August 1, 2023 by Ed Barno
American economist and Nobel Prize winner, Dr. Harry Markowitz, died last month at the age of 95. Harry Markowitz may be the most widely recognized name in the history of investment academia, research, and portfolio management.
Before the publication of his research in the 1950’s, investment risk was determined on a security-by-security basis. It was believed that adding more volatile securities would always increase a portfolio’s total risk. Consequently, portfolios often held mostly blue chip stocks that looked and acted very much the same.
Markowitz’s work, published in his 1952 dissertation “Portfolio Selection”, proved mathematically that the risk in any portfolio is less dependent on the riskiness of its component stocks and other assets than on how they relate to one another. His work, which became known as “Modern Portfolio Theory”, replaced the traditional portfolio construction approach by examining the relationship between risk and reward.
Markowitz’s work showed that diversification could reduce overall portfolio volatility while maximizing returns. His theory argues that any given investment should not be viewed alone but should be evaluated by how it affects the portfolio’s overall risk and return.
In addition to expected return, how an asset’s return correlates with others and the variability of those returns are important factors in determining the benefit of including such stock, asset, or asset class in a portfolio.
A simple example demonstrates the benefit of diversification.
Assume we have $100,000 to invest in portfolios one, two, or three (assume an IRA and no taxes).
- Portfolio one is a single asset, a CD paying 10% and compounding annually. After 20 years, you would have $672,750 in your portfolio.
- Portfolio two consists of a group of high growth stocks, with an arithmetic average annual return of 10%, but very high positive return years and very low negative return years. After 20 years, portfolio two has a balance of $507,000.
- Portfolio three starts with the assets in portfolio two and adds large and small value stocks, along with international stocks. The average return for the 20 years is again 10%, but the positive return years are not as high as portfolio two and the negative return years are not as low. After 20 years, portfolio three has a balance of $606,800.
We know mathematically that we should achieve better overall results, with lower aggregate portfolio risk through diversification.
Modern Portfolio Theory, the genius of Harry Markowitz, lives on as the foundation for portfolio construction today.
Thanks Harry - rest in peace.