Out of nowhere a 25-year-old graduate student from the University of Chicago published a paper titled “Portfolio Selection” in the March 1952 issue of the Journal of Finance putting forward a rigorous mathematical argument for diversification of assets in a portfolio, for there is a difference in the riskiness of an individual stock and that of an entire portfolio. The 14-page long paper that was endowed with intellectual rigor and originality led to its author Harry Markowitz being recognized subsequently as the father of modern financial economics.
After three decades, he was also honored with the Nobel Prize in Economics in 1990 for his pioneering work on the theory of portfolio choice which, arguing that “the riskiness of the portfolio had to do not only with the riskiness of the individual securities therein, but also to the extent that they moved up and down together”, proposed that a diversified, or optimal portfolio could be created through the mixing of assets that do not move exactly together so as to maximize return and minimize risk.
Of course, it is not that Markowitz was the first man to come up with the desirability of portfolio diversification. Even the Babylonian Talmud of 500 C.E. advocates diversification as it proclaims a simple rule: one-third in real estate, one-third in merchandise, and the remaining in liquid assets. For that matter, even Shakespeare’s Antonio of The Merchant of Venice says, “… I thank my fortune for it,/My ventures are not in one bottom trusted, /Nor to one place; nor is my whole estate/Upon the fortune of this present year …” Later in 1738, Daniel Bernoulli argued in one of his articles that risk-averse investors prefer to diversify: “…it is advisable to divide goods which are exposed to some small danger into several portions rather than to risk them all together”.
Thus, diversification of investment is an age-old phenomenon. But what makes Markowitz’s advocacy for diversification different and pioneering is that he provided a quantitative framework to analyze the merit of a portfolio as a whole. This methodology facilitated investors to assess the degree and returns of diversification of a chosen portfolio through three important variables, namely, return, standard deviation, and coefficient of correlation.
His theory proposes the idea of risk-return trade-off, which means that investors aiming for higher returns must be prepared to take more risk. It is from this assumption that the idea of the efficient portfolio—one that offers the highest expected return for any given degree of risk, or that has the lowest degree of risk for any given expected return—emerged. In fact, this idea of an efficient frontier became the guiding principle of investors who had till then been relying on ad hoc rules, or gut feeling for investment decisions, albeit with several modifications.
Nevertheless, there are financial analysts who complain that Markowitz’s framework suffers from two weaknesses. The first is its reliance on the correlation matrix of returns from the portfolio that reveals the extent to which any two assets move together. According to them, even a small change in correlation values leads to significant differences in the conclusions drawn, and hence believe that structuring a portfolio based on such values may not yield the intended results.
The second complaint is about Markowitz’s selection of standard deviation of returns as a proxy for risk. The analysts, arguing that risk is the possibility of the expectations going wrong, while uncertainty is not knowing what the future might bring in, opine that standard deviation, the statistical metric which focuses on dispersion, cannot differentiate a return higher than expected from that of lower than expected. To put it otherwise, standard deviation captures uncertainty but not the risk of the portfolio.
Of course, this shortcoming though came to light with the emergence of risk metrics such as VaR which focuses on financial losses, theoreticians were said to be slow in accepting it while investors moved away from Markowitz’s ideas much faster. Great ideas often suffer from implementation challenges!
This does not mean that Markowitz’s theory is wrong. On the contrary, his ideas of risk-return trade-off, the efficient frontier, and the merits of diversification have remained as the fundamental principles for all that happened in the field of financial economics since 1952.
His innovative approach to portfolio management stood the
test of time and still continues to be the benchmark against which the emerging
alternatives are assessed. And the world of practicing financial professionals
should be thankful for his seminal ideas.
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