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What Does Harry Markowitz Think?

Sam Savage and Paul Kaplan built a new approach to the pioneering economist's models. Now, they ask for his blessing.

Paul D. Kaplan, 06/15/2010

In the April/May 2010 issue of Morningstar Advisor magazine, Sam Savage of Stanford University and I wrote an article titled "Markowitz 2.0," which outlines our vision for the next generation of portfolio construction. Subsequently, I asked Harry Markowitz, the father of Modern Portfolio Theory, who was awarded the Nobel Prize in Economics for his pathbreaking work on portfolio construction tools, to join Savage and me for a discussion on the origins of MPT and where it is going in light of the sometimes erratic behavior of financial markets. Our conversation took place on April 14 and has been edited for clarity and length.

Paul Kaplan: Harry, while much has been written about how you developed the mean-variance efficient frontier, our readers would enjoy hearing the story directly from you. Please briefly recall for us how you first developed the mean-variance model.

Harry Markowitz: The magic moment--the moment of epiphany--happened while I was reading John Burr Williams' Theory of Investment Value. I was looking into the possibility of doing a Ph.D. dissertation at the University of Chicago, applying mathematical, statistical, or econometric techniques to stock market investment problems.

I was working off of a reading list a professor of finance had supplied. I'd already read Graham and Dodd's Security Analysis. I read Wiesenberger's Investment Companies and Their Portfolios, and I was reading Theory of Investment Value. Williams asserted that the value of a stock should be the present value--the discounted value of future dividends. Because future dividends are not certain, he said you should use the expected value of future dividends.

Now, I knew that if you were maximizing an expected value, the way you would do that was to put all your money into just one stock. That didn't make sense. People do diversify. You could see it in Wiesenberger's Investment Companies and Their Portfolios. They diversified because they were worried about risk as well as seeking return.

So, I postulated that investors were interested in expected return and standard deviation. I drew a trade-off curve, like economists always do, and so that afternoon in the business school library at the University of Chicago, I came up with the first efficient frontier.

Williams asserted that with sufficient diversification, risk would disappear; you would receive the expected value. But risk only disappears with diversification if you have uncorrelated risk and, of course, markets are not uncorrelated. So, that was when and how the moment of epiphany happened.

De Finetti's Scoop
Kaplan: In 2006, the Journal of Investment Management published the first English translation of a paper by the Italian mathematician Bruno de Finetti on mean-variance optimization. The Italian version of the paper was published in 1940, 12 years before your famous paper. In the same issue of the Journal of Investment Management, you published an introduction to the de Finetti paper, which you graciously titled, "De Finetti Scoops Markowitz." In your view, what was the historical significance of de Finetti's work?

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