Harry Markowitz found a free lunch in finance

0:06Pushkin. A few weeks ago, we lost a titan of modern finance. Harry Markowitz, academic 1990 Economics Nobel Prize winner, passed away on June 22nd. And his legacy in some ways defines modern finance. There's no way to think about any of the concepts we use to discuss finance or markets without talking at least a little bit about Harry Markowitz's contributions. So, you know, it's a Thursday. It's after July 4th. We thought it'd be a good time to step back into the annals of history, ask what did Harry Markowitz do and why does he matter today? This is Unhedged, the markets and finance show from the Financial Times and Pushkin.

0:47I'm reporter Ethan Wu, joined today in the New York studio by Alphaville reporter Alex Skaggs, who has just emerged from the dusty tomes of the academic financial literature to talk to other human beings. Yeah, it's very exciting to just like be with a person again, you know. When's the last time you saw another human face and not a book? No, in all seriousness, Alex has just written a very good obituary of Harry Markowitz in the Financial Times, which you all should read and will have in the show notes. But I think because Markowitz was so influential, Alex, in some ways it makes it hard to talk about because one of his main findings is about diversification, which literally everyone who has graduated high school has heard about.

1:29Right. It's like standard personal finance curriculum now. And so I think to talk about Markowitz, you need to talk about pre-Markowitz. And you kind of get at this in your piece. Like the first line is there's a pre-Markowitz world and a post-Markowitz world. What is that pre-Markowitz world to you? Yeah. So the pre-Markowitz world reminds me of, you know, people take out their corporate balance sheets. They look at it. They say, oh, this one looks nice. And I've heard of this company and I like using their stuff. So let me have 50 % of my money in that and then 50 % in another stock just to be safe.

1:59Yeah, like the way it works in my head is you'd go to the richest guy in town who was also the stockbroker. He'd have a top hat and a cane and would own a big boat. And you'd say, hello, I'd like to invest my money. And he'd say, here's some GE and some Ford. Now go play golf. I don't know if this is true, but it feels true. Exactly. I think that you'd probably talk about the stock picks on the golf course over like your third whiskey of the day at 3 p.m. But, you know, it was sort of this like old boys club, you know, lots of conventional wisdom. And the thing is, like, it made sense, right? But it wasn't very rigorous.

2:32There wasn't a lot of math, or at least not high level math involved, lots of arithmetic, you know, balance sheets and stuff. But then Markowitz came in and basically imposed pretty rigorous math and optimization ideas on investing. And, you know, I think he said this, you know, the only free lunch, basically, in investing comes from diversification. end. Exactly. And just to sharpen that point a bit, if you own five stocks, right, those stocks are going to give you a certain amount of return and they're going to have a certain risk attached that, you know, they might go up, might go down. But if you expand that from five to 50 or 500, you can get the same or greater return for the same or less risk, right?

3:16More return, less risk, just by expanding the kind of base of investments that you're using because each of those individual stocks has various risks, but if they cancel out, they kind of point in opposite directions over a broad sweep of investments. Your portfolio can do better. This is kind of the basic concept, but higher return, lower risk. It's a great deal if you're an investor. Yeah. And the thing is diversification was like, it sounds reasonable. So people did it kind of, but Markowitz was the first guy to really model this out in sort of a sophisticated mathematical way. He sort of showed it as almost a rule, right?

3:50And that kind of made him the first quant, which I know is a little surprising because you think markets, you think numbers, you think everything's quant. But really, I think before him, it was this sort of like genteel, like, oh, this company seems nice. And I met their CEO last week. And then after him, a lot of optimization strategies, a lot of math. Yeah. And I think in some ways, Markowitz's biggest legacy came through one of his collaborators. And you tell the story a bit in your obituary, Alex, of William Sharp, who I believe you talked to, if I'm not mistaken. I did. I did. B. William Sharp.

4:25Yes. So B. William Sharp, basically, if you've invested in any fund of any kind, you probably recognize the Sharp ratio, which is a measure of risk-adjusted return. William Sharp is the guy who came up with that. And so he did that building off of Markowitz's work. So he was at Rand Corporation while he was working on his PhD. And one of his bosses was like, oh, you should talk to this guy, Harry Markowitz, or you should check out his work. And he built on that sort of quanti foundation to come up with a formula and sort of a model that redefined finance like wholesale. So this is the idea. This is jargony, but it's important of the capital asset pricing model, commonly known as CAPM.

5:08This is kind of sharp speed innovation. And what it tells you is how do you put a price on a stock? And with some kind of basic inputs that these days you can get off Google, like what's the prevailing interest rate? What is the S &P 500 return? You can come up with a reasonable first approximation of what a stock should be worth. Again, it sounds jargony, but this is widespread even today. Half a century later, there was a recent paper that we wrote about on the Unhedged Newsletter earlier this year, finding that 85 % of major U.S. corporate finance departments use the capital asset pricing model, use CapM to make business decisions.

5:42It's still widespread. And that's directly from the pens of Sharp and Markowitz. Exactly. Was Markowitz like, what was he like as a person? Markowitz sounds like a really interesting guy. So I didn't get to talk to him much, but I think he sort of like built the mold of the like quant personality, right? He was sort of irreverent, really open-minded, but also very rigorous. So like he would hear ideas from anyone, he would talk to grad students, you know, he sort of was not into these kind of traditional hierarchies of finance and economics. And I think part of that was because he trusted his own intellect to be able to evaluate the ideas just on their merits.

