Harry Markowitz

An American economist who is best known for his Modern Portfolio Theory (MPT).

The world watches the Initial Public Offering (IPO) closely of any newly formed unicorn just as an opportunity to include the company's stocks in its investment portfolio. Financial advisors have made a very prosperous career handling their clients' portfolios.

Harry Markowitz

The stock market has become a world of its own. It has amassed to this level only because a few intellectuals formed a solid foundation for the business. One such contributor is Harry Markowitz.

He is an American economist best known for his Modern Portfolio Theory (MPT), which earned him a Nobel prize and revolutionized how people operate their businesses, assess risk against their investments, etc. 

He is the pioneer who introduced the entire world of the stock market to a new approach that deals with the risk involved in investing. He, later on, worked on SIMSCRIPT under RAND Corporation. His codes, just like his theoretical work, did wonders for the financial world.

Harry Markowitz: Alma Mater

Harry Markowitz was born in 1927 in Chicago, USA. He was born and brought up in a decent, well-to-do family. His family was financially stable enough, which is why he never had the first-hand experience of the repercussions of the Great Depression.

Graduation caps

He had generated interest in the original work of philosophers earlier in his life. After high school, he got his Bachelor's degree from the University of Chicago. However, he did not want to become an economist from the get-go. 

After graduation, he thoroughly researched options that fascinated him and eventually decided to specialize in Economics. He was already influenced by works of legendary intellects like Von Neumann, David Hume, etc. 

He was more fortunate to have Milton Friedman, Jacob Marschak, and Leonard Savage as his professors. Although he was still just an undergraduate, he was invited to join the well-reputed Cowles Commission for Research in Economics.

Cowles Commission is an institution that has produced many Noble laureates. But, little did the world know, another future noble laureate was added to the Cowles Commission in the form of Harry Markowitz. He then completed his M.A in Economics in 1950. 

Modern Portfolio Theory

When choosing his dissertation, he was fiddling with the idea of applying applied mathematics to the stock market. Professor Marschak found it reasonable and introduced him to Professor Marshall Ketchum.

Reading one of the books (John Burr William's Theory of Investment Value) recommended by Professor Marshall Ketchum was how Markowitz ideated Modern Portfolio Theory. Markowitz understood that paying attention to the risk factor associated with investments is very important for all investors.

Portfolio

In his book, John William states that a stock's value is equivalent to its future dividends' present value. 

However, this leads to a dilemma: if investors were only concerned about the stock's expected dividends, they would invest in one store with the highest due tips to maximize their return.

This reassured Markowitz that if investors circle individual investments to determine the best bet for themselves. It might reward high returns, but the risk is also amplified. Everyone understood that putting all of their eggs in one basket was a risky maneuver.

However, no practical technique existed before MPT that could enable investors to diversify their investments. Through MPT, Markowitz allows investors to diversify their portfolios according to their risk appetite.

He completed his dissertation on "Portfolio Selection." His article got published in the papers in 1952. Eventually, after four decades, it earned him a Nobel prize and was regarded as the "first pioneering contribution in the field of economics."

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What is Modern Portfolio Theory?

Upward arrows and downward arrows

Modern Portfolio Theory is a formula developed by Harry Markowitz. It helps in establishing a relationship between the risk associated with returns on investments in a portfolio. It further enables investors to design their model portfolios according to risk tolerance and expected returns.

Everyone has always hoped for high returns with as low a risk as possible. However, Markowitz provided the necessary means to implement this philosophy practically in the stock world through MPT. 

He realized focusing on individual stocks is a risky business. When selecting an investment, it is essential to consider its effect on other assets included in the portfolio.

Diversification is beneficial was a general perspective even before MPT. However, he provided a mathematical formula that determines the ideal combination of investments required to achieve their financial goals keeping the risk appetite into consideration.

