Theorizing Risk with Harry Markowitz

Harry Markowitz is best known for his pioneering work in Modern Portfolio Theory (MPT). He evaluated the impact of things like asset risk, diversification, and correlation on the expected return of an investment portfolio.

His cutting-edge research changed our perception of risk and return along with revolutionizing the way investors build portfolios.

In 1990, Markowitz was awarded a Nobel Memorial Prize in Economic Sciences and he serves on the advisor panel of investment research firm Research Affiliates. In addition, 81-year old Markowitz still works as an economist at the Rady School of Management at the University of California, San Diego. He took time to visit with Research magazine to offer his insight about the current state of the financial markets and investing.

With the stock market down by more than 50 percent, a deflated housing market, a weak job and economic climate, when was the last time you can remember this many things going wrong all at the same time?

Never. Remember I was born in 1927, so I wasn’t aware of 1929 through 1933. I think the big difference between now and say the tech bubble bursting is that it affected all of those folks that were foolish enough to concentrate their portfolios in high-tech stocks. That subsequently led to a recession which I think will prove to be mild compared to the current recession. The closet thing I can think of that’s similar is the Japanese bubble that broke shortly after 1990 and was led down by real estate. If we play our cards wrong, we’re in for a decade of stagnation.

What do you think is the basic cause of our current economic problem?

For a good many years Congress has been pressuring Fannie Mae to increase the mortgages they hold or buy for low income housing. I remember an interview with the former head of Fannie Mae and he said, as early as 2000, by 2010 there would be $2 trillion worth of low income housing. And then around 2005, there was considerable pressure by Congress and regulators to increase the amount of low-cost housing. As it turns out, the only way this could be done was by lowering borrowing standards and once you’ve done that all sorts of people can get loans. Somebody’s who’s reasonably wealthy can pay no money down for a second home and if the market goes up they won; if the market goes down they just put it to the bank.

How would you grade the U.S. government’s response to the financial crisis? What should they be doing?

I think it’s a sad situation. First, Congress should announce to Fannie Mae, to themselves and to the world that whenever there’s a conflict between the objective of low-income housing and financial stability, the latter has absolute priority. Second, the government should do a survey of what goes into what. For example, they need to determine what mortgages go into a CMO or what tranches of a CMO or anything else go into a CDO and so on. This is a big job, but no bigger than something like the annual survey of manufacturers which the Census Bureau does every year. This is a lot more urgent than that. Then the government needs to use math and computers to figure out what the direct and indirect exposures are of this paper. This math is also similar to the math used by search engines. After that’s done, the data needs to be aggregated by Zip code and payment history and then distributed to relevant parties like stockholders, counterparties, regulators and supervisors. Ideally, the survey should be updated daily like a clearinghouse.

A lot of blame for the current financial mess has been put on the lack of transparency with complicated financial products. Wall Street’s propensity to innovate has gotten not just itself in trouble, but the global economy. Any comments about that?

Nobody knows the direct and indirect exposure of various kinds of financial paper. Mortgages are pooled together into a collateralized mortgage obligation that’s split into tranches and various people can invest in it. For example, a collateralized debt obligation could have as one of its assets a tranche from a CMO, or tranches from CDOs, which can go into other CDOs and so on, until nobody knows what anybody has. If A depends on B and B depends on C and C depends on D, then if A gets a cold, everybody sneezes. We’ve always had contagion because if somebody has problems financially, everybody gets more cautious and they try to spend less and, as they do that, the person downstream has less income as a result.

What about other complicated financial instruments like credit default swaps?

I think credit default swaps are called that rather than insurance to confuse insurance regulators into thinking they don’t need reserves, but they need more reserves than life insurance. Deaths are fairly uncorrelated events whereas business risks [are] fairly correlated risks. If General Motors is doing bad like it is doing now, then Ford is probably going to do bad like it’s doing now and so are their suppliers. If you have uncorrelated risks, then by diversifying sufficiently you can drive a risk that’s as close to zero as you want, but that is not true with correlated risks. And that, by the way, is the same information from Chapter 5 of my 1959 book.

I don’t want the financial system to collapse, but I have absolutely no sympathy for the management that said to their financial engineers, “If you say these things are OK, then they must be OK.” I hope stockholders diversified.

What are some things investors can do to reduce their financial risk — without reducing their returns? Is that possible or is it just a pipe dream?