Nobel Prize-winning American economist Harry Markowitz (1927) pioneered Modern Portfolio Theory (MPT), recognizing the importance of a portfolio over individual stock performance. Since Markowitz’s 1952 essay “Portfolio Selection” in The Journal of Finance, MPT has revolutionized investment strategies.
Markowitz Wil, Liam F. Sharpe, and Merton Miller shared the 1990 Nobel Memorial Prize in Economic Sciences for their portfolio choice theory, which explains financial asset allocation under uncertainty. The Nobel Committee called Markowitz’s portfolio choice theory the “first pioneering contribution in financial economics.” The Nobel Committee recognized Markowitz’s portfolio theory as the foundation for William Sharpe and others’ 1960s Capital Asset Pricing Model (CAPM), which explains financial asset price formation.
Early Career and Education
Markowitz received his M.A. and Ph.D. in Economics at the University of Chicago, studying under famous scholars such as Milton Friedman, Jacob Marschak, and Leonard Savage. As an undergraduate, Markowitz joined the Cowles Commission for Research in Economics (now the Cowles Foundation) at Yale University, headed by Nobel Laureate and mathematician Tjalling Koopmans.
1952 Markowitz joined the RAND Corporation, a worldwide policy research agency, to develop huge logistics simulation models. He worked at General Electric on manufacturing plant models before returning to RAND to develop SIMSCRIPT, a computer simulation language that allowed academics to reuse code for analysis. In 1962, he founded CACI and supervised the marketing of a private version of SIMSCRIPT after leaving RAND. Additionally, Markowitz is an adjunct professor at the Rady School of Management at UC San Diego and is the co-founder and chief architect of GuidedChoice, a financial adviser business in San Diego. He leads the Investment Committee.
Modern Portfolio Theory Development
In his 1990 Nobel Committee talk, Harry Markowitz stated that he discovered portfolio theory while reading John Burr Williams’ Theory of Investment Value in the library. According to Williams, the stock value should match the present value of future dividends. I thought Williams meant to evaluate a stock by its predicted future dividends, as future payouts are unknown. If the investor were just interested in the anticipated values of securities, they would only be interested in the portfolio’s expected value, and one need only invest in one asset to maximize it.”
However, Markowitz concluded that single-security investing “was not the way investors did or should act.” He understood that “investors diversify because they are concerned with risk as well as return.” He also realized that investors understood diversification’s benefits but required tools to identify the right degree.
Markowitz developed the Efficient Frontier, which determines optimal diversity given an investor’s desired return and risk. The “efficient frontier” region of the graph represents the portfolio with the highest return for that investor’s risk tolerance. Outside the efficient graph, portfolios have too much risk or too little return. Each investor has varied risk tolerance and return expectations; hence, there is no efficient frontier.
The Impact of Harry Markowitz’s Modern Portfolio Theory
Before Harry Markowitz’s MPT, investing was mainly based on individual investment performance and pricing. Diversification was haphazard.
MPT, Diversification
Markowitz’s approach wasn’t fully realized until the 1960s, but MPT has become a staple investment technique, and all money managers understand the benefits of diversification. Even robo-advisors, a revolutionary financial technology, employ MPT to create proposed portfolios.
Streetwall
Markowitz’s approach has become standard in portfolio management, with Nobel laureate Paul Samuelson stating, “Wall Street stands on the shoulders of Harry Markowitz.”
Mathematical Portfolio Management
Milton Friedman said Markowitz’s Ph.D. on applying mathematics to stock market research was not economics in 1954 since it was so novel. Since 1992, his mathematical and statistical approaches to portfolio management have been highly regarded, with economist Peter Bernstein calling them “the most famous insight in the history of modern finance.”
Risk-Correlation
Markowitz revolutionized economics by recognizing the significance of risk correlation, which considers both individual stock risk and the cumulative influence of numerous stock prices.
A fellow economist, Martin Gruber, credits Markowitz with the simple but groundbreaking idea that investors should evaluate stock linkages rather than individual stocks.
Modern Portfolio Theory Criticisms
MPT, like every popular theory, has detractors. A typical one is that diversification requires no absolute number of stocks. MPT-based portfolio management may also encourage risk-averse investors to take on more risk than they can handle. Another critique calls for moving beyond MPT to address real-world systemic risk.
Outgrowing Modern Portfolio Theory
Jon Lukomnik is the managing director of Sinclair Capital and a senior fellow at the High Meadows Institute, a Boston-based policy institute focused on business leadership and sustainability. James Hawley, Head of Applied Research at TruValue Labs, a San Francisco start-up that uses artificial intelligence analytics to create sustainability and ESG metrics, is one of the critics of Modern Portfolio Theory (MPT).
Lukomnik and Hawley’s 2021 book, Moving Beyond Modern Portfolio Theory: It’s About Time!, addresses the “MPT paradox”: Markowitz’s diversification only addresses idiosyncratic risks, not systemic risks that could bring down an industry or financial system.7
A decade before climate change, antibiotic resistance, and resource scarcity were considered investment challenges, Lukomnik and Hawley invented MPT. They contend that real-world systemic risks to environmental, social, and financial systems contribute more to returns than idiosyncratic risks to any investment or firm. According to their book, the lack of MPT tools to handle real-world systemic risks is a critical concern for modern investors.
Markowitz’s Biggest Amateur Investor Mistake?
According to Harry Markowitz, “the chief mistake of the small investor is that they buy when the market goes up, on the assumption that it’s going to go up further, and they sell when the market goes down, on the assumption that it may go down further.”
How Does Harry Markowitz View Robo-Advisors?
Markowitz said robo-advisors use MPT principles: “They bring advice to the masses. Robotic advisors can deliver good or harmful advice. Good counsel is great.”
What was Markowitz’s “a-ha” moment?
Markowitz got his “a-ha” moment when reading a mathematical probability book and had his famous risk correlation idea: “that the portfolio’s volatility depends not only on the constituents’ volatility but also on how much they go up and down together.”
Bottom Line
Harry Markowitz has been one of the most influential pioneers in financial economics since he created Modern Portfolio Theory (MPT) in 1952. His innovations in portfolio theory and computer programming language shaped Wall Street. Markowitz popularized diversification, portfolio risk, and return, moving the focus away from stock performance.
Conclusion
- Harry Markowitz’s MPT theory changed how people and institutions invest by showing that portfolio performance is more significant than stock performance.
- The Nobel Committee dubbed Markowitz’s portfolio choice theory the “first pioneering contribution in the field of financial economics.” He was one of three Nobel Memorial Prize in Economic Sciences winners in 1990.
- The Nobel Committee called his MPT theory the cornerstone for the Capital Asset Pricing Model (CAPM), the “second significant contribution to the theory of financial economics.”
