Risk and Returns — The Story of Harry Markowitz and Modern Portfolio Theory
By: Msfl India
Tags: Modern Portfolio Theory, Harry Markowitz, Return On Investment, Portfolio, Stock Market

This year the stock markets have been on wild swings. From early February to mid-March the BSE Sensex fell by over 37% and from those lows has now risen by close to 70%. Who knows how the stock market will fare going forward? There are of course “many roads to Rome”, that is, there are many investment philosophies and strategies that might succeed. This week we look at Modern Portfolio Theory, perhaps the most used investment framework by sophisticated global institutional investors.

From Stock Picking to Quantifying Risk to an Efficient Frontier

Warren Buffett is a great investor. Buffett believes in having a concentrated portfolio and in holding the same stocks for a very long time. However, Buffett’s success at understanding businesses and investing in particular stocks is incredibly difficult to replicate. Many of us believe we can successfully pick stocks and make a fortune only to later find out that at best our returns are mediocre and at worst we have lost money.

The New York Stock Exchange can trace its beginnings to 1792. (The Bombay Stock Exchange, Asia’s oldest, began in 1875.) For most of the 200 plus years since the beginning of stock markets the concept of risk remained unquantified. Historian and writer Peter Bernstein writes that “Stocks were risky and some were riskier than others. Risk was in the gut, not in the numbers. For aggressive investors, the goal was simply to maximize returns; the faint-hearted were content with savings accounts and high-grade long-term bonds.”

Then in 1952 a young 25-year old economist, Harry Markowitz published an original paper that radically changed how risk and returns can be measured. Markowitz’s theory is called the Modern Portfolio Theory and Markowitz got a Nobel Prize for his work in 1990. Astonishingly, many investors remain ignorant of Markowitz’s theory. Part of the reason is that Markowitz’s paper is highly mathematical and implementing his recommendations requires the use of advanced statistics. The basic ideas though can be easily appreciated.

Investors should be focused as much on risk as on expected returns.

As a measure of risk Markowitz considered a statistical term called variance. In simple terms, the variance of a stock price, for example, tell us how much the stock price goes up and down. If the variance is high, then the risk is higher that the price could be much lower than at present or go much higher.

As a measure of risk Markowitz considered a statistical term called variance. In simple terms, the variance of a stock price, for example, tell us how much the stock price goes up and down. If the variance is high, then the risk is higher that the price could be much lower than at present or go much higher. Diversification is essential but only if it is correctly “optimized”.

Putting all your eggs in one basket is risky. The basket could fall, and all the eggs could be broken. Thus, for most investors the more one diversifies the better. However, suppose one diversified by having a large collection of similarly high-risk stocks? Supposed one bought only technology stocks. Would that be the best way forward?

No says Markowitz, the collection of securities in a portfolio must be such that they reduce the overall variance. That is, the portfolio must balance out the individual risks of each security.

Putting all your eggs in one basket is risky. The basket could fall, and all the eggs could be broken. Thus, for most investors the more one diversifies the better. However, suppose one diversified by having a large collection of similarly high-risk stocks? Supposed one bought only technology stocks. Would that be the best way forward? No says Markowitz, the collection of securities in a portfolio must be such that they reduce the overall variance. That is, the portfolio must balance out the individual risks of each security. Markowitz showed that optimization results in an “efficient frontier”.

Investors should, Markowitz wrote, assemble a portfolio based on their individual risk appetites. For a given risk appetite, Markowitz showed that there is a point on an “efficient frontier” which gives the best mix of the various asset classes and securities in the portfolio.

Markowitz’s 1952 paper remained just an academic study till US investors faced a huge crash in 1973–74. The S&P fell 43% and many funds fell by as much as 60%. The US dollar also suffered by falling by close to 50%. Institutional investors began understanding that risk needed to be quantified and handled carefully. Markowitz’s theory began to be used. Today, many improvements and corrections have been made to the theory and a large number of institutions use this as the basis for their investment strategies.

Challenges to using Modern Portfolio Theory

There are broadly three challenges to Markowitz’s Modern Portfolio Theory

Need for Data and Optimization.

Markowitz’s assumptions are not always valid.

As in all good theories, Markowitz had to make certain assumptions, such as how the data follows what is called a “Normal Curve”. Not all these assumptions are valid all the time. A large number of professionals and investors have modified Markowitz’s original theory to make it better fit different circumstances. Some of these modifications are quite complex and all of them require the use of highest mathematics and statistics.

As in all good theories, Markowitz had to make certain assumptions, such as how the data follows what is called a “Normal Curve”. Not all these assumptions are valid all the time. A large number of professionals and investors have modified Markowitz’s original theory to make it better fit different circumstances. Some of these modifications are quite complex and all of them require the use of highest mathematics and statistics. Rational choices. Markowitz all along assumed that investors in equities and bonds are rational, that they examine all the data carefully and make well calculated choices. However, investors can often be swayed by beliefs, fads and fashions. Especially in times of booms and busts investors tend to over or under react. Markowitz does not take this into account. A large amount of work has been done in this area of “Behavioral Investing” and this is a topic for another week!

Despite the above challenges, Markowitz’s theory can be used as the base on which to build a portfolio. It is always wise to diversify intelligently. Markowitz wrote

“To reduce risk it is necessary to avoid a portfolio whose securities are all highly correlated with each other. One hundred securities whose returns rise and fall in near unison afford little protection than the uncertain return of a single security.” It is best to diversify using a range of asset classes (mix of equity, debt, real estate, gold) and within each asset class to have a range of securities (for example in equities one might select a few from those in technology, finance, consumer goods etc).

“A good portfolio is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies.”

Harry Markowitz

Markowitz is now a Professor of Economics as well as a senior consultant, advisor, and director in large financial investment firms. Surprisingly, when Markowitz began researching for his original paper of 1952, he had no knowledge or interest in investing. In those days economists did not consider investing and financial markets as serious topics for research. Markowitz did base his work on a number of famous mathematicians, but investment experts seemed to have had no idea about the statistics and mathematics.

Markowitz writes that “becoming an economist was not a childhood dream of mine.” His early interests were more in philosophy, physics and astronomy. However inspiring economics professors at the University of Chicago made him select economics for his major subject of study.

Markowitz got the idea of researching how portfolios might best be put together by chance. Markowitz was waiting to see his PhD thesis advisor and began talking to a stockbroker who was also in the waiting room. That chance encounter led to a suggestion that he should look at optimizing portfolios. Had it not been for this lucky meeting, Markowitz might never have created Modern Portfolio Theory.

© Kaikhushru Taraporevala