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Tribute to Nobel winner Markowitz: When Harry met Graham

Harry Markowitz, the 1990 Nobel Laureate for Economic Sciences and Pensions & Investments Magazine's 'Man of the Century', died last week at the age of 95. His 1952 seminal paper Portfolio Selection pioneered our understanding of risk, return and correlation in investment portfolios. His Efficient Frontier and Modern Portfolio Theory ideas are still taught in universities and business schools. 

I met Harry a few times in California at the Research Affiliates Advisory Conference. Long-time friend and colleague of Harry, the Chairman of Research Affiliates, Rob Arnott, provided this obituary exclusively to Firstlinks:

"In his last decade, Harry and I talked a couple of times about the inevitability of death. Harry did not fear death; he loved life. Accordingly, Harry would not want grief at his passing, but celebration of his living.

As will many who met him or worked with him, I will remember him as an intellectual giant. But, he was also a mensch, a mentor, a caring friend, and a truly happy man, showing joy and passion for all that life has to offer. Like most polymaths, he was impatient with mediocrity, especially in academe, where he expected intellectual curiosity and rarely found it. He liked to dive into the data, looking at the outliers, to see what could be learned from them, disdainful of the quant community addiction to data mining, using backtests to improve the backtests.

Among friends, he was quick with a joke, with a special fondness for Jewish jokes and bemused quips. At an outdoor restaurant during the early scary days of Covid, where the hostess insisted he mask up for the 10-foot walk to the table, he dryly remarked, “Thank you, I feel so much safer now.” This was a 92-year-old bemusedly challenging a 26-year-old to let him take responsibility for his own well-being.

I was fortunate to count Harry as a friend and a colleague. Farewell, Harry!  We will miss you!"

A 2010 video interview between Rob and Harry where Modern Portfolio Theory is explained, is linked here.

***
 
In my interviews in 2013 and 2014, he explains his views on risks and returns and how he arrived at his Modern Portfolio Theory and Efficient Frontier. It's a fascinating insight in to classic 'aha' moment. I edited three previous articles into one piece on asset allocation and portfolio selection and republish it as a tribute to a legend of our industry.

Harry Markowitz was born on 24 August 1927 in Chicago. He studied economics at the University of Chicago under important economists, including Milton Friedman. While still a student, he was invited to become a member of the prestigious Cowles Commission for Research in Economics, leading to his 1952 breakthrough work.

Harry Markowitz on investing until 100

This discussion with Harry Markowitz took place at the Research Affiliates Advisory Panel Conference, Laguna Beach, California, 30 May 2014.

Markowitz identifies the development of databases and ability to model expected outcomes as the major recent improvements in his portfolio construction work. Given a set of investments with forward-looking returns and defined risks, portfolio theory will show an efficient frontier for the investor. This principle has guided asset allocation and diversification for the 64 years since his original ideas. Says Markowitz, “I lit a small match to the kindling, then came the forest fire.”

Long-term asset allocation

Markowitz tells me he has a wall in his office dominated by a cork board, and on it, a large graph shows returns over time from various asset classes. It shows $1 placed in small cap stocks in 1900 growing to $12,000, while the bond line has reached $150. I asked whether this shows that for anyone with a long-term investment horizon, their portfolio should be heavily dominated by equities, maybe even 100%.

He said he is asked this asset allocation question all the time. His advice is different to a waitress in a coffee shop versus a well-informed investor with good professional advice. He tells the waitress to go 50/50, a mix of growth from a broad stock fund and security from bank deposits, because she cannot tolerate the volatility of a 100% equity portfolio. But an educated investor with good advice should take their current portfolio mix, find the most efficient frontier, then simulate possible future outcomes focusing on income expectations. The investor can then better judge whether the portfolio is the right mix to achieve the end goals.

Markowitz believes active stock selection is for a few highly skilled people who usually find returns not from stock-picking on the market, but by participation in private placements. He cites Warren Buffett and David Swensen (of Yale University) as consistently delivering excess returns but mainly because of the private deals they are offered and their ability to value them. Otherwise, outperformance is not worth chasing.

His own portfolio is currently equally weighted municipal bonds and equities, the latter with an emphasis on small caps and emerging markets, but with a stable core of blue chips. This is because he feels so many stocks are overvalued at the moment, and his portfolio is also influenced by his age. “I want enough bonds that if I die, and the equity market goes to zero, my wife will have enough capital and income to live well.” His current objective is to reach 100 without appearing on the right-hand column of The Wall Street Journal, with the heading “Harry Markowitz f*cked up”.

He is a great believer in rebalancing, and this is one reason why a cash reserve is always required. As equity markets rise, shares should be sold to retain the same proportional asset allocation mix. This provides a natural protection from overvalued stocks. He recalled working with a major Fortune 500 client in November 2008, after the rapid stock market fall, allocating more to equities in a rebalancing exercise. This has subsequently paid off handsomely. But it was scary at the time, and as the market continued to fall, he thought if he keeps allocating more to equities at this rate, the whole place will be owned by him and Buffett. He likes the expression ‘volatility capture’ for this process, which is why there is a role for bonds as part of the reallocation mix.

I was still curious why a person with good savings at age of say 40, and strong income flows, would not invest 100% in equities, given their long-term outperformance versus cash or banks. He said,

“They may think their income is assured, but then may hit a rough patch and need to sell equities at the worst moment.”

He highlighted that many people have jobs which are also heavily exposed to the strength of the economy, and that they should also “diversify their own job and other income sources”. He suggests investors should not become too smart, using leverage and unusual investments, and not try to become rich overnight.

