Markowitz

Professor Harry Markowitz – 25th Anniversary of Becoming a Nobel Laureate

Markowitz
"If I have seen further, it is by standing on the shoulders of giants." – Sir Isaac Newton

This time of the year marks the 25th Anniversary since Professor Harry Markowitz, alongside Professors William Sharpe and Merton Miller, was awarded the Nobel Memorial Prize in Economic Sciences for his pioneering work in the field of financial economics. Specifically, Professor Markowitz developed one of the first models for understanding portfolio allocation under uncertainty.

Originally earning his Bachelor in Arts in Philosophy, Professor Markowitz was inspired by the works of Scottish Empiricist, David Hume. Hume very much believed in the idea of scientific inquiry and notions that could be tested and quantified. In like manner, Professor Markowitz continued his academic endeavors at the University of Chicago, focusing the use of mathematics and statistics in understanding the stock market and ultimately earning his Ph.D. in the field of Economics in 1955. Below is a series of videos of Professor Markowitz speaking about his early work as a student.


Building off of John Burr Williams’ “Theory of Investment Value,” and J.V. Uspensky’s “Introduction to Mathematical Probability,” Professor Markowitz’s work in understanding risk and how it applies to the stock market was seminal in the development of what is known as modern portfolio theory. In his infamous 1952 paper, “Portfolio Selection,” published in the March 1952 edition of the Journal of Finance, Professor Markowitz uses mathematics to explain the tradeoffs that investors make when selecting a proper portfolio. This body of work went on to influence other developments in the field of financial economics as well as the practical investment implications with real money in real time, including the concept of diversification and how risk and return are related. In essence, Professor Markowitz shifted investors’ focus from individual security selection to looking at a portfolio in its entirety. The 100 IFA Index Portfolios are very much a great representation of how Professor Markowitz’s ideas have helped the many investors that IFA serves.

The basic idea of Professor Markowitz’s work has to do with finding an optimal portfolio for an individual investor based on their capacity to take risk. When combining of mix of risky assets, whether at the individual security or asset class level, we can compute a combination of three different metrics: the mean (expected return), the standard deviation (risk), and the covariance or correlation (statistical relationship between two variables). Once we have these three variables for each and every combination of risky assets in our portfolio, we can then run an optimizer to see what combination of each risky asset yields the highest return (mean) for a given level of risk (standard deviation). When these combinations are plotted on a 2 dimensional graph, we start to see a line or curve, which Professor Markowitz coined “the efficient frontier.” Portfolios that lie below the efficient frontier are mean-variance inefficient portfolios. In other words, there is a better combination of risky assets in which investors could earn a higher expected return for that particular level of risk. No portfolios lie above the efficient frontier without the use of leverage.

Likewise, the 100 IFA Index Portfolios take a mix of all risky assets which encompass a positive expected return (hence why commodities, precious metals, and hedge funds are excluded), and build asset allocations that attempt to provide the highest expected return for any given level of risk. You can see the similarity between the curves presented in the two graphs.

Professor Markowitz’s work also laid the foundation for many of the later developments in the field of financial economics including Professor William Sharpe’s Capital Asset Pricing Model. With the development of computers in the late 1950’s and early 1960’s, financial empiricists, like Nobel Laureate Eugene Fama, began to run more advanced statistical models in understanding the behavior of stock prices and the use of factor models.

Professor Markowitz continues to educate and inspire many professionals and businesses around the world. Currently, Professor Markowitz serves as an adjunct professor at the University of California, San Diego’s Rady School of Management and as an academic consultant for Index Fund Advisors, among others. We continue to celebrate his life’s accomplishments and commitment to bringing important insight to our clients.

Congratulations and thank you, Professor Markowitz.