modest returns from buying and holding triple-A bonds to maturity were more than enough reward. Markets at Risk: Modern Portfolio Theory, or MPT as it is most often referred to, has been a crucial element in the unleashing of this recent The Limits of Modern wave of demand for risk. It may not be difficult to understand how MPT, with its Portfolio Theory sophistication, elegance, and complexities, has succeeded in persuading investors that large risks can be controlled. Putting the STEVE LYDENBErg genie of MPT back in the bottle, however, DOMINI SOCIAL InVESTMENTS will be a more difficult task. Fixing MPT, correcting its flaws, is not sufficient to this task. We will need an entirely new theory to underpin investment practice if we hope to IN THE FACE OF ONE OF THE GREATEST tame this powerful force that has been set financial and economic crises of the past 100 free in the financial world. years, legislators and regulators are deciding Even the most casual, unsophisticated what new steps need to be taken to keep the observer can intuitively understand that abuses that have provoked such situations financially risky products are at the heart of from recurring. They are, understandably, today’s financial crisis. It is easy to see that focusing on the supply side: the host of new, it was a $450 billion bet on credit default highly risky financial products and practices swaps that brought down AIG, the largest around the world that need to be reined in insurance company in the world; that highly and brought under control. risky subprime mortgages broke the back of Unfortunately, not as much attention Washington Mutual, one of the fast growing is directed at the demand side: the regional banks in the United States; that out- Iapparently insatiable demand for risky of-control hedge managers bankrupted Bear products coming from our largest and most Stearns; and that highly leveraged real estate sophisticated institutional investors. Those deals contributed to the downfall of Lehman demanding these risky products have been Brothers. Risk-taking has devastated as responsible for their spread around the financial institutions around the world and world as have those providing the supply. brought whole national economies—Iceland Regulating that demand—tempering it, is the most dramatic example—to the brink restraining it, controlling it—is as likely to of fiscal collapse. prevent the recurrence of future financial These risky products purveyed by reckless crises as is trying to prevent super-smart financial institutions existed in part because money managers from finding fancy ways to there was a willing market—and institutional package risk in today’s marketplace. investors bound by fiduciary principles of Not more than forty or fifty years ago this prudence to their beneficiaries were part demand was easily controlled. Fiduciaries— and parcel of that market. These institutions the largest institutional investors of today: are among the largest investors in the world. pension funds, mutual funds, and trust Pension funds around the world control officers—were by and large limited in their some $25 trillion in assets. (Watson Wyatt abilities to invest in stocks because they were 2008) In the United States, endowments of too risky, not to mention mortgage-backed universities alone exceeded $400 billion in securities, synthetic collateralized debt assets as of 2008. (NACUBO 2009) Some obligations, credit default swaps, double- of the most technically expert investment barrier foreign exchange options and their professionals in the world clearly thought the like. A true fiduciary did not take risks with investments they were making were prudent, other people’s money. The security and and the reason they thought so was MPT. 2009 SUMMIT ON THE FUTURE OF THE CORPORATION | PAPER NO. 6 | 42 To understand the front-page headlines developing a theoretical rationale for the about today’s financial crises we must step “prudent man” to invest in stocks. MPT behind the scenes to understand some of provided that theoretical framework. those fundamental precepts of MPT that (Bernstein 2005) It demonstrated that the have been so influential. Although a full risks inherent in investing in stocks could be exposition of MPT—its origins, its primary measured and controlled at a portfolio level elements, and the debates about its various during normal market conditions. hypotheses—is not attempted here, the The origins of MPT can be traced to the following highlights a number of its most seminal work of Harry Markowitz. In a 1952 important contentions and theories and article in the Journal of Finance, Markowitz examines their implications for investment pioneered the concept of controlling risk practices today. at a portfolio level through diversification. Markowitz’s work was revolutionary because ORIGINS OF MODERN PORTFOLIO it viewed risk as a portfolio problem, not THEORY a problem in individual security selection. The progenitors of MPT were academics Investing in countercyclical stocks was who, starting in the 1950s, set out to solve the key