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Finance studies can be easily divided into two eras: before and after Harry Markowitz.
The economist, who died June 22, was one of the first scientists to introduce abstract mathematical concepts – and rigor – into investment decisions. In doing so, he triggered a revolution in the understanding of the financial markets.
“Everyone knew something about diversification — not putting everything in one basket,” said Andrew Lo, a professor at the Massachusetts Institute of Technology and co-author of “In Pursuit of the Perfect Portfolio.” “But Markowitz told us more. He told us how many eggs to put in the different baskets and how to systematically diversify.”
Markowitz had an important lesson when he read that stock prices are the present value of future dividends. He realized that this definition did not take into account uncertainty; In reality, stocks could only be valued based on their expected dividends. This thought evolved into his doctoral thesis, in which he modeled the optimization of investments across an entire portfolio.
This development has spread widely. Almost all modern professional investing is based on this type of quantitative analysis, with an emphasis on optimization and risk management concepts that might not exist in their current form without Markowitz.
His innovation also helped create trillion-dollar passive investing behemoths like Vanguard, supplanting a cadre of fund managers and stock pickers who relied primarily on company fundamentals and gained wisdom in managing money.
Markowitz’s work was followed by William Sharpe, who invented the standard for modeling and measuring risk-adjusted returns. Sharpe, Markowitz and Merton Miller received the 1990 Nobel Prize in Economics. “I would never have walked this path without Harry’s work,” Sharpe said.
Born in Chicago in 1927, Markowitz was the only child of Morris and Mildred, who owned a grocery store. He said they always had enough to eat despite the economic crisis. He first studied liberal arts at the University of Chicago and then applied for his MA and Ph.D. to economics. He learned from Milton Friedman, Leonard Savage and Tjalling Koopmans. He said Koopmans’ activity analysis course was “a crucial part” of his training because it defined efficiency and provided a framework for analyzing efficient sets.
After Chicago, he mixed academic and business work. Sharpe and Markowitz met in the late 1950s at RAND Corporation, where Sharpe worked while completing his PhD. “The RAND Corporation was a big influence on me,” Sharpe said. Markowitz also studied Operations at RAND, another field that has benefited from the real-world application of mathematical theories.
Rob Arnott, founder of Research Affiliates, felt the influence of Markowitz from the beginning of his career. In his first job at The Boston Company in 1977, he used the economist’s algorithm in a quadratic programming optimizer, he said. Since then he has built a systematic investment empire and has approximately $130 billion under management worldwide.
“He knew he changed the world of finance beyond recognition,” Arnott said. “Prior to Harry, investing was a set of rules of thumb. . . When someone of his phenomenal stature dies, it’s easy to portray him as an intellectual giant because he was one. But he was also a kind, gentle and fun-loving person.”
Many friends and colleagues spoke of Markowitz’s irreverent humor and open-mindedness. His aversion to conventional wisdom and intellectual rigor may have helped him radically change the status quo in financial markets, they say. It is rare for a mathematician to see his work have such a far-reaching impact over the course of his life. But the transition to systematic and passive investing was not without controversy.
“The industry has been slower to embrace these ideas. . .[Markowitz and Sharpe]were certainly iconoclastic, but more importantly, they threatened the very existence of stockbrokers and gunslingers, who charged fairly high fees for their services, in some cases over 5 to 10 percent,” Lo said.
However, Markowitz was not an advocate of passive management or systematic investing. Arnott said he felt quantitative strategies were only as good as the thinkers who created them.
“He was a patient, gentle man, but he had no patience for willful stupidity,” Arnott said. “If your inputs are processed carelessly, optimization becomes garbage-in, garbage-out. He’s always been fascinated when people just throw numbers into a formula without thinking it through carefully.”
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