Father of Modern Portfolio Theory By Alan Lavine Harry Markowitz’s Nobel Prize win- bonds and gold bullion. These investments liked reading comic books. But in high ning Modern Portfolio Theory was put to performed well while stocks worldwide school, he took to studying physics and the supreme test in The Great Recession and high-yield corporate bonds plunged, astronomy. He also read the philosophy of 2008. The stock market plunged nearly MarkowitzStill says. Diverof David HumeS andifie Charles Darwin’sD The 40%, stock and corporate bond markets For over six decades, “MPT,” as Mod- Origin of Species. crashed, the money markets froze up. ern Portfolio Theory is nicknamed, has Markowitz said he had no plans to go Uncle Sam had to bail out major banks, provided money managers and sophisti- into economics when he graduated from while letting Bear Stearns and Lehman cated investors with a tried-and-true way the University of Chicago after completing Brothers fail. to select portfolios. a Bachelor’s degree in two years. He was It raised the big question: Does Modern Markowitz’s work is the key to squeez- fascinated with the economics of uncer- Portfolio Theory hold up during once-in- ing the best returns with the least amount tainty, and credits a course on “Observa- a-lifetime events? of risk out of portfolios of different asset tion, Interpretation and Integration” with “It is sometimes said that portfolio the- classes. It analyzes the effects of asset risk, having a strong impact on him. ory fails during a financial crisis because correlation and diversification on expected Modern Portfolio Theory did not all asset classes go down and all correla- portfolio returns. But much depends upon emerge from a vacuum. The use of sta- tions go up,” Markowitz said in a tele- how you split up your investment pie, tistical methods has its roots in the 17th phone interview from his office in San Markowitz stresses. and 18th centuries. Christian Huygens, in Diego, CA. Markowitz, at 84 years old, teaches his 1657, published a work on the calculus of But this, stressed the Ph.D. winner of the landmark Modern Portfolio Theory at the probabilities, based on communications Nobel Prize for economics, is already pre- Rady School of Management at the Uni- with French mathematicians Blaise Pascal dicted by his Modern Portfolio Theory. versity of California, San Diego. He is also and Pierre de Fermat. Swiss mathemati- “Generally, asset classes move roughly working on a book and consulting with cian Johann Bernoulli published studies in proportion to their historical betas,” he companies, such as Index Fund Advisors, on mathematical expectations. Work by said. The beta value is a measure of how an investment advisory firm, and Guided English mathematician Thomas Bayes in risky an asset is in relation to the overall Choice, advisor to 401(k) plan sponsors. 1763 determined probabilities based on stock market. The S&P 500, for example, Markowitz was born an only child in observed frequencies could be applied to has a beta value of one. So a stock or Chicago in 1927. His parents, Morris and social decision making. In 1812, a Pierre- mutual fund that has a beta value greater Mildred, owned a neighborhood gro- Simon Laplace book, The Analytic Theory than one will lose more money when the cery story. Because his family was in the of Probabilities, revealed probability esti- market declines than a stock that has a food and dry goods business, he was not mates could be used to solve many differ- beta value less than one. severely affected by the Great Depression. ent types of problems. Portfolio managers that limited risk Like other boys his age, he liked playing In the early 20th century, many of the during the 2008 recession kept a percent- basketball and football. He also played the faculty members in the economics depart- age of their portfolios in US Treasury fiddle in the high school orchestra and ment of University of Chicago emphasized www.MoAF.org | Fall 2011 | FINANCIAL HISTORY 17 mathematics in economic decision-mak- on Wall Street in 1792. But the invest- dissertation. At the time, he was working ing. His mentors included renowned fac- ments were often more highly correlated for the Cowles Foundation. Economist ulty members Leonard Savage, Tjalling and riskier than anticipated. The reason Milton Friedman argued that portfolio Koopmans, Milton Friedman and Jacob was that they failed to use the tools to theory was not economics, so Markowitz Marschak. mathematically evaluate performance should not be awarded his Ph.D. But after One study, published by Milton Fried- relationships. a short debate by the dissertation commit- man and Leonard Savage in The Jour- Markowitz believed variance should be tee, the work was approved. nal of Political Economy in August 1948, used as a measure of risk in conjunction “At the time I defended my disserta- especially influenced him. The study, with expected rates