The key assumptions on which the Modern Portfolio Theory is based are: 

  • Each investor requires maximized level of returns possible at any level of risk.
  • Diversity in asset classes of a portfolio results in reduced risk. Most of the investments can be categorized as high- or low-- or low-risk investments. 

Markowitz believed an optimal combination of the two kinds could be chosen to reduce risk due to their risk-compensating relationship.

Other assumptions are: -

  • Investments in different asset classes are typically distributed.
  • All investors are privy to the same information.
  • Risk and returns are directly related. To earn higher returns, high risk will have to be tolerated.
  • Rational investors will avoid risk as much as possible. Out of two portfolios, a sensible investor will pick the risk-averse portfolio, provided both offer the same expected returns.

Diversification

In a market, the risk is referred to as the variance in an asset's price on average. The high risk associated with a specific volatile purchase can be mitigated through MPT by choosing a combination of safe investment assets. Therefore, a portfolio's overall risk is less than the risk associated with a few purchases in the portfolio.

MPT only helps an investor in controlling their systematic risk. MPT provides a risk-averse approach to investors. It relies heavily on variance and correlation. MPT enables investors to compute the expected returns and degree of risk arithmetically.

Harry Markowitz realized how to express the risk associated with investments in numerical terms. He regards this as his "a-ha moment." He figured out that variance and standard deviation of weighted assets were the missing pieces of the puzzle.

Risk

Systematic and Unsystematic Risk

Systematic Risk: It refers to the market risks that cannot be controlled by adjusting the amounts of the asset classes in a portfolio. The times when the whole market is crashing down, its adverse effects are faced by individual investments as well. Modern Portfolio Theory is not designed to reduce this type of risk.

Unsystematic Risk: It refers to the risk associated with individual investments. It can be controlled through diversification with the help of MPT. 

Understanding with an example

Stack of coins

MPT helps predict an average of expected dividends and the risk associated by looking at the portfolio in its entirety. It does so by allotting different weights to all the individual investments that together form a portfolio.

The weights are allotted based on the ratio between all the investments. for instance, if a portfolio comprises two asset classes: -

  • The asset I am worth is $200,000 with 5% expected annual returns.
  • Asset II is worth $50,000 with 10% expected annual returns.
  • Portfolio expected return then will be

= [($200,000/$250,000) * 5%] + [($50,000/$250,000) * 10%]

= 4%+2%

= 6%

  • If an investor wants to increase his expected returns more and is not satisfied with 6%.

Then all he has to do is take some amount from the asset class with low expected returns (in this case, asset I) and invest it in the asset class that reflects high returns in the future (in this case, asset II).

BETA

A similar formula can determine the risk associated with different investments. It also lets you choose the average risk associated with your portfolio. Beta (β) is the unit of measurement for systematic risk.

Beta lets you compare the risk associated with one asset class to the average risk in the market.

  • Beta=1, the risk associated with a particular investment correlates with the average risk in the market.
  • Beta<1, the investment, in particular, is less volatile than the average market volatility (less risky).
  • Beta>1. The acquisition is particularly volatile than the market's average volatility (more risk).

For instance, a portfolio comprises three asset classes.

  • Asset I, with a Beta of 0.57 worth $50,000
  • Asset II with a Beta of 1 worth $50,000
  • Asset III, with a Beta of 1.23, is worth $50,000
  • Portfolio's systematic risk or Beta

= (33%*0.57)+(33%*1)+(33%*1.23)

= 0.924

A beta of 0.924 reflects that risk on a portfolio is more or less equal to the average risk in the market. If the investor wants to be even more cautious, he can adjust the weights allotted to the investments accordingly.

One can withdraw from risky investments (in this case, asset III) and invest in less volatile investments (in this case, asset I) to reduce the Beta even more. 

Any beta can be achieved by adjusting the amounts invested in different asset classes. Because of Markowitz, risk degrees could be quantified and were made comparable with the rewards. It was one of the best strategic advantages of MPT.

