Nobel laureate Harry Markowitz recently died at age 95. You might not recognize his name, but he was one of the academics behind an economic revolution that transformed investing and the financial markets. Thanks to Markowitz and other ivory tower scholars, financiers, financial advisers and individual investors are well-versed in concepts such as asset allocation, diversification and the trade-off between risk and return.
Markowitz's seminal paper on diversification and portfolio selection was published in the early 1950s. Back then the business of managing money leaned conservative. When it came to stocks the trick was to pick the stock with the best return prospects, a practice reminiscent of comedian Will Rogers' quip: "Buy stocks that are going up. After they have done that, sell them. If they ain't going to go up, don't have bought them."
Markowitz thought about risk as well as return. He understood that one of the best ways to manage risk is by diversifying assets. Of course, diversification is an ancient concept. The Swiss mathematician Daniel Bernoulli wrote in 1738 that risk-averse investors should diversify. Shakespeare captured the idea in the "Merchant of Venice" when Antonio said he wasn't worried about his investments since they were in different ships and places (although his confidence turns out to be mistaken).
My ventures are not in one bottom trusted,
Nor to one place; nor is my whole estate
Upon the fortune of this present year.
Markowitz developed the mathematical formalization of diversification into a systemic method of portfolio construction based on the idea of maximizing potential returns while minimizing overall risk (depending on goals, household circumstances, and other factors). "It was like a thunderclap, and it changed the way people think about investing," said Peter Bernstein, the late financial philosopher of risk, in an interview. "You're making a bet on an unknown future. ... They can't manage the outcome, so they have to manage risk."
Markowitz, along with scholars such as William Sharpe and Merton Miller, understood how difficult it is to beat the market. Their ideas led to the innovation of low-cost broad-based index funds. They are concepts that encouraged investors to focus on diversification, while adjusting the mix of assets to risk their risk tolerance and risk capacity. The concepts of modern portfolio management that have helped savers manage their money during the 401(k) era owe a huge debt to Markowitz.
Chris Farrell is senior economics contributor, "Marketplace"; commentator, Minnesota Public Radio.
