Last Thursday, Donna Mitchell, a writer for Financial Planning Magazine, interviewed me for about a half an hour about the importance of Harry Markowitz. For those of you who haven’t read my book (oh…the shame of it), Markowitz is the author of the Nobel Prize winning paper, Portfolio Selection, published in 1952. His paper is the foundation for a body of work now known as Modern Portfolio Theory, which is central to how modern institutional portfolios are constructed. Not knowing what I said in the interview, and certainly not knowing what will end up in print, here is what I hope, or wish, or think, I said (or should have said) about Markowitz.
The late Nobel Prize winner, Merton Miller, called Markowitz the “big bang” of modern finance. His description accurately describes the importance of Markowitz, even if it does falsely imply that Markowitz did not build on the work of other academics before him. (I believe that Louis Bachelier deserves the title of “father of modern finance” for his work on quantitative option pricing as a graduate student in France in 1900.) The name of Markowitz’s paper, Portfolio Selection, does much to describe how his work contrasted with the prior “value investing” methodology popularized by Benjamin Graham in his 1934 work, Security Analysis. The titles say it all…Markowitz introduced us to quantitatively building portfolios, as opposed to evaluating individual securities. His algorithm for building portfolios was elegant and easy to understand. With three inputs, future returns (mean returns), future volatility (future variances), and future correlations, you can build the most “efficient” portfolio, a portfolio that generates the most return for the minimum amount of risk. This notion of efficient or optimal portfolios based on means/variance optimization is central to everything financial planners are taught in terms of portfolio construction.
My issue is not with Markowitz, who deserves the acclaim he now receives, but with the industry that has misinterpreted and misrepresented his work. Instead of using forecasts of future means and variances to run his model, the industry found a way to use the historical average of returns and volatility as inputs to the model. The result can be dangerously misleading. The way Markowitz’s model is used today investors may believe that diversifying their holdings is the best and only method to manage portfolio risk. As we have repeatedly said, if assets are overvalued then diversification may not help to manage risk at all. If I have any beef with Markowitz it is in the notion that volatility (variance) is the best measure of risk. Most value investors cherish volatility and view it as a means to manage risk. Value investors would say a much better way to view risk is simply the probability of losing your money. Downside volatility in price allows value investors to buy assets at discounts to their intrinsic value. This allows for a “margin of safety” that actually reduces risk. Harry Markowitz published his paper in 1952. He is an iconic figure in our business that deserves our greatest respect. I hope that any comments I made to Donna last Thursday reflect that sentiment.
