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How Markowitz Put Forward the Idea of Portfolio Theory

The groundwork of MPT laid by Harry Markowitz is at the core of newly developed GeWorko Method. The theory of portfolio allocation under uncertainty appeared to be crucial one when it comes to investment diversification. It won him Nobel Memorial Prize and John von Neumann Theory Prize from the Operations Research Society of America. Currently, Mr. Markowitz is teaching at the University of California and is a practicing consultant in Investment Management, Business Management and Practice Development.

Harry M. Markowitz

Harry Max Markowitz, the father of Modern Portfolio Theory (MPT), was born on August 24, 1927 in Chicago, to Morris and Mildred Markowitz. During the high school Markowitz developed his interest in physics, astronomy and philosophy. He began reading the original works of serious philosophers. Particularly he was impressed by the ideas of David Hume: the infatuation with ideas of this philosopher followed him during his undergraduate years when he pursued B.A. at the University of Chicago.

After leaving the high school Markowitz made up his mind to continue studies at the University of Chicago. During those two years he drew special attention to the course of OIL: Observation, Interpretation and Integration. After receiving the Bachelor's degree he had to choose an upper division. Considering the matter for a short while, Harry decided on Economics. Though he referred to the micro and macro as very interesting fields of investigation, it was the "Economics of Uncertainty" that fascinated him.

During his studies Markowitz had a great opportunity to study under the leadership of well known economists Jacob Marschak, Tjalling Koopmans, Leonard Savage and Milton Friedman. In this period he got an invitation to become a member of Cowles Commission for Research in Economics located in Chicago. The latter was considered a gigantic research center that had an enormous influence on Economic and Econometric thought, and was remarkable by the number of Nobel laureates it had produced. The experience he got working on the Cowles Commission helped him get an idea for his dissertation. Markowitz had already learnt from his dissertation advisor, Jacob Marschak, about the usage of mathematics to study the elasticity of demand for money and the relationship of money with wealth. Quite naturally he broadened that idea across financial market performance.

The Groundwork of Research

Choosing a topic for dissertation has been crucial for Malkowitz, he decided upon applying mathematics to the analysis of stock market. His thesis advisor Jacob Marschak supported Malkowits, especially taking into consideration the fact that it was the area of interest of Alfred Cowles – the founder of the Cowled Commission.

Harry was provided by a reading list as a guide to the financial theory. Among the great diversity of reading materials he was especially influenced by “The Journal of Political Economy” by Milton Friedman and Leonard Savage, and the study “The Utility Analysis of Choices Involving Risk” which reveals that when individuals choose investments, occupations, or business ventures, they essentially make one decision out of two. They either take risks or play it safe.

The Influences

While reading “Theory of Investment Value” by John Burr Williams he got some basic ideas of then existing understanding of stock prices that consisted in the value model presented by the author. The book emphasized that the stock value should equal the present value of future dividends that a company is expected to pay shareholders. While conducting research into the mechanism of stock prices, Markowitz realized that the theory lacked analysis of the impact of risk. This was the start of the basic concepts and further development of portfolio theory.

Henthforth, Williams' idea suggested that the stock value should be equal to the present value of its future dividends.However, as the future dividends are uncertain, Markowitz interpreted Williams's proposal to be valuing a stock by its expected future dividends. But if the investor was interested only in the expected values of securities, s/he would be interested only in the expected value of the portfolio and in order to maximize the expected value of a portfolio one needs to invest only in a single security. Markowitz accepted that this was not the way investors did or should act. According to him, investors diversify because they are concerned with risk and return. At this point variance, as a measure of risk, came to his mind. The fact that portfolio variance is based on the security covariances added to the trustworthiness and plausibility of the approach. Since there were two main criteria - risk and return - it was natural for investors to choose from the set of optimal risk-return combinations.

This observation served as a basis and led to the development of his crucial theory of portfolio allocation under uncertainty. He introduced the theory in his paper "Portfolio Selection" which was published in the Journal of Finance in 1952. In the same 1952, Markowitz went to work for the RAND Corporation (a global policy non-profit think tank that offers research for U.S. armed forces since 1948), where he met George Dantzig. Dantzig assists Markowitz to start investigation into optimization techniques, compiling the critical line algorithm for singling out the optimal mean-variance portfolios, that base upon what later received the name of the Markowitz frontier.

The Breakthrough Theory

In 1955, Malkowitz got a PhD from the University of Chicago with a thesis on the portfolio theory. While defending the dissertation the topic was so novel that Milton Friedman argued that Harry's contribution was not economics. The academic year of 1955–1956 Markowitz spent at the Cowles Foundation at Yale University, at the invitation of James Tobin. His book on portfolio allocation was principally written in Yale University and was published in 1959.

Diverse theoretical and practical criticisms have been leveled against the theory including the following points:

  • Financial returns don't follow a Gaussian distribution or any symmetric distribution
  • Correlations between asset classes are not fixed, however they can vary depending on external events (especially in crises)
  • Investors are not rational and markets may not be efficient.

In spite of all those critical approaches, the Portfolio Theory, also known as Modern Portfolio Theory, found its exceptional place in the financial world. As a result, in 1990 Markowitz won the Nobel Memorial Prize in Economic Sciences for the Theory. Similarly, in the preceding year, he won the John von Neumann Theory Prize from the Operations Research Society of America for his contributions in the theory of three fields: portfolio theory; simulation language programming (SIMSCRIPT) and sparse matrix methods.

Up till now MPT is considered an important advancement in the field of mathematical modeling that represents the behavior of any financial asset or portfolio. Moreover, Markowitz has built a solid career in academy and consulting business. He currently teaches it at the Rady School of Management at the University of California, San Diego. He is in the advisory board of Sky View Investment Advisors, as well as serves in the Investment Committee of Loring Ward - Investment Management, Business Management and Practice Development - company. Markowitz consults companies, such as Index Fund Advisors, and he is the co-founder and chief architect of GuidedChoice investment solutions for which he currently designs software analytics. The architect of MPT is actively working on a new retirement solution that allows the retirees to distribute their savings by means of GuidedSpending.