Market view and Insights
Most of today’s investment strategies are based on theories that date back to 1952. Meet the father of modern portfolio theory.
The idea that you shouldn’t put all of your money into one investment is not a new one. In fact, investors were already trying to spread their risks as best possible when Wall Street was founded in 1792. However, their approach tended to be intuitive, and they used the eggs-in-a-basket method (something many investors continue to do today, by the way). It was only 160 years later, in 1952, that an article appeared in an American trade publication called the Journal of Finance, in which a scientific model for creating an optimally diversified portfolio was presented for the first time. The author of the article was the then 25-year-old Harry Markowitz, who was studying economics at the University of Chicago and was investigating the application of mathematical methods to securities markets as part of his doctoral thesis. The model he developed would earn him a doctorate in 1955 and the Nobel Prize in Economics in 1990, alongside scholars Merton H. Miller and William F. Sharpe. In addition to these two official accolades, Markowitz was later unofficially given the title of the father of Modern Portfolio Theory.
The theory co-developed by Markowitz shows how a portfolio can be efficiently diversified using mathematical and statistical methods to divide it among various individual investments and in doing so, optimize it. Such an optimal portfolio should be every investor’s goal, as it maximizes the expected return for a given risk or minimizes the expected risk for a given return. In order to be successful, it is necessary for the individual securities in the portfolio to not be fully correlated, or in other words, that they do not move in the same direction. This makes it possible for losses on individual securities to then be offset by gains on other securities. In his doctoral thesis, Markowitz developed a mathematical method for combining different investments to create an overall portfolio that makes the best possible use of this effect.
The concept of mathematically optimized portfolios was groundbreaking in Markowitz’s time. But the fact that he even came up with the idea of taking a scientific approach to optimizing portfolios is partly due to a lucky coincidence. When he went to meet his doctoral advisor Jacob Marschak to discuss possible topics for his dissertation, he encountered Marschak’s stockbroker, who also had a meeting with Marschak, in the anteroom. Since the professor was running late, the two men found themselves having to wait for quite some time. They struck up a conversation and it was the broker who suggested that he apply mathematical and statistical methods to the study of investing and financial markets for his doctoral thesis. Marschak also liked the idea, and the rest is history.
Just how groundbreaking his theory actually was became apparent when Markowitz was asked to defend his doctoral thesis before the dissertation committee in 1955. Among the committee members was Milton Friedman, one of the most influential economists of the 20th century and also a future Nobel Prize winner. And it was Milton Friedman, of all people, who argued that portfolio theory had nothing whatsoever to do with economics and that Markowitz should therefore be denied his doctorate. However, after a short, heated debate, Friedman was outvoted by the other committee members. Although not undisputed, the insights relating to Modern Portfolio Theory, which was later further developed, have become indispensable in professional investing and form the basis for the investment decisions of many institutional as well as private investors.
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