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MPT: The Watershed Event of Modern Finance

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

It’s a rare thing for a graduate student’s thesis to change the world. But Harry Markowitz’s 1952 dissertation did just that. Later republished as Portfolio Selection, Markowitz’s work laid the foundation for modern portfolio theory, or MPT. And investing hasn’t been the same since.

Jump-Starting a Science

It’s hard to imagine today just how revolutionary Markowitz’s ideas were. Previously, nobody had bothered to define risk, let alone attempt to manage it in the investment process.

What had been done by that time? Some thought had been given to security selection. Dividend discount models were widely used. Benjamin Graham and David Dodd had published their seminal work, Security Analysis. Yet security selection was still considered a process of maximizing return without consideration of risk.

In just a few short pages, Markowitz asserted that:

  • Investors should be concerned not just with return but also with risk.
  • There is a direct relationship between risk and reward.
  • Risk may be fairly defined several ways, the most useful being standard deviation of expected returns.
  • A portfolio is more than just a collection of securities; portfolio selection begins where security selection leaves off.
  • Risk should be measured, monitored, and controlled at the portfolio level.
  • Individual securities should be considered not only on their own merit but also on how they affect the portfolio as a whole.

Markowitz’s treatise laid out a model wherein risk could be reduced by constructing an “optimal” portfolio. He reasoned that:

  • If all securities moved in lockstep, then diversification would not reduce risk.
  • On the other hand, if they moved completely independently, diversification would completely eliminate risk.
  • The real world falls somewhere in between. As a result, using the “right” kind of diversification, owning securities with low correlation to one another, can reduce risk.

With a given number of securities, an endless number of portfolios could be formed. However, at every level of risk (however defined), one dominant portfolio will generate the highest return. Markowitz called this portfolio “efficient.” And he called the line that connects all these optimum portfolios “the efficient frontier.”

No point on the efficient frontier should be considered to be better than any other point. Investors must examine their own risk/return preferences to determine where they should invest on the efficient frontier.

One of the great benefits of this approach is that the investor can reduce risk at no cost in return, or he can increase return at any particular level of risk. This diversification benefit is as close to a free lunch as investors can expect from the world’s markets.

Taking the World by Storm … Not!

The world wasn’t quite ready for Markowitz, though. Fame and fortune were a long time coming. First, financial economics had barely established itself as an independent study. Moreover, it took a lot of computer power to run a complete optimization model–a lot more than was available at the time he first presented his ideas. William Sharpe, a student of Markowitz’s and the namesake of the Sharpe ratio, simplified the math considerably some years later. But optimization still wasn’t anything that could be done on the back of an envelope.

Not until the crash of 1987 did risk get Wall Street’s full attention. By then, computing power had caught up to Markowitz’s genius, and MPT became a widely accepted and widely used technique. In 1990, 38 years after Markowitz’ dissertation was published, the father of modern portfolio theory shared the Nobel Prize for Economics.

What’s in It for You?

Markowitz’s paper addressed the problem of portfolios for large institutions or wealthy individuals. The widest application today, though, is in asset allocation for all types of investors. In fact, individuals of pretty modest means can purchase entire asset classes through mutual funds. By mixing asset classes that have a low correlation with each other (that is, asset classes that don’t behave alike), you can control risk in your investment account.

Want to Learn More?

For more, go right to the source: Markowitz’s Portfolio Selection. It’s lucid, compelling, and only modestly challenging. Markowitz gives us a break by alternating readable chapters with the heavy-duty math.

If you read just one book on modern finance in your life, Peter Bernstein’s Capital Ideas is the one I recommend. Bernstein devotes an entire chapter to Markowitz’s discoveries.

For Web fans, Yale’s School of Management generously provides a graduate-level program about investment theory here.

And one of my previous articles, Improving a Portfolio: Adding International Equities, illustrates a practical application of modern portfolio theory.