Understanding the Revolutionary Work of Harry Markowitz in Finance
The Legacy of Harry Markowitz
The study of finance can easily be divided into two eras: before and after Harry Markowitz. The economist, who died on June 22, was one of the first academics to introduce abstract mathematical concepts – and rigor – into the investment decision-making process. In doing so, he sparked a revolution in the way financial markets are understood.
The Introduction of Mathematical Concepts in Finance
“Everyone knew about diversification, don’t put all your eggs in one basket,” said Andrew Lo, a professor at the Massachusetts Institute of Technology and co-author of Looking for the perfect wallet. “But Markowitz told us more. He told us how many eggs to put in the different baskets and how to diversify systematically.”
Valuing Stocks: Markowitz’s Key Insight
Markowitz had a key insight as he read that stock prices are the present value of future dividends. That definition failed to account for uncertainty, he realized; in reality, shares could only be valued by their own expected dividends. That thought grew into his doctoral thesis, in which he modeled investment optimization on an entire portfolio.
The Impact of Markowitz’s Work
This development has caught on widely. Nearly all modern investing professionals are based on this type of quantitative analysis, with a focus on optimization and risk management concepts that might not exist in their current forms without Markowitz. His innovation also helped create the trillion-dollar passive investments behemoths like Vanguard, and in the process they replaced a group of fund managers and stock pickers who relied primarily on company fundamentals and received wisdom to manage money.
The Collaboration with William Sharpe
Markowitz’s work was developed by William Sharpe, who invented the standard for modeling and measuring risk-adjusted returns. Sharpe, Markowitz and Merton Miller won the Nobel Prize in economics in 1990. “Without Harry’s work, I would never have gone down that path,” Sharpe said.
Early Life and Education
Markowitz, born in 1927 in Chicago, was the only child of Morris and Mildred, who owned a grocery store. He first studied liberal arts at the University of Chicago and then turned to economics for his master’s and Ph.D. He learned from prominent economists such as Milton Friedman, Leonard Savage, and Tjalling Koopmans.
Applying Mathematics to Real-World Problems
After Chicago, Markowitz mixed academic and corporate work. He worked at the RAND Corporation, where he met William Sharpe. The real-world application of mathematical theories, including their work on investment optimization, became a crucial aspect of their collaboration.
The Influence of Markowitz on Investment Strategies
Rob Arnott, founder of Research Affiliates, has been influenced by Markowitz since 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 has since built a systematic investment empire, managing approximately $130 billion worldwide.
An Intellectual Giant with a Personal Touch
Markowitz’s colleagues and friends have spoken of his irreverent humor and open-mindedness. His distaste for received wisdom and intellectual rigor may have helped him fundamentally change the status quo in financial markets. While his work had a widespread impact, his patient and kind nature defined his interactions with others.
The Transition to Systematic, Passive Investing
The transition to systematic, passive investing, driven by Markowitz’s work, was not without challenges. The traditional industry, characterized by stockbrokers and high commissions, was slower to embrace these ideas that threatened their livelihoods. However, Markowitz himself was not a proponent of passive management or systematic investing. He emphasized the importance of thoughtful analysis and careful consideration of inputs.
Expanding the Boundaries of Finance
Markowitz’s pioneering work in finance expanded the boundaries of the field and introduced rigorous mathematical models to investment decision-making. His collaboration with William Sharpe and the subsequent recognition with the Nobel Prize showcased the groundbreaking nature of their contributions. Today, the concepts and principles established by Markowitz continue to shape the modern investment landscape.
Summary
Harry Markowitz revolutionized the field of finance through his introduction of abstract mathematical concepts and rigor into investment decision-making. His insights on diversification and systematic portfolio optimization have become foundational principles for modern investing professionals. Markowitz’s legacy is evident in the trillion-dollar passive investments industry and the transformation of traditional stock picking approaches. His collaboration with William Sharpe and the recognition with the Nobel Prize further solidifies the significance of his work. While originally met with resistance, Markowitz’s contributions have transformed the way financial markets are understood and continue to shape the industry today.
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The study of finance can easily be divided into two eras: before and after Harry Markowitz.
The economist, who died on June 22, was one of the first academics to introduce abstract mathematical concepts – and rigor – into the investment decision-making process. In doing so, he has sparked a revolution in the way financial markets are understood.
“Everyone knew about diversification, don’t put all your eggs in one basket,” said Andrew Lo, a professor at the Massachusetts Institute of Technology and co-author of Looking for the perfect wallet. “But Markowitz told us more. He told us how many eggs to put in the different baskets and how to diversify systematically ».
Markowitz had a batting average of key insight as he read that stock prices are the present value of future dividends. That definition failed to account for uncertainty, he realized; in reality, shares could only be valued by their own expected dividends. That thought grew into his doctoral thesis, in which he modeled investment optimization on an entire portfolio.
This development has caught on widely. Nearly all modern investing professionals are based on this type of quantitative analysis, with a focus on optimization and risk management concepts that might not exist in their current forms without Markowitz.
His innovation also helped create the trillion-dollar passive investments behemoths like Vanguard, and in the process they replaced a group of fund managers and stock pickers who relied primarily on company fundamentals and received wisdom to manage money.
Markowitz’s work was developed by William Sharpe, who invented the standard for modeling and measuring risk-adjusted returns. Sharpe, Markowitz and Merton Miller won the Nobel Prize in economics in 1990. “Without Harry’s work, I would never have gone down that path,” Sharpe said.
Markowitz, born in 1927 in Chicago, was the only child of Morris and Mildred, who owned a grocery store. He said they always had enough to eat, despite the Depression. He first studied liberal arts at the University of Chicago and then turned to economics for his master’s and Ph.D. He learned from Milton Friedman, Leonard Savage and Tjalling Koopmans. He said Koopmans’ course in activity analysis was “a crucial part” of his education, as he defined efficiency and provided a framework for analyzing efficient ensembles.
After Chicago he mixed academic and corporate work. Sharpe and Markowitz first met at the RAND Corporation in the late 1950s, where Sharpe worked while completing his Ph.D. “I was very educated by the RAND Corporation,” Sharpe said. Markowitz also studied operations at RAND, another realm that has benefited from the real-world application of mathematical theories.
Rob Arnott, founder of Research Affiliates, has been influenced by Markowitz since 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. He has since built a systematic investment empire, managing approximately $130 billion worldwide.
“He knew he changed the world of finance beyond recognition,” Arnott said. “Before Harry, investing was a bunch of rules of thumb. . . When someone of his phenomenal stature dies, it’s easy to portray him as an intellectual giant because he was. But he was also a kind, gentle, fun-loving person.”
Many friends and colleagues have spoken of Markowitz’s irreverent humor and open-mindedness. His distaste for received wisdom and intellectual rigor may have helped him fundamentally change the status quo in financial markets, they say. It is rare for a mathematician to see their work have such a widespread impact throughout their lifetime. But the transition to systematic, passive investing has not been unchallenged.
“The industry has been slower to embrace these ideas. . .[Markowitz and Sharpe]they were certainly iconoclasts, but more importantly they threatened the livelihoods of the stockbrokers and gunslingers who charged quite high commissions, in some cases as high as 5 to 10 percent for their services,” Lo said.
However, Markowitz was not a proponent of passive management or systematic investing. He felt that quantitative strategies were only as good as the thinkers who built them, Arnott said.
“He was a patient and kind man, but he wasn’t patient with willful stupidity,” Arnott said. “If your inputs are made carelessly, optimization becomes garbage, garbage. He was always fascinated when people just put numbers into a formula without thinking carefully.
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