Harry Markowitz’s Monumental Legacy

On this special episode of The Long View, we are honoring the life of Harry Markowitz, a finance giant and leader in research on diversification and Modern Portfolio Theory. Dr. Andrew Lo, professor of finance, and the director of the Laboratory for Financial Engineering at MIT, had the opportunity to interview Harry Markowitz for his book, In Pursuit of the Perfect Portfolio.

Here are a few excerpts from Dr. Lo’s conversation with Morningstar’s Christine Benz and Jeff Ptak:

Markowitz and Modern Portfolio Theory

Jeff Ptak: I wanted to talk about some of those luminaries that you profiled, the first of which is a giant in the field. All of these are giants in the field, but maybe he arguably looms largest, is Harry Markowitz. You explained in the book, in telling his story, that if it weren’t for a chance encounter, Markowitz might never have gone down the path that eventually led to his research on Modern Portfolio Theory. Can you talk about that chance encounter?

Dr. Andrew Lo: It was a very strange story that Harry told about being in a, I think it was a waiting room, and trying to get some feedback on some work that he had done. And it turned out that that feedback ended up leading him toward thinking about portfolio optimization, which he would have never done had it not been for that occasion. And, of course, portfolio theory is such an important part of what we do in modern finance, that it’s kind of hard to imagine that it was really due to that random event that got him down that path to think about how to apply optimization processes to this particular setting.

Ptak: It was a stockbroker in his doctoral advisors’ waiting room, wasn’t it, who said,

“Maybe take a look at the market.” And that eventually led him down the path he went down, correct?

Dr. Lo: That’s right. And I think that he had very little experience with investing prior to that. He had no particular interest in it. But given the tools that he had at his disposal and given the problem that was proposed to him, it was just a natural application.

Portfolio Management

Christine Benz: As you explained in the book, there had been little academic interest in portfolio management until Markowitz came along. Now there are whole journals devoted to the topic. But back then, the disinterest reflected attitudes toward the stock market, which was perceived as a bit of a backwater, right?

Dr. Lo: Absolutely. It’s really quite a stunning change, because when Markowitz started applying these principles, nobody had any interest in portfolio optimization. And today, I don’t imagine there’s a financial analyst out there who doesn’t know of mean-variance analysis. A very interesting story that Harry tells is at his thesis defense, when Milton Friedman, who was on his thesis committee, half-jokingly said, “Well, we can’t really give him a Ph.D. in economics, because, of course, this isn’t really economics, it’s just math.” And Harry Markowitz I think had the last laugh, when, as part of his Nobel acceptance speech, he mentioned this story. And he said that, “Well, at that time, Friedman was right. It wasn’t economics or finance. But now, it is.”

How Did Markowitz Change Portfolio Construction?

Ptak: In one afternoon—I think you recount this in the book—Markowitz had worked out the two major inputs to what became Modern Portfolio Theory: correlation and the notion of mean-variance optimization, as well as the notion of an efficient frontier. Can you talk about how those discoveries changed portfolio construction, maybe by contrasting with how it had been done up to that point?

Dr. Lo: This is really quite a stunning achievement, and it’s one that most people aren’t aware of, because they just take for granted that we now think about correlation, diversification, and portfolio construction the way we’ve always done it. But, in fact, prior to Markowitz, the way that people thought about investments was really from the perspective of the portfolio manager, the culture, and the personalities involved. They were often called gunslingers. Because these were larger-than-life celebrities that were able to pick stocks in much the way that certain art experts are able to pick the very best pieces of art. And so, that’s the way that the investment industry operated until, I would say, the 1960s and ‘70s, well past the first decade after Markowitz’s publication.

But something happened in that process, which is that portfolio managers began to see a different way of constructing portfolios, not by picking the best stocks, but rather by creating a combination of securities that had good properties overall. And correlation was a key feature. What you wanted to do was to put together a collection of securities that were not all highly correlated, not highly related. And the reason for that is you wanted to make sure that you had good diversification, not putting all your eggs in the same basket. And by managing the correlation, you’re able to produce a portfolio that had better returns, lower risk, and therefore over time, would grow into a much larger nest egg than the traditional stock-picking approach. That was a combination of Markowitz and Sharpe and all of the other luminaries that had ultimately taken this academic idea, a rather dry set of mathematics, and really turned it into something practical and genuinely useful.

The ‘Grandfather of Behavioral Finance’

Benz: Markowitz is rightly credited as the father of Modern Portfolio Theory, but you call him the grandfather of behavioral finance in your book. What do you see as his contribution to this field?

Dr. Lo: Well, if you think about portfolio theory the way he looked at it, he made a behavioral statement. His statement was, individuals, they care about two things: risk and reward. They don’t like risk; they do like reward. Those are actually behavioral assumptions. And based upon those behavioral assumptions, he derived tremendously powerful implications about how individuals would ultimately manage their money to achieve those goals. Since then, he’s actually spent some time thinking about other criteria, other behavioral approaches. And so, in that respect, I think he really is the very first behavioral economist. He took human behavior seriously and then worked out the implications and ultimately developed a tremendously valuable framework for helping everybody manage their particular behavioral desires. And of course, since then, we’ve learned that there are many other kinds of behaviors, some of which are conducive, others of which are not, to wealth creation. And there’s a lot more research that’s being done on that today.