FPP is a publication of the New York Society of Security Analysts (NYSSA).

12/28/2011

Harry Markowitz — Father of Modern Portfolio Theory — Still Diversified

Harry Markowitz’s Nobel Prize winning Modern Portfolio Theory was put to the supreme test in The Great Recession of 2008. The stock market plunged nearly 40%, stock and corporate bond markets crashed, the money markets froze up. Uncle Sam had to bail out major banks, while letting Bear Stearns and Lehman Brothers fail.

It raised the big question: Does Modern Portfolio Theory hold up during once-in-a-lifetime events?

“It is sometimes said that portfolio theory fails during a financial crisis because all asset classes go down and all correlations go up,” Markowitz said in a telephone interview from his office in San Diego, CA.

But this, stressed the PhD winner of the Nobel Prize for economics, is already predicted by his Modern Portfolio Theory.

“Generally, asset classes move roughly in proportion to their historical betas,” he said. The beta value is a measure of how risky an asset is in relation to the overall stock market. The S&P 500, for example, has a beta value of one. So a stock or mutual fund that has a beta value greater than one will lose more money when the market declines than a stock that has a beta value less than one.

Portfolio managers that limited risk during the 2008 recession kept a percentage of their portfolios in US Treasury bonds and gold bullion. These investments performed well while stocks worldwide and high-yield corporate bonds plunged, Markowitz says.

For over six decades, “MPT,” as Modern Portfolio Theory is nicknamed, has provided money managers and sophisticated investors with a tried-and-true way to select portfolios.

Markowitz’s work is the key to squeezing the best returns with the least amount of risk out of portfolios of different asset classes. It analyzes the effects of asset risk, correlation and diversification on expected portfolio returns. But much depends upon how you split up your investment pie, Markowitz stresses.

Markowitz, at 84 years old, teaches his landmark Modern Portfolio Theory at the Rady School of Management at the University of California, San Diego. He is also working on a book and consulting with companies, such as Index Fund Advisors, an investment advisory firm, and Guided Choice, advisor to 401(k) plan sponsors.

Markowitz was born an only child in Chicago in 1927. His parents, Morris and Mildred, owned a neighborhood grocery story. Because his family was in the food and dry goods business, he was not severely affected by the Great Depression. Like other boys his age, he liked playing basketball and football. He also played the fiddle in the high school orchestra and liked reading comic books. But in high school, he took to studying physics and astronomy. He also read the philosophy of David Hume and Charles Darwin’s The Origin of Species .

Markowitz said he had no plans to go into economics when he graduated from the University of Chicago after completing a bachelor’s degree in two years. He was fascinated with the economics of uncertainty, and credits a course on “Observation, Interpretation and Integration” with having a strong impact on him.

Modern Portfolio Theory did not emerge from a vacuum. The use of statistical methods has its roots in the 17th and 18th centuries. Christian Huygens, in 1657, published a work on the calculus of probabilities, based on communications with French mathematicians Blaise Pascal and Pierre de Fermat. Swiss mathematician Johann Bernoulli published studies on mathematical expectations. Work by English mathematician Thomas Bayes in 1763 determined probabilities based on observed frequencies could be applied to social decision making. In 1812, a Pierre-Simon Laplace book, The Analytic Theory of Probabilities. revealed probability estimates could be used to solve many different types of problems.

In the early 20th century, many of the faculty members in the economics department of University of Chicago emphasized mathematics in economic decision-making. His mentors included renowned faculty members Leonard Savage, Tjalling Koopmans, Milton Friedman, and Jacob Marschak.

One study, published by Milton Friedman and Leonard Savage in The Journal of Political Economy in August 1948, especially influenced him. The study, “The Utility Analysis of Choices Involving Risk,” revealed that when individuals choose occupations, investments or business ventures, they essentially make one of two decisions. They either take risks or play it safe. Also influencing his thinking was Tjalling Koopmans’ graduate course on activity analysis.

While working on his PhD, Markowitz was invited to become one of the student members ofthe Cowles Commission for Research in Economics, now the Cowles Foundation at Yale University in New Haven, CT. The commission, affiliated with the University of Chicago from 1939 to 1955, fosters the development and application of rigorous logical, mathematical and statistical methods of analysis in economics. Economist Alfred Cowles III, its founder, was a fellow and treasurer of the New York–based Econometric Society, an international society for the advancement of economic theory in relation to statistics and math. Cowles, whose grandfather was a founder of The Chicago Tribune . applied statistical techniques to compare financial performance.

Markowitz said his experience working on the Cowles Commission helped him get an idea for his dissertation. While waiting to see his dissertation advisor, Jacob Marschak, he began chatting with Marschak’s stockbroker, who also awaited Marschak. Markowitz already had learned from Marschak about using probability mathematics to study the elasticity of demand for money and the relationship of money to wealth. So he naturally expanded that idea to financial market performance.

Markowitz got some basic ideas of portfolio theory while reading John Burr William’s book, Theory of Investment Value (Fraser). Williams’ book stressed that the value of a stock should equal the present value of future dividends that a company is expected to pay shareholders. He began applying probabilities to determine the risk and return of portfolios.

Investors already had been spreading their risks ever since the first bull market on Wall Street in 1792. But the investments were often more highly correlated and riskier than anticipated. The reason was that they failed to use the tools to mathematically evaluate performance relationships.

Markowitz believed variance should be used as a measure of risk in conjunction with expected rates of return on a portfolio of stocks. The expected rate of return, simply put,is the average of the probability distributions of returns. The variance, or standard deviation, which is the square root of the variance, measures how far the numbers spread out from each other.

“Variance came to mind as a measure of risk,” Markowitz said. “The fact that portfolio variance depended on security covariance added to the plausibility of the approach. Since there were two criteria—risk and return—it was natural to assume that investors selected from the set of optimal risk-return combinations.”

In the 1959 edition of his book, Portfolio Selection (Blackwell), Markowitz explained that that variance does not go to zero when risks are correlated. Variance can be substantial even if correlations are just .1 to .3 among securities, on average.

Markowitz said investors should estimate the likely returns, risks and correlations among various asset classes and use these inputs to conduct a Modern Portfolio Theory analysis. This produces a curve of “efficient” risk-return combinations. If you want greater return on average, you have to take on greater risk. If you want less month-to-month and year-to-year fluctuations, you have to accept less return on the average in the long run.

This article originally appeared in the Fall 2011 issue of Financial History a publication of the Museum of American Finance .