Happy Anniversary Harry!
by Mark Neil

Fifty years ago a young PhD candidate at the University of Chicago successfully defended his doctoral thesis on a idea that would eventually change the way investors built their stock portfolios.  Harry Markowitz, at the age of 26 developed what we know today as Modern Portfolio theory and the significance of his work would earn him a share of the 1990 Nobel Prize in Economics.  So revolutionary was his thinking that a member of the doctoral examing committee, Milton Friedman, a famous economist almost held back Harry’s degree because the substance of his work did not neatly fit into the field of economics, mathematics or finance.  However, the significance of his work was clear to his doctoral committee and they knew his theories would create a windstorm of controversy and debate in the tight circles of professional money managers. 

Harry had devised a system of equations that affirmed the old saying, "don't put all of your eggs in one basket."  Sophisticated investment theory at this time was virtually undeveloped and when professional money managers gathered stocks into portfolios they depended largely on instinct and experience in diversifying the portfolio.  Information technology in this postwar era was primitive compared to today's environment and it was relatively easy for a few investment firms to dominate the portfolio management industry.  When Harry came on the scene the stock market crash of '29 and the resulting depression were still fresh in the public's mind and they viewed investing in the stock market as very risky and best left up to the professionals on Wall Street.  The professionals of course were very happy with this thinking because it kept stock selection in their hands and enabled them to continue to build their financial empires. 

As you can imagine Harry's theory was not well received in the investment community because his work pulled away the cloak of secrecy about portfolio management and demonstrated that by using mathematics a better portfolio could be developed.  His theory essentially demonstrated the power of diversification in a portfolio and that by using the proper mix of assets an investor could increase his return while reducing his overall risk.  He was able to prove that not only was it a bad idea to put all of your eggs in one basket, but he also demonstrated what other kinds of “eggs” you should put in your basket to make your portfolio safer and more productive. 

The major weakness of his approach however was the vast amount of computing power necessary to construct his efficient portfolio of stocks.  Thousands of calculations were needed to compute outcomes of multiple equations in order to find the right mix of assets, and in the 50's and 60's this level of computing power was not readily available.  As computing time became more available and follow-up works were published on his original theory, his ideas became more accepted into the investment world mainstream.

Today it is a basic precept of investing that portfolios should be diversified across multiple asset classes, such as stocks and bonds, as well as across multiple investment styles.  With all of the investment information on the Internet, one would think that this 50-year-old idea would be universally applied.  Unfortunately it is not as pervasive as one might think.  Individual investors are fighting an uphill battle with these ideas because like the investment professionals of the 50's, they make many of their investment decisions based on their feelings rather than their intellect.

A recent study by Richard Thaler of the Graduate School of Business, University of Chicago found that the number and type of choices offered to a participant in a retirement plan affect how investors allocate their assets.  He found that if there is a simple choice between an equity fund and a bond fund, the average participant puts half of his portfolio in the equity fund and half in the bond fund.  If they are given more equity fund choices, more money goes into those funds, in the approximate mix of the choices.  If they are given more fixed income choices, more money goes into the fixed income category.  In my work with individuals, I have found some plans offer so many choices that people become confused and make very irrational decisions.  Markowitz and his theory turned the selection of stocks for a portfolio into a very rational choice.

To begin to understand his theory you have to understand that different asset classes have different performance characteristics.  Stocks, for example, perform differently than real estate holdings and these two asset classes can be combined to produce better overall performance.  Therefore to balance a portfolio you should include different asset classes to lower the risk and increase the return of the portfolio.   Within each asset class you can diversify even further. 

For example, in diversifying the stock portion of your portfolio you would want to consider stocks of large, medium and small companies.  You might also want to consider mixing stocks of companies, which fall into the growth style of investing with those that fit into the value style of investing.  If you choose to stay with growth types of stocks you can achieve significant diversification by purchasing mutual funds rather than the individual stocks.   Many investors turn to mutual funds because on average they hold between 75-100 different stocks.  You can achieve your diversification goal by selecting funds that for the most part don't own the same stocks. 

Markowitz's theory makes use of statistical measures to determine the optimal mix of stocks, mutual funds or other assets to achieve diversification in a portfolio.  His equations calculate the most efficient mix of assets that balances the risk of investment loss with the reward of investment gain.   It becomes optimal when adjusting the mix would increase the risk without improving the gain or result in less gain for the same amount of risk. He recognized that there were infinite combinations of stocks, but there was only one mix that would perfectly meet the needs of an individual investor. 

A simple example to illustrate his theory is to consider the palette of colors an artist has when painting a landscape.  By mixing the right colors together, the artist can obtain the perfect shade of blue to color the sky or the right shade of green for the forests.  It is the same when creating a portfolio of stocks.  Stocks can be mixed in proportions that will be offer the right blend and present the most pleasing tradeoff between risk and reward to the investor.   The challenge each investor has is to determine which “color” they prefer and then leave the rest up to Harry and his Modern Portfolio theory to identify the proper mix of investment assets.
 
 

© 2002 Mark Neil    Photo is a link to a Nobel page.