Harry Markowitz: Creator of Modern Portfolio Theory

Harry Markowitz (born 1927) is a Nobel Prize-winning American economist best known for developing Modern Portfolio Theory (MPT), a groundbreaking investment strategy based on his realization that the performance of an individual stock is not as important as the performance and composition of an investor's entire portfolio.

Since Markowitz introduced MPT to academic circles in his article, "Portfolio Selection" in The Journal of Finance in 1952, his original theory has fundamentally changed the way that people and institutions invest.

For his theory of allocation of financial assets under uncertainty, also known as the theory of portfolio choice, Markowitz shared the 1990 Nobel Memorial Prize in Economic Sciences with William F. Sharpe and Merton Miller. Specifically, the Nobel Committee cited the theory of portfolio choice developed by Markowitz as the “first pioneering contribution in the field of financial economics.” The Nobel Committee also acknowledged that Markowitz’s original portfolio theory was the basis for “a second significant contribution to the theory of financial economics”: the Capital Asset Pricing Model (CAPM), a theory of price formation for financial assets, developed by William Sharpe and other researchers in the 1960s.

Education and Early Career

Markowitz earned an M.A. and a Ph.D. in Economics from the University of Chicago, where he studied under famous academics, including the economists, Milton Friedman and Jacob Marschak, and the mathematician and statistician, Leonard Savage. While still an undergraduate, Markowitz was invited to join a prestigious economic research institute, the Cowles Commission for Research in Economics (now the Cowles Foundation at Yale University), under the direction of Tjalling Koopmans, a mathematician, economist, and Nobel Laureate.

In 1952, Markowitz joined the RAND Corporation, a global policy research institute, where he built large logistics simulation models. After a stint at General Electric building models of manufacturing plants, he returned to RAND to work on SIMSCRIPT, a computer simulation language that made it possible for researchers to reuse computer code rather than write new code for each analysis. When he left RAND to found Consolidated Analysis Centers, Inc (CACI) in 1962, he led the commercialization of a proprietary version of SIMSCRIPT. In addition to his current role as Adjunct Professor at the Rady School of Management at the University of California at San Diego, Markowitz is Co-Founder and Chief Architect of GuidedChoice, a San Diego-based financial advisor firm, where he heads the Investment Committee.

The Development of Modern Portfolio Theory

In his lecture to the Nobel Committee in 1990, Harry Markowitz said, "the basic concepts of portfolio theory came to me one afternoon in the library while reading John Burr Williams's Theory of Investment Value. Williams proposed that the value of a stock should equal the present value of its future dividends. Since future dividends are uncertain, I interpreted Williams's proposal to be to value a stock by its expected future dividends. But if the investor were only interested in expected values of securities, he or she would only be interested in the expected value of the portfolio; and to maximize the expected value of a portfolio one need invest only in a single security."

But Markowitz realized that investing in a single security “was not the way investors did or should act.” He knew that “investors diversify because they are concerned with risk as well as return.” He also knew that, while investors understood the benefits of diversification, they needed tools to determine the ideal level of diversification.

This insight guided Markowitz’s design of the Efficient Frontier, an investment tool that charts the level of diversification that will offer the highest return for an investor’s desired level of risk. If a certain portfolio lands on the “efficient frontier” section of the graph, it is considered efficient, which means it delivers the maximum return for that investor’s risk tolerance. Portfolios outside the efficient section of the graph have either too much risk vs. return or too little return vs. risk. Of course, because the risk tolerance and return expectations of each investor are different, there is no one efficient frontier.

The Impact of Harry Markowitz's Modern Portfolio Theory

Prior to Harry Markowitz's work on MPT, investing was largely seen in terms of the performance of individual investments and their current prices. Diversification was unsystematic at best.

MPT and Diversification

Although it took well into the 1960s for Markowitz's work to be properly appreciated, MPT has become a mainstay of investment strategy, and the benefits of diversification are widely understood by all money managers. Even robo-advisors, one of the most disruptive technologies in finance, draw on MPT when compiling suggested portfolios for users.

Wall Street

So much of Markowitz's work has become standard practice in portfolio management that fellow Nobel laureate Paul Samuelson summarized his contribution by claiming that “Wall Street stands on the shoulders of Harry Markowitz.”

Mathematical Portfolio Management

In 1954, when Markowitz was defending his doctoral dissertation on the application of mathematics to the analysis of the stock market, the idea was so unprecedented that Milton Friedman commented that his thesis was not even economics. By 1992, his ideas were so respected that the economist Peter Bernstein in Capital Ideas called his development of mathematical and statistical methods for portfolio management "the most famous insight in the history of modern finance."

Criticisms of Modern Portfolio Theory

As with any widely adopted theory, there have been criticisms of MPT.

A common one is that there is no absolute measure of how many stocks one needs to hold for proper diversification. It had also been argued that managing a portfolio according to MPT principles will nudge risk-averse investors into taking on more risk than they can tolerate.

Yet another criticism focuses on the need to move beyond MPT to address real-world systemic risk.

Moving Beyond Modern Portfolio Theory

Two critics of Modern Portfolio Theory (MPT) are Jon Lukomnik, Managing Director of Sinclair Capital and Senior Fellow of High Meadows Institute, a Boston-based policy institute focused on the role of business leadership in creating a sustainable society, and James Hawley, Head of Applied Research at TruValue Labs, a San Francisco-based start-up which provides artificial intelligence analytics to create sustainability/ESG metrics.

In 2021, Lukomnik and Hawley published a book, Moving Beyond Modern Portfolio Theory: It’s About Time!, to address what they call “the MPT paradox”: the fact that Markowitz’s MPT diversification works only to mitigate idiosyncratic risks, which are specific to certain assets, sectors, or asset classes—and does nothing to mitigate systematic risks, which could collapse an entire industry or the entire financial system.

Lukomnik and Hawley acknowledge that MPT was developed decades before certain systemic risks, such as climate change, antimicrobial resistance, and resource scarcity, were recognized as investment issues. However, they argue that these systemic risks to the environmental, social, and financial systems in the real world matter much more to returns than idiosyncratic risks associated with any individual security or company. In their book, they identify MPT’s lack of tools to address these real-world systemic risks as an urgent issue for modern investors.

The Bottom Line

Since he developed Modern Portfolio Theory (MPT) in 1952, Harry Markowitz has been one of the most important pioneers of the new field of financial economics.

His groundbreaking work on concepts ranging from portfolio theory to computer programming language laid the foundation for how Wall Street operates today.

Markowitz's work has also popularized concepts like diversification and overall portfolio risk and return, shifting the focus away from the performance of individual stocks.