Can we make risk less risky?

"I'm Grandpa Harry," says a youthful looking 88-year-old gentleman with a smile. "I’m grandpa Harry with a Nobel Prize in economics. Not a Nobel Laureate with grandchildren. But I’m also the grandpa of behavioral finance, and the father of portfolio theory. It’s a lot of fun to be Harry Markowitz."

This is just one of the joyful ways in which Harry Markowitz introduces himself. But in fact, the man does not need an introduction in many circles, even those outside of academia.

"Wall Street stands on the shoulders of Harry Markowitz" This was allegedly uttered by a fellow Laureate, the late Paul Samuelson. Whether he actually said this is a matter for debate, but the sentiment is true, regardless. Markowitz didn’t create Wall Street, but he is responsible, almost singlehandedly, for the Wall Street we know today.

Harry M. Markowitz

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (shared), 1990

At a glance

Born: 1927, Chicago, Illinois, USA

Field: Financial Economics

Prize-winning work: Pioneering work in portfolio management theory for individual wealth holders

His three heroes: John von Neumann, Leonard J. Savage and George Dantzig

A piece of advice: Diversify and start young

On art connections: "Shakespeare is to literature, what Bach is to music"

Life credo: "You can judge a man by his friends"

On teaching a class: Never tell a joke at the beginning of a class - it always falls flat

Revolutionizing financial investing

Markowitz is interested not only in your questions, but he’s also curious about you as a person. With a pinch of modesty, he says: "I don’t want to seem vain. I am vain, I just don’t want to seem vain. I really enjoy being Harry Markowitz."

As a 24-year-old graduate student at the University of Chicago, Markowitz wrote an article on Portfolio Selection that, in 1990, won him the Nobel Prize. In those almost four decades until he received the award, he established portfolio theory, influenced the way academic research treated portfolio diversification, revolutionized risk assessment of financial investments, ran a business, consulted others, and developed computer programming language SIMSCRIPT, all the while receiving many other awards and recognitions.

When speaking about his groundbreaking work, Markowitz simply says,

I was awarded for portfolio theory, which in brief says 'don’t put all your eggs in one basket'. But there’s a trade-off between return on the average in the long run and variability of return, so I worked on the mathematics of risk-return trade-off.

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Don’t put your eggs in one basket

Getting to this point warrants a little story. In the early 1950s, young Markowitz knew that, according to John Burr Williams in his Theory of Investment Value, the expected value of a stock should be the present value of its future dividend. "So I’m thinking, dividends are uncertain, he must mean an expected value or a mean." Markowitz continues: "Later he even said that if you diversify enough, you will make risk go away and you will get the mean. Well, the notion that if you diversify enough, risk will go away, that’s true of uncorrelated risks." Markowitz, who was two at the start of the Great Depression, and has lived to an age where he’s also seen the effect of the 2008 crash, goes one to say: "Any fool, especially one who’s just lived through the depression - or the stock market crashes, can probably see that we have correlated risks and then things do not go to zero. But theory was not consistent with practice."

Discovering the disconnect between theory and practice set Markowitz on the path to remedying it. Bringing the theory in line with the practice meant searching for a way to mathematically express the change in expected values of dividends, and account for correlated risks. This led him to look for the variants and standard deviations of weighted sums in Introduction to Mathematical Probability by J. V. Uspensky in the library. "And that was the 'a-ha' moment. The volatility of the portfolio depends not only on the volatility of the constituents but to what extent they go up and down together."

The aha-moment

However, the implications of this lightbulb moment go much further than the field of investment management. As his longtime friend Martin J. Gruber describes it, Markowitz’s work "had a major impact on economics because we began to see that you can’t view items in isolation, you have to look at the relationships between them; whether we’re talking about the relationship between GNP in different countries or two stock markets within the same country. They tend to move together, the extent to which they move together determines the extent to which you can reduce risk. And until Harry’s work, nobody had ever looked at that."

A life’s goal: Having fun

Needless to say, Uspensky's book made its way to a special shelf in Markowitz's office, where the laureate also keeps the leather-bound copy of his 1959 book, among others that have somehow become important in his life. "Being a small businessman was never my objective. Having fun, having interesting problems, having to struggle - that’s the bread and butter, the meat and potatoes. And then the 'a-ha' moments, those are the dessert. But they’re random. They happen all of a sudden, you hit a nut in this, you’re eating butter pecan and you hit a pecan and that’s the aha-moment," reflects the laureate.

Celebrating the 25th anniversary of his Nobel Prize

Across town at the University of California, San Diego (UCSD) campus, guests are gathering to celebrate the results of this one particular a-ha moment: the 25th anniversary of Markowitz receiving his Nobel Prize.

Academics, colleagues from the financial industry, friends and family have come from all over the world to honor Markowitz’s life and achievements. The laureate, gracefully basking in all the attention, doesn’t forget to mention that he believes one can tell a man by his friends, and he’s been a lucky one. Having friends and loved ones around him is a prize enough. The laureate engages in various conversations with the guests on topics far away from portfolio selections, drawing them in with his broad intellect, knowledge and curiosity. And all this at almost 90 years old!

As one of the guests, former colleague John Guerard, points out: "The correlation coefficient between Markowitz at 62 and Markowitz at 88 is probably somewhere between 0.95 or 0.9. He is every bit as brilliant at 88 as he was at 62." Markowitz seconds the point by saying, "I was a young smart ass kid. Now I’m a smart ass old man." His laugh is contagious and stimulates the audience. "And the only thing that’s different between now and then, is that I’ve had many, many years to be a smart young kid, a smart middle-aged kid and a smart old man."

Creating a profession

As we’re bidding farewell, we hear one last time: "Well, let me tell you a story," he says after getting our full attention. "When people are effusing over my Nobel Prize, I like to tell them: My Nobel Prize was not my greatest honor. My greatest honor was awarded to me in the men’s room of a large Washington DC hotel, after dinner, sometime between Christmas and New Year of 1990." He’d been invited by the American Finance Association and, after an evening at which Markowitz, along with his co-laureates William F. Sharpe and Merton Miller said a few words, Markowitz went to use the men’s room. It was here that somebody in the next stall said to him:

Thank you, Dr. Markowitz, for creating the profession in which we all make our living. And that’s better than a Nobel Prize.

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What does Markowitz's work mean for us?

"Markowitz's research showed how investors could assemble the perfect portfolio given their expectations about the rate of return and the variants of each asset."

Tim Harford
Financial Times columnist and author of
The Undercover Economist

"If there's one thing to be learned working in financial markets, it's that risk or uncertainty is a key part of our lives."

Paul Donovan
Global Chief Economist UBS Wealth Management

More Nobel Perspectives

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Robert E. Lucas
Nobel Laureate, 1995

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Peter A. Diamond
Nobel Laureate, 2010

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