Trader's Notes #3 : Harry Markowitz and the Creation of the Modern Portfolio Theory

This theory is so entrenched in markets and has been there for so long, it feels it was there at the beginning of time itself and we take it for granted. But It was only in the 1950s that methods of measuring risk really took off. A young Ph.D student named Harry Markowitz published an article in The Journal of Finance related to his doctoral research at the University of Chicago. Markowitz made the immense contribution of putting risk on equal footing with return. His work won him a Nobel Prize in Economics.

As a side note, it also tells us that Nobel Prize works differently in Economics than most hard sciences. There you have to discover the not yet know, i.e go search to prove or disprove something. But to get one in Economics, you have to take what’s already happening and give it in a name, fit it in a neat box, in a model. Not saying it is any easier or harder than the other, just saying. The only way to know is to go try getting one.

Anyhow, Before Markowitz, Risk was seen as just a footnote to return. People took kind of a general feeling-based approach when trying to reduce risks by diversifying across assets, companies, and industries, in a less method based manner.

The Making of Markowitz Portfolio Theory

  1. Modern portfolio theory has its roots in Markowitz’s work in the early 1950s. It’s still called modern portfolio theory all these decades later because changes in investment thought over the past 50 years have been the foundation on which most of the portfolio management, at least the good one, sits on

  2. Many great things in life start out with what appears to be a random series of coincidences. Markowitz was looking for a thesis topic in the early 1950s. He was waiting outside his advisor’s office when he met a stockbroker.

  3. The broker suggested that Markowitz write his thesis on something related to the stock market. Markowitz’s advisor thought the idea had merit and sent him to discuss possible topics with the dean of the business school, who recommended a book called The Theory of Investment Value, by John B. Williams.

  4. The essence of this book is still taught in finance: The price of a stock is equal to the value of its future dividends, adjusted for the time value of money. That is, a dividend of 1 Rupee today is worth more than a dividend of 1 Rupee in the future.

  5. Markowitz concluded that if you followed Williams’s logic, you would wind up with a portfolio of a small number of stocks because almost everything else had an inferior return and looked to be a questionable investment. But Markowitz knew, people diversified their portfolios fairly widely.

Defining Risk - Making it an Independent Concept

  1. Although there is no uniform way of measuring risk, many market participants focus on measures of volatility. The standard deviation: the square root of variance which is one widely used measure of volatility.

  2. Markowitz used standard deviation as his primary measure of risk, but he recognized the possibility of using other measures of risk as well, such as returns below a certain threshold.

  3. Markowitz had insight that the risk of a portfolio is primarily based on the interaction of the portfolio’s holdings, not on the risk of the securities individually or in isolation.

  4. According to Markowitz’s Portfolio Theory, two securities that are very risky in isolation may not be as risky when put together :

For example say a Blue Chip stock in U.K and a health care stock in India—might have less risk than two health care stocks in India because Indian stocks move in tandem because of their dependence on the Indian economy and regulations.Meanwhile Blue Chip stocks in U.K probably have little to do with health care in India . One may zig, while the other zags.This lack of common movement reduces the overall risk of the portfolio.

  1. The mathematical term for the way two assets move with or against each other is a correlation, a number that ranges between negative 1 and positive 1. Two securities with a positive correlation move in sync: When one goes up, the other goes up, and they have little diversification. The art of picking a diversified portfolio is to select securities that have low correlation and positive expected returns.

The Optimal Portfolio

  1. Markowitz’s next challenge was to find the best portfolio for any particular person: an optimal portfolio. Markowitz returned to the notion of the production possibility frontier and imagined a graphed curve that shows the range of portfolios that maximize return for a given level or tolerance of risk.

  2. Markowitz called this curve the efficient frontier. Any portfolio below the efficient frontier is inefficient, and no rational person would select it because it would yield a lower return and higher risk than another possible portfolio.

William Sharpe and creation of CAPM

  1. What if all investors tried to maximize their returns according to their risk tolerance? William Sharpe another Ph.D student set out to find the answer in his own thesis. It described a way to simplify the calculation of efficient portfolios that were using of Markowitz’s Portfolio Theory.

  2. He thought a bout what prices would look like in equilibrium if everyone tried to maximize the returns for a given level of risk. Sharpe’s insight was that the only risk worth paying for is risk that can’t be diversified away—that is market risk, or what markets call beta.

  3. Sharpe developed a model showing that the expected return on any risk asset is equal to the risk-free rate of interest plus the market risk of the asset (beta) times the market risk premium as a whole. The model is known as the Capital Asset Pricing Model or CAPM.

  4. The risk-free rate, say a fixed-income security issued by the government, is virtually free of default. It should be the minimum hurdle for any investment to pass. To this risk-free rate add beta. The average beta of the market as a whole is one. Therefore, stocks with a beta lower than one are less risky than the market. Stocks with a beta greater than one are riskier than the market.

  5. According to the theory, a portfolio of high beta stocks yields a high return. When the market goes up, such portfolios tend to outperform the market and low beta portfolios tend to underperform the market. But when stocks go down, portfolios of low beta stocks tend to lose less than high beta portfolios.

  6. Yeah, he won a Nobel Prize too.

Momentum and Liquidity and effect on Portfolio.

  1. Momentum investors buy stocks that have been rising and sell or sell short investments that have been falling. In the short run, say a year or less, researchers have found that momentum works.High flyers keep flying and losers keep falling.

  2. Liquidity refers to the ability to sell an asset quickly and at fair market value: Your house is probably not liquid, but (most) Stocks,ETFs etc are liquid.

  3. Researchers have found that over long periods, investors get paid to own illiquid assets. These assets are basically another type of risk.

  4. During times of panic , the opposite happens, which is, people gravitate towards the safety of liquid investments.

  5. According to the theory, if you want to make the most money, buy illiquid, small cap, value stocks that have upward momentum. The stocks that tend to have the lowest return are the most liquid, large cap growth names, with downward momentum.

  6. But if you follow this approach, be prepared to face large draw downs when the market is falling, because in the short run you will lose the most money with this kind of security.And please for the love of all things holy, do not go shopping penny stocks, because a theory told you so, its called theory for a reason.

That was for today, if you have any views or opinions on this topic do share. How do you handle your portfolio ? Hunch, Guess work, Common Sense, using Physics and Calculus ? Will be interesting to know.

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Hi, nice writeup. Any book recommendations for light reading on modern portfolio theory?

Also, never thought about this:

Thanks.

2 Likes

Hey Thanks, Portfolio theory being a slightly abstract academic topic, doesn’t have good light reading going on for it, at least I haven’t come across much. But if you were to slowly burn down these two books I think you will be golden :

1. Portfolio Selection By Markowitz (Straight from the horse’s mouth, every market geek must own a copy I believe, if for nothing else than its historical value )

  1. Capital Ideas by Bernstein A perfectly written book, summarizes all major financial theories in great detail and way better than I could ever personally write. One of my all time favourites.

Apart from this if any user has some good resources they can share here :slight_smile:

3 Likes

Thanks, got both the books. :smiley: