How Harry Markowitz Revolutionized Investing with Modern Portfolio Theory

In 1952, American economist Harry Markowitz introduced Modern Portfolio Theory (MPT), the premise behind a groundbreaking investment strategy that emphasized the structure and performance of an entire portfolio rather than individual stocks. With its Efficient Frontier of asset diversification and its novel approach to risk correlation, MPT fundamentally changed how individuals and institutions manage investments. Markowitz, along with William F. Sharpe and Merton Miller won the 1990 Nobel Memorial Prize in Economic Sciences. The Nobel Committee cited Markowitz's theory of asset choice as the “first pioneering contribution in the field of financial economics.” MPT has influenced many investment tools and strategies, including the development of robo-advisors. Yet, despite its wide acceptance and success, MPT has faced criticisms, particularly of its inability to account for systemic risks.

Education and Career of Harry Markowitz

Markowitz earned an B.A. and a Ph.D. in Economics from the University of Chicago, where he studied under famous academics, including the economists, Milton Friedman and Jacob Marschak, and the mathematician and statistician, Leonard Savage. As an undergraduate, Markowitz joined the Cowles Commission for Research in Economics, led by Nobel Laureate Tjalling Koopmans.

In 1952, Markowitz joined the RAND Corporation, a global policy research institute, where he built large logistics simulation models. After a stint at General Electric building models of manufacturing plants, he returned to RAND to work on SIMSCRIPT, a computer simulation language that made it possible for researchers to reuse computer code rather than write new code for each analysis. When he left RAND to found Consolidated Analysis Centers, Inc (CACI) in 1962, he led the commercialization of a proprietary version of SIMSCRIPT. In addition to being an Adjunct Professor at the Rady School of Management at the University of California at San Diego, Markowitz was the Co-Founder and Chief Architect of GuidedChoice, a San Diego-based financial advisor firm. He chaired their Investment Committee until 2018. Harry Markowitz passed away in 2023.

The Origins and Development of Modern Portfolio Theory

In his lecture to the Nobel Committee in 1990, 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 future 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."

But Markowitz realized that investing in a single security “was not the way investors did or should act.” He knew that “investors diversify because they are concerned with risk as well as return.” He also knew that, while investors understood the benefits of diversification, they needed tools to determine the ideal level of diversification.

This insight guided Markowitz’s design of the Efficient Frontier, an investment tool that charts the level of diversification that will offer the highest return for an investor’s desired level of risk. If a certain portfolio lands on the “efficient frontier” section of the graph, it is considered efficient, which means it delivers the maximum return for that investor’s risk tolerance. Portfolios outside the efficient section of the graph have either too much risk vs. return or too little return vs. risk. Of course, because the risk tolerance and return expectations of each investor are different, there is no one efficient frontier.

Modern Portfolio Theory's Lasting Impact on Investment Strategies

Before MPT, investing focused on individual investments and prices, with little emphasis on systematic diversification.

MPT and Diversification

Although it took well into the 1960s for Markowitz's work to be properly appreciated, MPT has become a mainstay of investment strategy, and the benefits of diversification are widely understood by all money managers. Even robo-advisors, one of the most disruptive technologies in finance, draw on MPT when compiling suggested portfolios for users.

Wall Street's Reliance on Modern Portfolio Theory

Markowitz's work is so integral to portfolio management that fellow Nobel laureate Paul Samuelson said, "Wall Street stands on the shoulders of Harry Markowitz.”

The Mathematical Foundation of Portfolio Management

In 1955, when Markowitz was defending his doctoral dissertation on the application of mathematics to the analysis of the stock market, the idea was so unprecedented that Milton Friedman commented that his thesis was not even economics. Eventually, his ideas became so respected that the economist Peter Bernstein in "Capital Ideas" called his development of mathematical and statistical methods for portfolio management "the most famous insight in the history of modern finance."

Criticisms and Challenges of Modern Portfolio Theory

As with any widely adopted theory, there have been criticisms of MPT.

A common one is that there is no absolute measure of how many stocks one needs to hold for proper diversification. It had also been argued that managing a portfolio according to MPT principles will nudge risk-averse investors into taking on more risk than they can tolerate.

Yet another criticism focuses on the need to move beyond MPT to address real-world systemic risk.

Beyond Modern Portfolio Theory: Addressing Systemic Risks

Two critics of Modern Portfolio Theory (MPT) are Jon Lukomnik, Managing Director of Sinclair Capital and Senior Fellow of High Meadows Institute, a Boston-based policy institute focused on the role of business leadership in creating a sustainable society, and James Hawley, Head of Applied Research at TruValue Labs, a San Francisco-based start-up which provides artificial intelligence analytics to create sustainability/ESG metrics.

In 2021, Lukomnik and Hawley published a book, "Moving Beyond Modern Portfolio Theory: It’s About Time!", to address what they call “the MPT paradox”: the fact that Markowitz’s MPT diversification works only to mitigate idiosyncratic risks, which are specific to certain assets, sectors, or asset classes—and does nothing to mitigate systematic risks, which could collapse an entire industry or the entire financial system.

Lukomnik and Hawley acknowledge that MPT was developed decades before certain systemic risks, such as climate change, antimicrobial resistance, and resource scarcity, were recognized as investment issues. However, they argue that these systemic risks to the environmental, social, and financial systems in the real world matter much more to returns than idiosyncratic risks associated with any individual security or company. In their book, they identify MPT’s lack of tools to address these real-world systemic risks as an urgent issue for modern investors.

The Bottom Line

Harry Markowitz revolutionized investment strategy with his introduction of Modern Portfolio Theory (MPT) in 1952. MPT emphasizes the importance of a portfolio's composition over individual stock performance. It laid the groundwork for additional important financial models, such as the Capital Asset Pricing Model (CAPM) and has had an enduring impact on investment practices. MPT set the foundation for later financial models and strategies, fundamentally altering how investments are managed globally. Markowitz shared the 1990 Nobel Memorial Prize in Economic Sciences, which cemented his influence in reshaping financial economics.