He is also keen on using simulation to determine possible future outcomes. In his financial advice business, GuidedChoice, and especially in their new work on GuidedSpending, they ask clients to define an upper band of future income requirements, which might be say $50,000. Clients then define a ‘scrape through’ amount, such as $30,000. Simulations are done based on variables such as living longer and market returns “to capture the essence of the spending problem”. Clients can vary scenarios to see the outcomes. The most common consequence of the process is that people save more, often dramatically and commonly 50% or more.

What else would he do all day?

While the technology behind the scenes is complex in this modelling, it is presented in ways the client can easily understand. But he dislikes mechanical rules such as taking 4% from the portfolio each year. “Why should someone who is 90 only take 4% if they want to spend more?” he says.

I ask him how a fund with investors aged from 16 to 90 should allocate its assets. “It’s like a family,” he responds. “There is a trade off in a family structure between paying for the education of the children, versus the future retirement of the parents. All families make these ‘social choices’, and so must the fund. Their decisions may not be ideal for the 16 year old or the 90 year old but everyone makes these choices in life”.

And one of Markowitz’s choices is to keep working as hard as ever. “I enjoy this, and what else would I do all day?” He now dedicates every Friday to writing to ensure he meets his deadlines, spends every Thursday afternoon at GuidedChoice where he consults to their institutional clients, and he maintains a heavy teaching and advising schedule. If his health allows it, he’ll still be doing it when he’s 100, and that right hand column of The Wall Street Journal will be singing his praises.

Harry Markowitz on portfolio selection

I interviewed Harry at the 2013 Research Affiliates Advisory Panel meeting in San Diego.

GH: I'd like to start by going back to 1952 and your seminal paper, Portfolio Selection. Did the idea of mean variance and efficient frontier and risk reward come to you while you were having a shower, or was it more systematic that that?

HM: There was a moment of truth, a ‘ah ha’ moment. Let me give you some background. I was a PhD candidate at the University of Chicago and the reading list included Graham and Dodd, Weisenberg and John Burr Williams, The Theory of Investment Value, from 1939.

So I'm in the Business School Library, and Williams says the value of a stock should be the present value of its future dividends. I thought to myself, dividends are uncertain, so he must mean the expected value. So I thought if we’re only interested in the expected value of a stock, we must be only interested in the expected value of a portfolio, but to maximise the expected value of the portfolio, you must put all your money into the one stock with the highest expected return.

But that can't be right, everyone knows you should not put all your eggs in one basket, Weisenberg had shown people are willing to pay for diversification. So people diversify to reduce risk and volatility, and standard deviation is a measure of risk.

GH: So you knew statistical theory, you had that background?

HM: Yes, I had the usual courses you’d expect from an economics major in the leading econometrics school. So I visualised the returns on the securities as random variables, so that means the return on the portfolio is the weighted sum of the returns on those random variables. I know what the expected value of a weighted sum is, but I don't know off hand what the variance of a weighted sum is. So I get a book off the library shelf, Introduction to Mathematical Probability. I look up the formula for the variance of a weighted sum and there it is, covariance. Not only does the volatility of the portfolio depend on volatility of the individual securities, but the extent to which they go up and down together.

GH: That was the magic moment.

HM: That was the moment. So now I have two quantities, risk and return, and I know economics so I draw a trade-off curve. I’d heard of efficient and inefficient allocation of resources, Pareto optimums and so on. So I now had efficient and inefficient portfolios. In that flash, in that moment, much of Markowitz 1952 came together.

GH. So although there was this moment, there was a massive body of knowledge already built up.

HM. Sir Isaac Newton said, “I saw so far because I stood on the shoulders of giants.”

GH: Also in your career, you are credited with running one of the first hedge funds, doing arbitrage.

HM. No, a long way from the first. A bit of history. My first job out of college was with the Rand Corporation, where I developed a programming language called SIMSCRIPT, for simulation. The guy who wrote the manual was an entrepreneurial-type, he said, “Harry, let’s form a company.” We founded CACI in 1962, it still exists, it’s a big company now. Then UCLA invited me to be a full professor, full tenure, and another entrepreneur decided to form a hedge fund called Arbitrage Management, based on Thorp and Kassouf’s book, Beat the Market, doing all sorts of arbitrages. I was a consultant, then the portfolio manager. We made a decent return for clients but not really for us, we were generating a lot of brokerage, so we became a wholly owned subsidiary of a brokerage house before I left.

GH: Given it’s now 60 years since Portfolio Selection was published, do you feel any sense of disappointment about our profession, we haven’t really had any major breakthrough theory of investing since the 1950’s.

HM: A lot has happened. We have a lot of data now. In 1952, we hired a student to collect data on securities. But between the top down view, knowledge of data, and our experience, we are better now. When I was at Rand in 1950, I just did 50/50. That’s all I knew then, it’s not what I would do now and it’s not what I would recommend to a 25-year-old. My profession and I have learned a lot.

GH: I don’t like how so many investment discussions end up talking in generalisations.

HM: It’s a good point. There’s a big difference between my article of 1952 and book of 1959. In chapter 13, I talk about the division of labour between the computational part and the intuitive part. Computational part can show probability distributions of returns you can have at your disposal, we can tilt them so they’re correlated with inflation or whatever. But which particular probability distribution you want to have at this time of your life, for this year – you know, your kids go to college, you’re not feeling well, people might be dying in your family, etc - is beyond any model. We don’t understand all that goes on. If we could understand it, we couldn’t model it. If we could model it, we couldn’t estimate it. This year is different from next year.

On the following link, I also interviewed Harry Markowitz on financial advice, as he was heavily involved in a new business called GuidedChoice. His comments remain relevant to Australia's advice landscape today.

Graham Hand is Editor-At-Large for Firstlinks. This article is general information and does not consider the circumstances of any investor.

 

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