Thursday, May 14, 2009

Markowitz's Lost Message

Harry Markowitz is considered the father of modern finance by many, and his paper, Portfolio Selection, published in 1952, is the foundation of the Nobel Prize winning body of work known as Modern Portfolio Theory. It provides the mathematical foundation for strategic asset allocation, which is how professionals apply buy and hold investing to multiple asset class portfolios. To the surprise of many, here is what Markowitz has to say in the beginning of his famous paper:

“The process of selecting a portfolio may be divided into two stages. The first stage starts with observations and experience and ends with beliefs about the future performances of available securities. The second stage starts with the relevant beliefs about future performance and ends with the choice of a portfolio. This paper is concerned with the second stage.”

It is shocking how Markowitz’s work has been misapplied by the investment industry over the years. Instead of using observation and experience to make assumptions about the future performance of available securities, investors are taught to use average past performance of available securities and assume that performance is a certainty. In fact, it is the misplaced “belief” that past performance will repeat itself in the future that makes me believe that buy and hold investing is more like religion than an investment strategy. Investors who misapply Markowitz’s models in this manner must have faith that the past really is prologue to the future. Investors must choose. They can either rely on average past performance for their beliefs about future asset class performance, or they can reach their beliefs based on thorough study of absolute and relative value, market cycles, and technical analysis.

We choose the second method.