Harry M. Markowitz
ADVISOR TO 1ST GLOBAL’S INVESTMENT MANAGEMENT SOLUTIONS COMMITTEE AND CONSULTANT TO ITS INVESTMENT MANAGEMENT RESEARCH GROUP SAN DIEGO, CA
SOUNDBITE: “You probably heard I am a Nobel laureate?”
As the father of modern portfolio theory, Dr. Harry Markowitz needs no introduction. His first published article in 1952 provided a framework for how investors could most effectively face uncertainty. Seven years later, his groundbreaking book Portfolio Selection: Efficient Diversification of Investments expanded on the relationship of risk and return — a concept ubiquitous in investing today.
But Markowitz, a Nobel laureate honored in 1990 for his pioneering work, is not resting on his laurels or indeed his laureate.
Markowitz, who turns 84 this month, is working in collaboration with Dallas-based 1st Global on a new book that refines his earlier thinking about risk and return. Its goal: to provide investors with even better information about what they should expect from their portfolio selections over the long haul.
Tony Batman, CEO of 1st Global, calls the book, due out in 2013, an “intellectually rigorous” effort covering a wide range of supporting issues that drive modern portfolio theory. A self-described “long and proud” advocate of Markowitz’ signature work, Batman says the book will quiet critics who abandoned modern portfolio theory, or MPT, during the recent financial meltdown.
“The offensive noise attacking portfolio theory was very violent and still is. This re-engages modern portfolio theory so that people will never have doubts again if there is another 2008 crisis,” says Batman. “We’ve seen lots of advisors abandon this classic portfolio theory and that’s wrong. They didn’t understand it in the first place. They never formed proper beliefs around the future. They took an intellectually lazy approach.”
Markowitz, who lives in San Diego, hired on as a consultant with 1st Global in March 2010. The collaboration has led to five model portfolios — ranging from ultraconservative to aggressive growth — that 1st Global advisors share with their clients today. While the portfolios are deeply rooted in mathematics, their design is also based on very human concepts that explain how investors “ought” to act when faced with an uncertain future. In the works: the development of a methodology for tax-efficient portfolio selection.
In a white paper that lays out the five portfolios, Markowitz — who has been called “the first citizen of the field of modern finance” — offers a cautionary note to advisors and a glimpse at his fundamental thinking:
“We believe that a financial advisor will use the risk-return tradeoff curve of modern portfolio theory more effectively if the advisor knows, in general, the assumptions behind MPT, and the specific assumptions and procedures behind the particular product in hand. For example, contrary to views expressed by some MPT critics, the inputs to an MPT analysis are not supposed to be historical average returns, volatilities and correlations. Rather, they should be forward-looking estimates.”
He goes on to say: “While it is true that the well-advised investor may encounter unanticipated hardships, the ill-advised investor courts almost certain disaster.”
1st Global due diligence analyst Kenneth Blay worked closely with Markowitz as he developed the portfolios. As he puts it: “Imagine learning the theory of general relativity directly from Einstein where he had the opportunity to share with you what he was thinking when he came up with the theory and why he came to those conclusions. Not just the distilled versions that are often included in academic texts but all of the stories that are part of coming to those conclusions. This was just such an experience.”
Talking about his current research, Markowitz says: “If you just sit around and talk and have a dialogue, things come out no one came in the room with. That’s happening now. As time goes on, I keep discovering things. It keeps getting bigger and bigger.” Notably, page 121 of his 1959 book lists a chart that shows how well one can approximate return in the long run (compound or geometric return) using only expected return and risk (standard deviation or variance.) His research, according to Markowitz, provides “a better page 121,” identifying improved methods for approximating long-run wealth using only expected risk and return.
Markowitz, who frequently draws on quotes from Shakespeare, the Bible and the poet Robert Burns, adds: “This is a theory which properly needs to defend itself at the highest intellectual level. This confirms some things that may have been in doubt.” His conclusion: modern portfolio theory is better than originally believed.
For Batman, one primary takeaway is that modern portfolio theory does work in a “non-normal” world — an important insight, he notes, in a financial landscape populated by hedge funds and leveraged investments. Further, he said, while practitioners can learn from the past, they must also have a belief system wrapped around all asset classes and their correlation and possible volatility going forward: in other words, the future. “A lot of practitioners ignored the future,” Batman says. “That’s what got them into trouble.”
Markowitz is three chapters into his 12-chapter book — a project Batman likens to the ancient Greek apologetics. “Harry is not defending what’s not true. It’s an academic effort to support what is right. He’s not on the defense. He’s laying a broad foundation for it so that it doesn’t have to be defended again,” Batman says. “For someone with responsibility for managing billions of dollars in assets, this means a lot to us.”