Dr. Andrew Lo, a professor of finance and the director of the Laboratory for Financial Engineering at the MIT Sloan School of Management, joined the latest episode Morningstar’s The Long View podcast.
Here are a few of Lo's thoughts on the perfect portfolio, Harry Markowitz, and the history of portfolio management from his conversation with Morningstar's Christine Benz and Jeff Ptak:
The Perfect Portfolio
Ptak: Something we've discussed at some length on this podcast and in other work we've done is the idea that investors shouldn't make perfect the enemy of good when it comes to building a portfolio. A portfolio is imperfect if an investor is likely to misuse it. Did that come up in your conversations with the luminaries you interviewed? And if so, did they think we need to tweak our definition of the theoretically perfect portfolio to reflect reality?
Lo: It definitely did come up. And of course, we chose the title purposely. To be a little bit controversial, most people would argue that there is no such thing as a perfect portfolio. And yet, all of us seem to be constantly striving to achieve that level of perfection. And in a way, that's really what the book is about and how we end it. We basically point out that this is a never-ending journey, that we're constantly looking to improve the way we think about investing. And each one of the luminaries that we interviewed had their own version of what perfection means. And that's also part of our goal was to elicit the particular viewpoints of these individuals, knowing full well that they don't agree, but in a way, that's what we're looking for. We learn when we find other people who disagree with us. And so, just trying to understand the different kinds of disagreements gives us a much richer tapestry of the entire investment landscape. And in the end, I think that's what readers will benefit from, it's knowing the different perspectives and when certain perspectives are appropriate and applicable, and when others aren't.
Portfolio Construction and the Coronavirus
Benz: There's a tendency to fight the last war, and that probably holds for portfolio construction, too. I mean, thinking back to 2009 and 2010, it seemed like everyone was talking about risk parity and tactical asset allocation. But now that the markets have roared back, that's quieted down. Given this, what do you think constitutes a bona fide portfolio construction framework, especially knowing that different approaches can yield different outcomes, even over long stretches?
Lo: Well, a great example of that issue is the COVID pandemic. If we think about how things were looking, let's say, January 2020, I think the markets were going great guns, we had a fantastic year the year before that. And then, of course, sometime around February, COVID reached U.S. shores, and all of a sudden, financial markets panicked, we had a pretty significant drop in major indexes. And over a four- or five-week period, it really looked like there was going to be no end to this terrible affliction. But of course, there is an end, and markets take that into account. And a few months after the panic started in February, markets actually recovered. And so, I think that's a really interesting microcosm for the lesson that we learned from talking with all of these financial leaders is that a perfect portfolio is one that will adapt to both an individual's changing circumstances as well as market conditions. And so, what's perfect today may not be perfect tomorrow. We constantly have to be thinking about reshaping our portfolio, and not only the portfolio, but the portfolio strategy, and trying to adapt those particular changes to the current conditions that apply. I think that's probably the biggest lesson. It's that among these 10 luminaries, we now understand many different ways of applying these tools to different market conditions. I would say that being forewarned is being forearmed. And I think that providing readers with all of these various different perspectives will give them an opportunity to apply each and every one of them as market conditions change.
Harry Markowitz and the Beginnings of Portfolio Management
Benz: As you explained in the book, there had been little academic interest in portfolio management until Markowitz came along. Now there are whole journals devoted to the topic. But back then, the disinterest reflected attitudes toward the stock market, which was perceived as, I guess, a bit of a backwater, right?
Lo: Absolutely. It's really quite a stunning change, because when Markowitz started applying these principles, nobody had any interest in portfolio optimization. And today, I don't imagine there's a financial analyst out there who doesn't know of mean variance analysis. A very interesting story that Harry tells is at his thesis defense, when Milton Friedman, who was on his thesis committee, half-jokingly said, well, you know, we can't really give him a Ph.D. in economics, because, of course, this isn't really economics, it's just math. And Harry Markowitz having had the last laugh, when, as part of his Nobel acceptance speech, he mentioned this story. And he said that, well, at that time, Friedman was right. It wasn't economics or finance. But now, it is.
Modern Portfolio Theory
Ptak: In one afternoon, I think you recount this in the book, Markowitz had worked out the two major inputs to what became Modern Portfolio Theory, correlation and the notion of mean-variance optimization, as well as the notion of an efficient frontier. Can you talk about how those discoveries changed portfolio construction, maybe by contrasting with how it had been done up to that point?
Lo: This is really quite a stunning achievement, and it's one that most people aren't aware of, because they just take for granted that we now think about correlation, diversification, and portfolio construction the way we've always done it. But in fact, prior to Markowitz, the way that people thought about investments was really from the perspective of the portfolio manager, the culture and the personalities involved. They were often called gunslingers. Because these were larger than life celebrities that were able to pick stocks in much the way that certain art experts are able to pick the very best pieces of art. And so, that's the way that the investment industry operated until, I would say, the 1960s and 1970s, well past the first decade after Markowitz's publication.
But something happened in that process, which is that portfolio managers began to see a different way of constructing portfolios, not by picking the best stocks, but rather by creating a combination of securities that had good properties overall. And correlation was a key feature. What you wanted to do was to put together a collection of securities that were not all highly correlated, not highly related. And the reason for that is you wanted to make sure that you had good diversification, not putting all your eggs in the same basket. And by managing the correlation, you're able to produce a portfolio that had better returns, lower risk, and therefore over time, would grow into a much larger nest egg than the traditional stock-picking approach. That was a combination of Markowitz and Sharpe and all of the other luminaries that had ultimately taken this academic idea, a rather dry set of mathematics, and really turned it into something practical and genuinely useful.
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