Harry Markowitz

Index Fund Advisors, Inc. Interview with Harry M. Markowitz

Harry Markowitz

 

Mark T. Hebner:

Hi, I’m Mark Hebner, President of Index Funds Advisors and we’re especially excited to have Nobel Prize Winner, Harry Markowitz with us here today.  Professor Markowitz got his Nobel Prize in 1990 and he was also the 1989 Recipient of the John Von Newman Theory Prize.  Harry is famous on many levels but in particular it’s for his Foundation of Modern Portfolio Theory.  These are important discoveries that explain the impact of stock market risk, correlation and diversification on investment returns.  In his 1952 paper, he sparked an ongoing movement that is collectively known as The Modern Portfolio Theory and he is widely known as the Father of this particular theory.  His highly claimed research serves as a framework for the Prudent Investor Rule as well as the investment strategies of the institutional investors around the world.  It’s estimated that some 7 trillion dollars in institutional assets are invested according to Professor Markowitz’s Nobel Prize winning discoveries and we’re just ecstatic to have him here with us today.  He’s also the Professor of Portfolio Theory at the University of California at San Diego and he serves as an academic consultant to Index Funds Advisors.  Harry, welcome!

Harry M. Markowitz:

Thank You!



Mark T. Hebner:

Glad to have you.  We’ve just finished about a 4 hour session with Professor Markowitz in which we talked about many different subjects about risk and return and we’d like to share with you some of his perspectives on a few particular points.  Harry, in your 1959 book, “Portfolio Selection, Efficient Diversification of Investments”, you stated that a good portfolio is more than a long list of good stocks and bonds, it’s a balanced whole providing investors with protections and opportunities with respect to a wide range of contingencies.  Could you maybe expound on that a little bit and maybe share with some of our website viewers what you meant by that and maybe how that might apply to today’s environment where we’ve just experienced pretty significant declines.

Harry M. Markowitz:

Okay.  So, the investor is interested in having a high return on average and the investor is interested in having that return with a certain amount of stability.  So there’s 2 criteria, one is risk and the other one is return that we’re interested in.  Now risk, the riskiness of a portfolio depends not only on the riskiness of the individual securities but to what extent they go up and down together.  So in other words, if you have a lot of securities but they’re all high-tech and it’s the year 1999..

Mark T. Hebner:

And that didn’t work out so good (laughter)

Harry M. Markowitz:

There may be some motley fools around that say this is a great thing to do, but you didn’t say that and I didn’t say that…

Mark T. Hebner:

Yeah, yeah, no offense motley fools (laughter)




Harry M. Markowitz:

With all due respect to the motley fools…You have to worry about, on the one hand, expected return for each of the asset classes or securities that you are holding and you have to worry about the volatility of each asset class or security but you also have to worry to what extent they go up and down together, to what extent they are correlated.  It’s a subtle calculation based on these inputs that tells you what combination of securities would give you the least risk for this level of expected return and which would give you the least risk for a higher or lower level of return. 

Mark T. Hebner:  

Right, right.  Thank You.  How would you characterize or maybe expand on the term Modern Portfolio Theory and what it’s implications are.

Harry M. Markowitz:       

Well, let’s see.  Modern Portfolio Theory was first published in an article by me in 1952, so if that’s still modern, I’m still modern.  (laughter)
 
Mark T. Hebner:

(laughter)  I’m not so modern, by the way, and that was the year of my birth, but go ahead.

Harry M. Markowitz:

And that was the year of your birth and that was the year for my publication.

Mark T. Hebner:

I like to tell people that why it’s my destiny to bring this research to a lot of investors around the world because I was born the year you published it, but anyway go ahead.  So Modern Portfolio Theory, yes …..




Harry M. Markowitz:  
 
It is concerned with risk and return on the portfolio as a whole.  The name of the article, this 1952 article we are referring to, is portfolio selection, it’s not stock selection, it’s portfolio selection.  And it assumes, as we said before, that you are interested in risk and return on the portfolio as a whole and it explains why you have to worry about correlations as well as expected returns and volatility. 

Mark T. Hebner:                               

So what implications does that have for people who are maybe trying to pick stocks or trying to pick a time to invest or even pick a manager, for that sake.

Harry M. Markowitz: 

Well, unless a person has so much money that they can diversify widely, and so much time and skill, they have nothing else to do and they have the skill to pick out securities well, and they have some kind of a connection with somebody who knows how to diversify a portfolio, they would be a lot better off sticking with asset class portfolios, or with broadly diversified index funds.  Now, if they don’t have an advisor, they’re not a client of IFA let’s say, then what they should do is divide their money into two pools; one they put into a broadly diversified portfolio of stocks, maybe the S&P 500 in some small cap and so on, a broadly diversified no loan index fund and the other part of their money they should put into a bond fund or TIPS, the Treasury Index, inflation protected, but they should divide it between…

Mark T. Hebner:

Some low risk.