of return on a portfo- tion, portfolio theory was not part of eco- “The Utility Analysis of Choices Involv- lio of stocks. The expected rate of return, nomics,” he said. “But now it is.” ing Risk,” revealed that when individuals simply put, is the average of the probabil- Markowitz looks at the world based on choose occupations, investments or busi- ity distributions of returns. The variance, utility and personal probability. When he ness ventures, they essentially make one or standard deviation, which is the square goes for daily lunchtime walks, he notices of two decisions. They either take risks or root of the variance, measures how far the license plate numbers and routinely cal- play it safe. Also influencing his thinking numbers spread out from each other. culates the probability of seeing the same was Tjalling Koopmans’ graduate course “Variance came to mind as a measure number reoccur. For example, the prob- on activity analysis. of risk,” Markowitz said. “The fact that ability of seeing a license plate with four While working on his Ph.D., Markowitz portfolio variance depended on security of a kind such as 6666 is one in one thou- was invited to become one of the student covariance added to the plausibility of sand, he said. But every year, if you walk members of the Cowles Commission for the approach. Since there were two crite- enough you will see another license plate Research in Economics, now the Cowles ria — risk and return — it was natural to with four of a kind. It’s the same, he said, Foundation at Yale University in New assume that investors selected from the set with the stock market. Haven, CT. The commission, affiliated of optimal risk-return combinations.” Markowitz advocated optimizing port- with the University of Chicago from 1939 In the 1959 edition of his book, Port- folios to get the best return per unit of risk to 1955, fosters the development and appli- folio Selection (Blackwell), Markowitz by using asset correlations dating back to cation of rigorous logical, mathematical explained that that variance does not go 1926, rather than short-term and current and statistical methods of analysis in eco- to zero when risks are correlated. Variance correlations. History tends to repeat itself, nomics. Economist Alfred Cowles III, its can be substantial even if correlations are he believes, but not in the same sequence. founder, was a fellow and treasurer of the just .1 to .3 among securities, on average. So there is always a chance the investor New York-based Econometric Society, an Markowitz said investors should esti- could experience losses similar to 1929, international society for the advancement mate the likely returns, risks and correla- 1982, 2002 and 2008. of economic theory in relation to statistics tions among various asset classes and use “Personally I think that nature draws and math. Cowles, whose grandfather was these inputs to conduct a Modern Portfo- from the basket known as the S&P 500 a founder of The Chicago Tribune, applied lio Theory analysis. This produces a curve randomly every year,” he said. “The stock statistical techniques to compare financial of “efficient” risk-return combinations. If market losses in 2008 have a probability performance. you want greater return on average, you of occurring about once out of every 40 Markowitz said his experience work- have to take on greater risk. If you want years. The 38.5% loss on the S&P 500 was ing on the Cowles Commission helped less month-to-month and year-to-year more than 2.5 standard deviations below him get an idea for his dissertation. While fluctuations, you have to accept less return the mean.” waiting to see his dissertation advisor, on the average in the long run. Yes, the 2008 market crash could hap- Jacob Marschak, he began chatting with In 1989, Markowitz won the John von pen again, he said, but you don’t know Marschak’s stockbroker, who also awaited Neumann Theory Prize by the Institute when. The losing cards are in the deck. Marschak. Markowitz already had learned for Operations Research and Manage- Markowitz’s famous portfolio theory from Marschak about using probability ment Sciences, a Hanover, MD organiza- for allocating assets was refined by later mathematics to study the elasticity of tion dedicated to applying scientific meth- research. The Capital Asset Pricing Model, demand for money and the relationship of ods to help improve decision-making, designed by William Sharpe in 1963, gave money to wealth. So he naturally expanded management and operations. The honor money managers an extra measure of that idea to financial market performance. was for his research on portfolio theory, risk to consider. Sharpe’s theory consid- Markowitz got some basic ideas of port- sparse matrix analysis to solve simultane- ers systematic risk, or how an asset moves folio theory while reading John Burr Wil- ous equations and SIMSCRIPT, which is in relation to the overall market.