Ed Peters
May 11, 2022

An auspicious anniversary appears to have passed unnoticed recently. 70 years ago, on March 26, 1952, Harry Markowitz’s seminal paper, “Portfolio Selection,” was published in the Journal of Finance, heralding the birth of Modern Portfolio Theory (MPT). From the standpoint of financial economics, this paper was equivalent to Newton’s “Philosophiæ Naturalis Principia.” It laid down, for the first time, the mathematics behind diversification, and it moved financial analysis away from looking at individual stocks to how they fit into a broader portfolio. It showed how an investor could balance risk and return. Dr. Markowitz saw that risk could be defined not only by the variance of a stock’s returns, but also by its covariance (and correlation) with other stocks. In other words, a portfolio’s risk was different than the summed risk of its individual components. The paper was condensed from his doctoral thesis, where Milton Friedman famously suggested that he wasn’t sure they could give Markowitz a doctorate in economics because he wasn’t sure this was economics.

We take Markowitz’s insights for granted these days, and there are many off-the-shelf software packages which routinely do the optimization that came from his work. But I think we’ve lost something. I was lucky enough to take a course with Dr. Markowitz in 1980 when I was going to grad school at Rutgers School of Management. In those days, there was little software for doing this type of optimization. In addition, there were no PCs, so everything had to be done on a mainframe computer in a language like FORTRAN. Finding the data necessary to do the optimization was very difficult and expensive. Lacking access to a mainframe, Dr. Markowitz had the class do optimizations by hand. Optimizing three stocks took about 90 minutes worth of work on a hand calculator. I was just glad I didn’t have to do it on a slide rule, as I would have in my undergrad days! But doing the optimization by hand makes you face all the underlying assumptions that go into the Markowitz mean/variance framework. Many of those assumptions are “heroic” in that they assume, among other things, a level of stability that doesn’t exist in actual markets. As an asset manager, I found that the original version of optimization didn’t work as well as hoped without significant adjustments.

In my books, I criticized blind adherence to mean/variance optimization, as have many others. But just as Newton’s insights were partially negated by later research, Dr. Markowitz’s achievement cannot be minimized, as the Nobel committee recognized in 1990. He gave us the first steps to the quantitative methods that have become widespread in financial economics and basically created the field many of us work in. For that reason, we should celebrate Dr. Markowitz’s achievement and 70 years of MPT, but also commit to honoring his legacy by continuing to refine his breakthrough approach.

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