Often called the father of portfolio theory, Harry M. Markowitz, Nobel Laureate in Economic Sciences, has left an enormous mark on the investment profession — primarily through his ability to reconcile theory and practice. In 1952, assembling a portfolio entailed understanding which stocks were over- or underpriced and picking accordingly. It should be no surprise, then, that his essay "Portfolio Selection," published that year in the Journal of Finance, changed the investment industry forever.

For his PhD dissertation at the University of Chicago, Markowitz decided to apply mathematical methods to the stock market (a topic suggested by a chance conversation with a broker). At the time, investors diversified in a haphazard manner, if at all. To bring order to chaos, Markowitz formulated a mathematical, statistical method for assembling a portfolio and produced what Peter Bernstein called in Capital Ideas "the most famous insight in the history of modern finance."

"The basic principles of portfolio theory came to me one day," Markowitz said in his Nobel prize lecture, "while I was reading John Burr Williams, The Theory of Investment Value" in the university's library. Williams held that the value of a stock should equal the present value of its future dividends. Future dividends are uncertain, so Markowitz reasoned that Williams must mean the expected value. Logically, to maximize the expected value of the entire portfolio, investors would put all their money in the stock with maximum expected value — Apple or GE, all eggs in one basket, no diversification. But investors did not generally behave that way, nor should they, because it was too risky. "That afternoon in the library," Markowitz told Peter Bernstein years later, "I was struck with the notion that you should be interested in risk as well as return."

Markowitz linked risk to return not only for individual securities but also for the portfolio as a whole and, significantly, considered how elements of the portfolio move in relation to one another. In so doing, he arrived at a means for determining the "efficient frontier," the set of portfolios that generated the greatest expected return for a given level of risk or the lowest risk for a given level of expected return. Remarkably, on that day in the library, Markowitz recently told Mark Kritzman, CFA, he had the whole theory all in a blinding flash:

"Within the first hour, I had risk, return, efficient frontier, efficiency and inefficiency, the expected return, variance of return, subject to constraints, non-negativity, and the sum of the x's equal to 1."

Harry Markowitz may have had portfolio theory in an afternoon, but its adoption by the financial industry was not so swift. Although his pioneering ideas would eventually greatly alter investment management practices, they took more than 20 years to catch on. It required "the shock wave of the early 1970s stock market selloff and the passage of ERISA," Kritzman observed in a conversation, to motivate managers to seek sturdier ways of building portfolios. Additionally, computers had to become fast enough to handle the necessary operations, which could reach into the millions.

Being a good father of portfolio theory, Markowitz has had some notable descendants. James Tobin's separation theorem derives from portfolio selection, as do William Sharpe's capital asset pricing model, the development of index funds, and the mean-variance analysis of asset classes that portfolio managers use to develop risk-return tradeoffs for clients. Although Markowitz' theory is not without critics, "his effect on the profession has been profound," according to Sharpe, who shared the 1990 Nobel Prize with him.

Without a doubt, investment management owes Markowitz a debt of gratitude. But it is not the only discipline that has benefitted from his wisdom. As Martin Leibowitz, managing director of Morgan Stanley Research, put it:

Characterized by Kritzman as a person of great intellectual curiosity, intellectual honesty, and brilliance, Markowitz remains active in many fields. As he said himself in his Nobel prize biography, he likes to focus on the "application of mathematical or computer techniques to practical problems." He is currently writing a four-volume work on the theory and practice of rational investing, volume three of which concerns uncertainty. He never promised that uncertainty (risk) would be eliminated from investing by his pioneering mean-variance analysis, but he did provide a method for balancing it against return. Naming him "Man of the Century" in the 27 December 1999 issue of Pensions & Investments, the editors declared, "Harry Markowitz laid the foundation for investment management in the second half of the 20th century."

"I thought this was something that investors could use," Markowitz said in the Journal of Investment Consulting in 1990 about his elegant application of mathematics to the stock market. Given the trillions of dollars now invested using his methods for portfolio selection and diversification, it seems safe to say his work has proven useful indeed. In a sense, all those in the investment profession who are seeking to maximize return relative to risk are working within the orbit of Harry M. Markowitz.

CFA Institute Awards and Roles

Nicholas Molodovsky Award, 1998

Financial Analysts Journal Advisory Council 2003-2007