Harry M. Markowitz:

Some low risk, some stable, and then in deciding how to divide it between high return versus lower risk, they should get some kind of chart, a histogram or accumulated wealth over time, that shows them the volatility of the market and they should ask themselves, am I willing to be exposed to that much up and down and up and down, or half that much or a quarter that much or three-quarters that much and they should divide their wealth, their investable wealth, liquid assets, between stocks and bonds so that they would be willing to stay with that investment over the long run.

Mark T. Hebner: 

Well, as we talked about earlier, Eugene Fama has discussed what we call the Efficient Market Theory which basically says that stocks are fairly priced, most of the time if not all of the time, if they’re not fairly priced you probably won’t know about it until after the fact.  And so how would that impact somebody who even if they had enough time would want to sit and try to pick a stock that they think is going to be the best winner.  What are the implications of that theory?

Harry M. Markowitz:

I would not necessarily agree that all stocks are fairly priced at all times.  And there are people who seem to be able to consistently pick out under priced stocks, like Warren Buffett, seems to be able to consistently pick out under priced stocks.  Unfortunately for you, fortunately for Warren Buffett, if you want Berkshire Hathaway, you have to pay a very high price for his ability to pick out under valued stocks.  But for you, in particular, for the small investor, and by the small investor I mean somebody who cannot invest in enough issues to provide diversification and cannot spend enough time to really do the kind of research that Warren Buffett does.  You’re much better off getting a diversified portfolio, that diversified portfolio is already smoothing over the fact that one stock maybe over priced now and one stock might be under priced.

Mark T. Hebner:

That’s right.  As I like to say, you don’t really know that at the time you buy the stock and you only discover that in hindsight.  That’s one of our premises anyway. 

Harry M. Markowitz:

The folks who are both academic academicians and investors like Fisher Blatt and Jack Trainor, they speak of active passive.  So if you are an expect in some field, like oil discovery or something, or electronics, maybe you know something about that field that the market on the average doesn’t know.  So maybe you put 90 or 95% of your funds passively into some index and you take 5% or 10% of your funds and put it into something you know about.
Mark T. Hebner:

Or you think you know about it.  We like to call that the Las Vegas account.  (laughter)

Harry M. Markowitz:

It’s the think I know account.  I think I can account. 

Mark T. Hebner:

We have a lot of research about those “I think I can” on our website as to what percentage of those people end up doing better, and it’s pretty small.
What do you think about the research of Fama and French as to small stocks doing better than large and value stocks doing better than growth.

Harry M. Markowitz:

Well lately that’s the way that it has been..  I don’t endorse any particular methodology for coming up with expected returns and adherences and coherences but it is widely followed and it is certainly very respectable and very plausible. 

Mark T. Hebner:

Sure.  One of our clients is asking me this question and I’d like to pose it to you.  They are concerned that the Gross Domestic Product of our country is going to remain flat or decline and under those scenarios they were asking how is it that the stock market could continue to go up when GDP is, in their opinion, declining. 

Harry M. Markowitz:

Are they talking about 2009 or between now and 50 years from now?

Mark T. Hebner:

I think they’re maybe saying over the next 5 years, let’s say.



Harry M. Markowitz:

Well, that’s certainly an unusual prediction. 

Mark T. Hebner:

Well that’s my first concern but I thought I’d pose it to you anyway.

Harry M. Markowitz:

For GDP to decline for a year is worrisome and in our situation now it could decline a year, 2009 and maybe it could decline in 2010, but my goodness, I think the Capitalist system is here to stay.

Mark T. Hebner:

Do you see a link though between that GDP and stock returns?

Harry M. Markowitz:

Usually the stock market is a leading indicator.  Unemployment is a lagging indicator.  So the stock market will most likely go up in advance of the GDP going up.

Mark T. Hebner:

Sure, sure.  So what we experienced last year was an unusual decline based on the last 50 years and what words of wisdom do you have for investors who have been told by firms like ours that they should hang on to those portfolios and sort of ride out the storm.

Harry M. Markowitz:

Now, a couple of words of wisdom, not two words but a couple of thoughts.  Now in the first place, the typical public of small investors is they buy when the market is high and they think it is going to go higher and they sell when the market is low and they think it is going to go lower.  So they’re buying high and selling low and everybody knows you’re supposed to buy low and sell high.  Then, I can’t remember the other one.

Mark T. Hebner:

That’s okay.

Harry M. Markowitz:

I’m at an age where I can think of two things but I can’t remember the second one.  We can probably edit that out …
(laughter)

Mark T. Hebner:

We can edit that out or we can just leave it in there, it’s natural, I have a problem myself (laughter)….

Harry M. Markowitz:

It isn’t because I’m 81 years old, I’ve always had problems remembering everything. 

Mark T. Hebner:

The other thing may have been the time horizon, you might have been thinking that they have a long enough time that eventually it might come back, that’s something we often bring up.  But one of the big mistakes they could do is basically sell at some point in time …

Harry M. Markowitz:

At the low and we don’t know if it’s the low or not.

Mark T. Hebner:

We talked about the model that I’ve been working on, is there any compensation for the fact that you have a lot of uncertainty in the market and you’re starting off going forward from a relatively low price.