Efficient Frontier

Risk and reward

Efficient Frontier is a graphical representation of a portfolio's variations at different levels of systematic risk and expected returns. It determines the perfect level of diversification at varying levels of expected return, keeping the risk factor in mind.

If any combination of investments is not on the curve but under or over the curve, it is not the best combination based on the relationship between risk and returns. At any level of expected returns or risk tolerance, there will always be at least one ideal portfolio to achieve the financial goals.

If a point falls outside the curve, it indicates that the portfolio, in particular, is not optimal for one of two reasons. Either the risk is very high when compared to the returns, or the returns are too less compared to the risk associated with the portfolio.

If a portfolio is above the curve, the risk tolerated is not practical as it's too high compared to the expected returns. If it is below the curve, the expected returns are insufficient to handle that level of risk.

Work under RAND Corporation

Rhino structure

He joined the RAND Corporation in 1952, the same year his famous article on "Portfolio Selection" got published. He did not directly work on his portfolio theory during his first stint at the corporation. However, he learned optimization techniques which eventually helped him establish algorithms that helped his research on portfolio selection.

He had learned the fundamentals himself, and his learnings were noticeable in his work in the field of mean-variance frontiers. His critical line algorithm came into existence because of what he learned at the RAND Corporation with the help of George Dantzig.

He moved to General Electric (G.E.) for a brief period. He was not even remotely connected to his research during his time at G.E. He was mainly building models of manufacturing plants for the company. Soon after, he moved back to the RAND Corporation.

During the 1950s, technology was not as advanced as it is today. Applied mathematics, on the other hand, was striving. This created a gap between the two. Both of them needed to make simultaneously for the implementation of formulas developed by mathematicians in the real world.

This gap became the primary reason for Markowitz returning to the RAND Corporation in the early 1960s. A unique computer code was required to be developed whenever any idea was implemented. Due to this, he was inspired to create a programming language that would make the procedure more efficient.

He began to develop a programming language later called SIMSCRIPT. Its most significant ability was to produce reusable codes. This was a substantial contribution as unique codes were no longer required to be developed.

Visuals

In the form of SIMSCRIPT, a reusable code was formed that allowed the programmer to only add information to an existing simulation language for all the analysis. It reduced the time for research drastically. SIMSCRIPT holds relevance even in today's day and age.

B. Hausner assisted him in writing the language's compiler. On the other hand, H.Karr managed to write a manual for the language. H.Karr and Markowitz later co-founded a software company called Consolidated Analysis Centres, Inc (CACI).

The company's primary focus was to commercialize the simulation language. Under the company, they developed an upgraded version of SIMSCRIPT. The fact that SIMSCRIPT is still one of the widely used simulation languages is just a testimony of Markowitz's intellect and achievements. 

Current activities

Harry Markowitz has had a prolific career in the field of financial economics. Today's Wall Street rests on his shoulders due to this contribution via SIMSCRIPT and his revolutionary Modern Portfolio Theory.

He was fortunate to learn from modern-day legends like Milton Friedman, Jacob Marschak, and Leonard Savage. Moreover, his work under the RAND Corporation was a huge learning curve, enabling him to bridge the gap between applied mathematics and technology. 

He has been a recipient of various awards and accolades. He was awarded the Nobel Prize in Economic Sciences in 1990 and John Von Neumann Theory Prize. However, according to him, his most outstanding achievement is when people thank him for creating a profession that feeds millions of people worldwide.

Wall St. sign

He has always considered his work to be fun for him. It was never stressful for him, and he loved solving the mathematical problems that came his way. Even at 94, he continues to teach what he knows best at the Rady School of Management at the University of California.

He has not strayed away from Wall Street as well. Even today, he juggles between his teaching profession and as an investment advisor. He also co-founded Guided Choice to provide financial freedom to everyone.

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Researched and authored by Priyansh Singal | LinkedIn

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