Who is Harry Markowitz?
Harry Markowitz (1927– ) is a Nobel Prize winning economist who devised the modern portfolio theory (MPT). Markowitz introduced MPT to academic circles in his article, "Portfolio Selection," which appeared in The Journal of Finance in 1952. Markowitz's theories emphasized the importance of portfolios, risk, the correlations between securities, and diversification. His work, in collaboration with Merton H. Miller and William F. Sharpe, changed the way that people invested. These three intellectuals shared the 1990 Nobel Prize in Economics.
Understanding Harry Markowitz
Prior to Harry Markowitz's work on modern portfolio theory, investing was largely seen in terms of the individual performance of an investment and its current price. As an investor, you wanted to get a good stock at a good price, and then repeat that process when you had capital to invest. Markowitz showed that the individual performance of a particular stock wasn't as important as the performance and composition of an investor's entire portfolio.
- Harry Markowitz is the pioneer of modern portfolio theory, first laid out in "Portfolio Selection" published in The Journal of Finance in 1952.
- Markowitz shared the 1990 Nobel Prize in Economics with William F. Sharpe and Merton Miller.
- Markowitz's work has popularized concepts like diversification and overall portfolio risk and return, shifting the focus away from the performance of individual stocks.
The Development of Modern Portfolio Theory
In his own words, Harry Markowitz said, "the basic concepts of portfolio theory came to me one afternoon in the library while reading John Burr Williams's Theory of Investment Value. Williams proposed that the value of a stock should equal the present value of its future dividends. Since future dividends are uncertain, I interpreted Williams's proposal to be to value a stock by its expected dividends. But if the investor were only interested in expected values of securities, he or she would only be interested in the expected value of the portfolio; and to maximize the expected value of a portfolio one need invest only in a single security."
Investing in a single security did not make sense to Markowitz. Thus, Markowitz embarked on developing the modern portfolio theory with the foundation of diversification underpinned by concepts of risk, return, variance, and covariance.
Markowitz explains: "Since there were two criteria, risk and return, it was natural to assume that investors selected from the set of Pareto optimal risk-return combinations." Known as the Markowitz efficient set, the optimal risk-return combination of a portfolio lies on an efficient frontier of maximum returns for a given level of risk based on mean-variance portfolio construction. The theory of mean-variance portfolios that Markowitz revolutionized eventually extended to the development of capital asset pricing model, a vital component of investment management practice.
The Impact of Harry Markowitz's Modern Portfolio Theory
Although it took well into the 1960s for Markowitz's work to be properly appreciated, modern portfolio theory has become a mainstay of investing and finance. There are criticisms of MPT, as with any theory/practice that becomes so widely adopted. A common one is that there is no absolute measure of how many stocks one needs to hold for proper diversification. There is also the fact that managing a portfolio according to MPT principles will nudge risk-averse investors into taking on more risk, which can be uncomfortable despite the potential benefits.
Criticism aside, Markowitz's work continues to be a core concept in portfolio management and the benefits of diversification are widely understood by all money managers. Even the robo-advisors, one of the most disruptive technologies in finance, all draw on MPT when compiling their suggested portfolios for users.