Last month the Modern Portfolio Theory (MPT) turned seventy years old. In March 1952, Harry Markowitz published his paper, ‘Portfolio Selection’, in the Journal of Finance. Those fifteen pages not only helped Markowitz win a Nobel Prize in Economics, but also helped to shape an industry, and the way we invest today. Is the MTP still up to date and does it still deliver investors with a ‘free lunch’?
Everyone knows that diversification is key in balancing out your risk. It was Harry Markowitz who provided a theory and a process for the notion of diversification. Before Harry, there was not a single view that a diversified portfolio leads to a better trade-off between risk-and-return. Harry got the idea from a conversation with a stockbroker in front of the office of his doctoral advisor, and after he wrote history.
Harry knew many investors were concerned with diversification, and as such invested through mutual funds. He felt that the stockbroker he spoke with was missing a kind of concept of overall portfolio riskiness. Searching through one of his statistics books, Harry found a formula that could be adapted to measure the riskiness of a portfolio as a whole. He found that what was important in a portfolio was not simply the average risk associated with each individual stock or portfolio company, but rather the extent to which various stocks or industries moved either up or down relative to one another. Correlation was key in using the diversification benefits of portfolio optimization.
After his breakthrough, Harry successfully defended his thesis. Until today, Harry was able to build what is still seen as the foundations in portfolio construction. He built such a simple and easy to understand model, that it didn’t undergo a lot of changes in the past 70 years. Due to Harry, we know that there is still a free lunch, by using his diversified portfolio theory. It pays off to be diversified across all assets: Private Equity, Venture capital, stocks, real estate, bonds, commodities and as of recently, also crypto currencies. As the diversification of bitcoin and US stocks are reasonably low, and if the new asset class also fits your risk profile, go and enjoy this free lunch.
Bonne Appétit, Harry!