Richard Harris

The View | Figuring out today’s messy stock markets takes a dose of Harry Markowitz’s modern portfolio theory

The last quarter was dominated by narratives of rising interest rates and inflation, yet consumers are spending, job vacancies abound and house prices are firm

What to make of this is unclear, but Markowitz’s work would suggest a robust, long-term portfolio of equities and bonds, perhaps rebalancing every few years

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A currency trader walks by the screen showing the Korea Composite Stock Price Index (KOSPI) at a foreign exchange dealing room in Seoul on July 5. It has not been a good year so far for Asian markets. Photo: AP

Richard Harris

Published: 10:00pm, 6 Jul 2023Updated: 10:37pm, 6 Jul 2023

Harry Markowitz, one of the first researchers to put rigour into investment decision-making, died on June 22 at age 95. Rightly regarded as the father of modern financial analysis, his life neatly spanned the entire lifetime of financial research.

By coincidence, in Markowitz’s birth year of 1927, a frustrated Alfred Cowles commissioned an investigation into the inaccuracy of stock recommendations to his wealthy family. Cowles’ paper, published in 1933, was titled “Can Stock Market Forecasters Forecast?”. His next paper, “Stock Market Forecasting”, showed that such forecasts were “indefinite” and usually driven by the narrative of the day.

The young Markowitz was a mathematician looking for a PhD topic and a chance meeting led him to research the financial markets. He realised that contemporary investors looked only at returns, so he introduced the concept of risk (defined by probabilities) that can be visualised as a line on a graph that plots return against risk.

The concept Markowitz put forward was to strike a balance between asset returns and market risks, instead of focusing solely on returns. He used a quantitative framework to analyse the merits of combining different assets. This “efficient frontier” illustrated that in stable markets, it is possible to get a little more return at a little less risk – by diversifying.

Markowitz encapsulated diversification mathematically in his 1952 paper “Portfolio Selection”, from which came the term “modern portfolio theory”. In the same year, he published “The Utility of Wealth”, an early tilt towards behavioural economics. In two papers, published at the tender age of 25, he established financial economics and touched upon the two major topics of classical and behavioural finance.

It led to a lifelong association with the Cowles Foundation for Research in Economics and a Nobel Prize in economics in 1990. Financial economics research is full of irony, as the great economist Milton Friedman initially refused to give Markowitz his PhD because finance was “not economics”.