Thinking Out Loud: Dr. Harry M. Markowitz

The mathematics underlying the portfolio-management applications developed by New York City-based UMT and sold to clients such as AXA Financial Inc. owe an intellectual debt to Dr. Harry M. Markowitz, who won the Nobel Prize in economics, along with co-recipients Merton Miller and William Sharpe, in 1990. The award recognized Markowitz for work he began publishing 42 years ago, when he was a Ph.D. candidate at the University of Chicago. His research demonstrated that a diverse set of risky assets could give more consistent returns than individual investments. That’s gospel today, but it wasn’t in 1952. A research professor at the University of California at San Diego and former economist at the Rand Corp., Markowitz, 77, is retired and living in San Diego. What follows are edited remarks from an interview with CIO Insight in April 2004.

CIO Insight: Take us back for a minute. How did you come up with your portfolio theory?

Markowitz: I was a Ph.D. candidate at the University of Chicago, and I had to pick a dissertation topic. I picked up a book by John Burr Williams, The Theory of Investment Value, which says that the value of a stock should be the expected present value of its future dividends. But I thought that if I was interested only in the expected value of a security, then the value of the portfolio would only be the expected present value of that security—and that wouldn’t work, because you wouldn’t want to put all of your eggs in one basket. People choose their portfolios based on risk and return. So I simply asked the question, “What would be the return based on a weighted sum of those expected values?” This all happened in one afternoon, while I was reading this book, and I did what all economists do: I drew a graph showing the minimum risk for the maximum return—and that was “the efficient frontier.”

Volatile as some are, do you recommend investors include tech stocks in their portfolios?

Portfolio theory looks more at large caps, mid caps, small caps, long-term bonds, etc., and not as much at the industry level. Though, no matter how you slice it, the not-too-wild-and-crazy investor would certainly want to hold some IT stocks over the long term. A few years back I heard those guys at the Motley Fool saying “don’t bother with diversification, it will only slow you down,” and I just grimaced. But now we realize that truth and justice finally conquer all.

Are you aware that your theories on portfolio management are being applied to corporate IT assets and resources?

Really? Nope. Didn’t know anything about it. But I’m delighted when I hear that it’s being applied in other areas. I’m not sure it’s possible, but I’m still happy to hear it.