Harry M. Markowitz:

Well, as you know and Eugene Fama would emphasize, we don’t know whether it’s a low price until a year later.

Mark T. Hebner:

But you might say relative to a year ago, it’s lower at least and that might reflect something to do with the uncertainty or bad news we have in the markets. 

Harry M. Markowitz:

It’s lower.  I started investing roughly when I was a young man. On a new job they allowed me to invest in bonds and stocks as part of their long term retirement and I did that around 1951, 1952.  The S&P 500 adjusted to current was at 9 …

Mark T. Hebner:

Oh, wow.

Harry M.. Markowitz:

Well below 900, I know now it’s down to 870, 880, 890 or something like that, but somehow it got from 9 to 900 during the course of my investment experience.  Now, as you illustrate so well with your graphic displays, if you invest, not until you’re 81, but for 10 years, historically you’re almost sure to come out ahead and on the average you did very, very well.  Ah, I remember what I was going to say.  Last year was a bad year you say, how bad was it?  Was it just an end of the world kind of year?  We looked at the history of the S&P 500 for example and we have nice history going back to the 1920’s and nice graphs going back to 1926 to the present.  If you take that period, and on the average you would make about 10% but you had a standard deviation of 20%.  Now don’t worry if you don’t’ know what a standard deviation is, what you should know is that most of a probability distribution is between the average minus 2 standard deviations and the average plus 2 standard deviations.  We actually had a downward movement of 2 ½ standard deviations, that’s okay, that can happen.  There’s a 2 ½% chance that you would get worse then a 2 standard deviation downward movement.  So that’s 1 in 40 years, so we had a 1 in 40 years happening, you’ve just got to be able to withstand that, you have to have a combination of stocks and bonds, a combination of risk and return which allows you to say, well, you know, that’s a 2 standard deviation move, they told me that would happen.

Mark T. Hebner:

Right, right.  I don’t know if you’ve seen but a handful of journalists have been questioning the Harry Markowitz Model, we’ve just read about it recently…

Harry M. Markowitz:

Was it in the New York Times?

Mark T. Hebner:

I think it was in the Times, yes, I don’t have the article in front of me but they claim the Modern Portfolio Theory was no longer relevant thanks to the globalization of Capital Markets or in particular, they said during this year there was basically no where to hide and everything went down together, what’s your response to that?

Harry M. Markowitz:

Okay, I’m glad you asked that question.  Now, when you’re trying to anticipate the future you know the future is uncertain, the market may go up, the market may go down.  Now some asset classes, we’ll talk in terms of asset classes, are more volatile than other asset classes.  Let’s suppose we’ll take as our benchmark, as our standard, the S&P 500, so we’ll say that has a data of 1.  When the S&P 500 goes down 10%, the S&P 500 goes down 10%.  But emerging markets are more volatile, I don’t have data in front of me, but let’s suppose that when the S&P goes down 10% the emerging markets in fact go down 20% and we say they have a data of 2.  And in fact the emerging markets in the 2008 year went down a lot more than the S&P 500.

Mark T. Hebner:

I think we saw it hit 60% negative. 



Harry M. Markowitz:

Right, so instead of 38 ½% decline, it went 60% down, so that’s what you’re supposed to expect.  So part of your planning in advance is you should have a combination of asset classes that are efficient in the sense they give you minimum risk for a given expected return.  Some Financial Engineers talk about risk control, us Portfolio Theororists do not talk about risk control, it sounds like you can control risk, you can’t.  You can say this part of the efficient frontier, the risk return trade-off curve, has high return but it has high risk, this one has lower return, lower risk.  What makes up part of the riskiness of this one is it has more asset classes like emerging markets that do well on the average over the long run or at least have historically, but they are riskier.  So, Portfolio Theory was not invalidated, it was validated.

Mark T. Hebner:

I think so, yes.  What about bonds, our bond funds were all positive for the year, that’s sort of the ultimate in negative correlation to equities and so we saw actually a line of risk and return through our portfolios.

Harry M. Markowitz:

Suppose you had on your own decided you’re going to be 60% in stocks and 40% in bonds, the stocks were S&P 500, the bonds were high grade bonds and you had $600,000 in the stocks and $400,000 in the bonds, now you watch the $600,000 fall to $400,000 whereas the bonds, they went up.  So instead of having a million, you have $800,000 and you’re not happy, but you’re here to invest again.  You know I read in the Wall Street Journal that there are Municipalities in Australia that put all their money in credit default swabs, they didn’t buy the default swaps, they wrote the default swaps, and they’re bankrupt, they’re bankrupt.  How could they do that?

Mark T. Hebner:

How diversified were they? (laughter)




Harry M. Markowitz:

There are people who are jumping out the window because they gave all their money to Madoff, how diversified were they?                              
And they’re supposed to be sophisticated.

Mark T. Hebner:

I totally agree, it’s a shame.  Well Harry, it’s a pleasure.

Harry M. Markowitz:

My pleasure.

Mark T. Hebner:

It’s great having you here today and being able to spend so much time with you and it was great that you spent a little time with our web viewers as well.  Thank you.

Harry M. Markowitz:

Thank you.