The author is a former investment banker in New York and former head of the investment committee of the Chilean fund.
The merits of portfolio diversification were probably first recognized by the simple rule proposed in the Babylonian Talmud: one-third in real estate, one-third in commodities (working capital), and the remaining third in cash.
However, a rigorous mathematical argument for diversification has only been articulated by Harry Markowitz’s famous article, “Portfolio Selection”., appeared in March 1952 in the Journal of Finance. As the 70th anniversary of its publication approaches, it seems timely to assess its influence.
Markowitz is universally recognized as the father of modern finance. In fact, before him, portfolio management did not exist as a discipline. Investment decisions have been driven primarily by ad hoc rules and gut feelings rather than solid quantitative analysis. The fact that Markowitz is still alive testifies to the youth of this discipline.
Did Markowitz get it all right? Yes and no. His great contribution was to provide a quantitative framework for analyzing the merits of a group of investments (or a portfolio) as a whole. This framework allowed investors to assess the degree and benefits of diversification in a given portfolio. And he formally stated the idea of a risk-return trade-off; in other words, investors seeking higher returns must be prepared to bear more risk.
These concepts have stood the test of time well. In fact, they are still the foundation upon which much of modern finance is built.
A powerful offspring of these two concepts is the idea of the efficient frontier – that investors should aim for the sweet spot of return and risk in portfolio construction. The idea of the efficient frontier has not only stood the test of time well, but has become, albeit with many modifications, the guiding principle of all serious investors.
Markowitz’s framework, however, had two weaknesses. One was its reliance on a mathematical construct known as the correlation matrix (of returns). Essentially, it describes the extent to which two assets move together.
After all these years, financial analysts still disagree on the best way to determine this. Worse still, small changes in the correlation values lead to major differences in the conclusions drawn from them. Concretely, structuring an effective portfolio according to this approach does not work.
Yet it was another problem with Markowitz’s formulation that was more problematic – he confused risk with uncertainty. Risk is the possibility of things going wrong. Uncertainty is not knowing what the future holds.
By choosing the standard deviation of returns as a proxy for risk, he made a conceptual error. Standard deviation – a basic statistical measure – focuses on dispersion. It doesn’t distinguish between good and bad scenarios, between performing better than you expected and performing less than you expected. That is, standard deviation captures uncertainty, not risk. This conceptual misstep sent finance and economics down the wrong path for many years.
Although this gap was identified about 30 years ago with the introduction of risk measures focused on financial losses such as VaR (Value-at-Risk), the academic community has been slow to adopt these measures. Practitioners, however, moved much faster. No serious asset manager relies on the standard deviation of returns or the Markowitz correlation matrix for anything.
Would this empirical failure amount to an indictment of Markowitz’s ideas? Certainly not. Perhaps they could be forgiven as youthful indiscretions; remember, finance is a young discipline. In sum, one could say that Markowitz’s ideas were a practical failure (difficult to implement in reality) but a theoretical success (a set of sound principles to guide investment decisions).
This may seem like a harsh judgement; it’s not. Certainly, the numerical tools suggested by Markowitz have gradually been replaced by better algorithms, although to some extent this is still ongoing. However, the efficient frontier, the risk-return trade-off, and the merits of diversification have been the lightning rod behind just about everything that has happened in finance since 1952.
Great ideas are often marred by difficulties in implementation. Think democracy. Markowitz simply had a bunch of good ideas. Finance professionals should be grateful. And the fact that many people are still working hard to implement them is a testament to their timeless relevance.