to controlling risk. If companies a relatively simple problem: how to justify involved in home repair thrive when those investing in risky stocks. In the late 19th that build new houses struggle, then a and early 20th centuries, stocks were an portfolio of the stocks of both companies unregulated, highly risky, speculative will be less risky than investments in either investment prone to boom and bust—and company alone. Investing in one risky stock consequently were off limits to prudent might be unwise, but investing in two risky investors. The risks of investing in stocks stocks—each risky in its own way—can be were made painfully clear during the crash prudent. (Markowitz 1952, 1959) of 1929 when the stock market lost almost Increasing the opportunities to invest 90% of its value over three years. in risky securities is crucial to investment Initial attempts to legitimize investing managers today because the greater the in the stock market were made during the risks the greater the potential rewards. By depths of the Great Depression. Among the diversifying risk throughout a portfolio, most important were increased transparency managers can achieve greater portfolio and government regulation. The Securities returns without taking greater overall and Exchange Commission was created in portfolio risks. Diversification techniques are 1933 and 1934 and directed to oversee the what Peter Bernstein calls “the closest thing stock markets. Companies were, for the first to a free lunch” that there is in investing. time, required to disclose audited financial (Bernstein 2005) statements. Also in 1934, Benjamin Graham In the 1960s Eugene Fama, Sidney and David Dodd published their still Alexander, and others developed a second popular classic Securities Analysis: Principles mainstay of MPT: the efficient market and Techniques, which laid out convincingly hypothesis. In its various forms this principles for purchasing stocks at hypothesis asserts that the stock market reasonable prices. (Mitchell forthcoming) essentially reflects all available information This combination of regulatory initiatives at any given time. This implies that stocks and academic advice helped legitimize are appropriately—or “efficiently”—priced. investing in stocks, but essentially wasn’t In addition, this theory implies that a sufficient to justify fiduciaries taking the money manager cannot beat the market—at plunge into the equities markets because it least not all the time—because the market provided no theoretical reason why stocks knows more and is “smarter” than any one should be viewed as safe. individual. (Fama 1970) It wasn’t until the mid-1950s, when the A crucial variation on this theme was stock market once again reached its 1929 necessary as well to account for the fact that highs, that academics tackled the task of markets bounce around irrationally day 2009 SUMMIT ON THE FUTURE OF THE CORPORATION | PAPER NO. 6 | 43 to day. MPT concedes that stocks can be MODERN PORTFOLIO THEORY IN temporarily mispriced. These momentary Practice lapses in the otherwise efficient markets give Thus, all the elements of MPT were better-informed investors an opportunity effectively in place by the mid-1970s, but to take advantage of temporary market it took some twenty years for its basic anomalies and, brief as these anomalies precepts to be widely disseminated and might be, to buy or sell stocks before they accepted among institutional investors. The revert to their true mean. conservative investor of the 1970s and 1980s, Simultaneously, William Sharpe, James who had been told time and time again that Tobin and others were developing the Capital one of the primary duties of a fiduciary was Asset Pricing Model, which provides a means to avoid undue risk initially greeted MPT’s of measuring expected returns on any given brilliant academic proponents with doubt investment of a particular level of risk. This and skepticism. (Bernstein 2007) formula—and it is an algebraic formula— The tide turned gradually in the 1980s allows investors to measure the success of and early 1990s, as the proponents of this their investments. That is to say, it allows theory received increasingly widespread them to assess whether they have achieved an recognition—many were eventually awarded appropriate level of return for the level of risk a Nobel Prize in Economics1—and as the they have taken. (Sharpe 1970) technology and practical tools for measuring Crucial to this theory is the definition and controlling risk in investment portfolios of risk as the volatility of a stock’s returns were developed. But it wasn’t until the late relative to the market. A stock is risky if its 1990s that the floodgates truly opened price goes up or down more than the price and fiduciaries in charge of institutional of its peers. This simple, narrow definition investments embraced MPT wholesale. has led to the creation of innumerable Not only did MPT free fiduciaries to benchmarks that define the markets against invest in blue-chip stocks formerly deemed which investment success can be measured.