Harry Markowitz

So I'm trying to answer the idea of what is the optimum investment portfolio, so when we're looking at the asset allocation.

And one way of doing that is something called the efficient frontier, and it comes from Harry Markowitz, who published it in 1952 and then went on to win a Nobel Prize for his work.

Recently we mentioned it in I think it was a Money Vault, which got me thinking about the topic again.

And what made the research revolutionary was that up until the point that he published it, investing was largely about picking good individual investments.

Third, you get amazing diversification.

In the wise words of Nobel Prize laureate Harry Markowitz, quote, "Diversification is the only free lunch," end quote.

Owning part of an asset management company gets you tremendous diversification.

Why? Because a typical firm manages numerous funds.

So let's talk about where finance has arrived over the last 70 years in terms of assessing risk.

In fact, you can argue that modern finance as we know it was born that day when Harry Markowitz walked into a library as a PhD student and started thinking about what makes one company risky and another not.

And he came to the realization that the risk of a company is not the risk of that company standing alone, but the risk that it adds to an investor's portfolio.

It might by itself, you're saying, what's the big deal? It changed the way we think about risk.

Until Harry Markowitz, the way we thought about risk in companies is we thought about all of the risk in the company and we tried to bring it into the analysis.

And the Markowitz insight was it's only the risk you cannot diversify where that matters.

So you introduce the notion of a diversified investment.

This episode

It's now in the bucket of riskless asset classes.

I'm not going to throw Harry Markowitz's legendary work on modern portfolio theory into the waste paper basket just yet.

But that's just my big concern is really where expectations are.

And everybody is all in on the stock market.

So usually the asset allocation procedure, it's just one method, usually some variant of mean variance.

Thank you, Harry Markowitz from 1952, with some constraints.

But there are dozens and dozens, thousands of these construction methods.

And in the paper, we go through about two dozen.

All right, let's build the perfect portfolio.

Thinker number one, Harry Markowitz.

If this were a movie, and honestly, it should be, so someone call Scorsese, Harry Markowitz would be the origin story.

Markowitz is the father of modern portfolio theory, which he developed in 1952 in a paper so foundational that it's difficult to overstate its importance.

Before Markowitz, investing was largely intuitive.

You know, it's funny.

You and I probably talked about this, but when I first got involved in this notion of asset allocation, a la Harry Markowitz, a la William Sharp, right? A la Brinson B.

Bauer Hood.

You know, that kind of thing.

Then you have, like, broader portfolio construction where you're doing, you know, regressions and correlations in this asset class, and we need to get on the efficiency frontier.

And, you know, uh, Markowitz got a Nobel Prize for this stuff.

And it, it becomes just a simple concept that I don't think is executed well [laughs] right? It's, it's an intuitive concept that I think people have taken to some interesting places.

That's my spiel on diverse-

If you do that to the extreme and you're only looking at businesses from the ground up and not the broader portfolio, you're gonna run into problems.

Okay.

The other extreme, which I think, you know, some big institutions, wealth managers, asset allocators will do, is they look at it from the exact opposite, which is they're gonna take this giant portfolio of asset classes, large cap, small cap, value, quality, uh, bonds, European bonds, international, and then they try to do this, I'd say, pseudoscience, you know, efficiency frontier, which is, is the foundation of this, which is Harry Markowitz.

I don't wanna say it's pseudoscience.

Yeah.

So in terms of investment theory, the book really focuses on the past seventy-five years or so of academic research on investing, and I'm wondering if you could talk about Harry Markowitz and why he was such a pivotal figure in the birth of modern portfolio theory.

I think because he took these kind of common sense ideas, you know, don't put all your eggs in one basket, and translated them into a statistical framework that was much more useful.

So he created this framework that allowed you to test how the combination of different assets would affect a portfolio's volatility and its return.

And in his book, he talks about how he recognized that General Motors was riskier than a government bond.

And to account for that risk, he needed to assign a higher discount rate to its, um, cash flows when you're trying to figure out its intrinsic value.

But, you know, that process still leads you to a single estimate, a point estimate of what the, uh, security is worth, whereas the Markowitz framework, um, models risk as a possibility of outcomes.

What are some limitations of mean-variance optimization as an approach to portfolio construction?