6:21Like he didn't need to rely on that stuff. And it's so funny because I kind of see it even today with quants. Like he was apparently like a big wine guy. And I know a bunch of quants who are really into wine and like trading wine. And like, it's so funny to see these kinds of parallels like decades later. You've got to use all that excess and come on something. Yeah, exactly. So, okay, enough time praising Markowitz, great man of financial history, but let's talk about the haters, right? Any great man's got us detractors. I think some of the criticism of him I'm very sympathetic to. And, you know, I put it in kind of two big buckets.

6:55And so, you know, one is that Markowitz, at least in his published work, maybe he personally had a different understanding. Markowitz's published work misunderstood risk. This is one criticism you'll hear. And I want to read just briefly from Peter L. Bernstein's 1996 investing classic Against the Gods. He writes here, gives this little fictional story. A group of hikers in the wilderness came upon a bridge that would greatly shorten their return to home base. Noting that the bridge was high, narrow, and rickety, they fitted themselves with ropes, harnesses and other safeguards before starting across.

7:25When they reached the other side, they found a hungry mountain lion patiently awaiting their arrival. I have a hunch that Markowitz, with his focus on volatility, would have been taken by surprise by that mountain lion. And I think what Bernstein is trying to say here is, you crossed the bridge. That's great. Good for you. You've improved your return or lowered your risk, but you had the whole other risk of the mountain lion waiting to eat you. And if the stock goes up and down, that's one way of thinking about risk, but another way of thinking about it is have you actually lost money in the market?

7:54And maybe a second criticism of Markowitz that you'll hear is risk and return are just two dimensions. There's this trend of factor investing where people look at 25 bajillion factors to consider a stock buy. There's more than just two dimensions to evaluate an asset on. And one investor I was speaking to yesterday made this point to me. Markowitz, he conceptualized stocks as kind of a two-dimension pendulum swinging back and forth between risk on the one hand and return on the other hand. And, you know, maybe the way the stock market actually works is it's a 75 dimension pendulum swinging in directions we can barely even conceive.

8:27Well, the funny thing about those guys and their factor investors. Yeah, right. Yeah. If you look at their performance, I don't know how much good the other 73 directions are providing. Right. You know, because I think there is an edge to be had sometimes, but you have to be super rigorous about the inputs to these models. And I do think that still kind of fits with Markowitz's general framework. It's sort of the difference between like, okay, if you like pick the right factors, can you outperform or should you just invest in an index fund and let it go? And I'm glad you mentioned index funds because I think in some ways this is the biggest legacy of Markowitzian thought, which is that he set the bar really high.

9:12He said, if you can diversify across a large base of assets, you can get a pretty good return with totally manageable risk. And yeah, there are some active investors that are stock picking or doing some fancy 75D chess who can do a little better. But can they do a little bit over five years, over 10 years, over 20 years, over 40 years? It's tough. It's tough to clear that bar year after year after year. And, you know, the passive investing industry is just gigantic these days. And that comes directly from Markowitz. Oh, totally. And I think that it's funny because, you know, they say academics, it's like tyranny of small differences or whatever.

9:46Like, I do think that Markowitz was set apart a little bit from the people who came after and that he thought that active managers could beat the market or some of them could. But I think he was the guy who introduced the idea that if you're an active manager winning, there has to be another active manager somewhere else losing. Yes. And like, that's just a fact. Everyone in finance kind of knows this now. but he was sort of the guy that created the framework for people to understand that. Picking the stock picker is almost as hard, if not harder than picking the stocks. Exactly. Yeah. And you know, it's such a huge departure from that pre-Markowitz world we were talking about a little bit ago of go to the richest guy in town and ask him for GE stock.

10:28These days, if you're an average individual investor, probably what you want to do in most cases is just buy the index fund, right? Like don't try to overthink it. Yeah, exactly. And the funny thing is that, again, a lot of the haters of passive investing and even systematic investing tend to be the guys who think like, oh, those stock picking days were so great. Like, oh, yeah, those were the good old days. But the question is like, good for who? Yeah. Good for the guy in the top hat that really wants you to buy some GE. That's who it's good for. All right, Alex, we'll be back in a moment with Longshore.

11:11This is Long Short, that part of the show where we go long and short. One company, idea, stockbroker, financial theorist, whatever it might be. We go long one thing, short one thing. Last week, listeners, I beclowned myself by going long Biden's student loan forgiveness program, which was swiftly struck down the following day by the Supreme Court. So egg in my face for that. But today I've picked a nice, safe short. I am short economic forecasting. So the Federal Reserve, they have these meetings. They published minutes, which, you know, like records of what happens in the meeting. Their staff had one of the most useless forecasts I've ever heard in my life, which is they forecast a mild recession starting later this year.

11:51But the possibility they narrowly avoid a recession is almost as likely as the mild recession baseline, which to me is equivalent of just writing a question mark in the box. Yeah, that's shrugging. That's the equivalent of shrugging. What do I do with that? Thank you, Fed Economist. I am short economic forecasting. You know, mine is sort of related to that, too. I am long Beyonce. Beyonce tickets, you know, as we talked about before, they increased inflation in Sweden, which, you know, relatively small country, etc. But it turns out ticket prices have actually showed up in UK inflation data, too, even though the economy is much bigger.

12:28The funny thing is, of course, that the ONS will not actually tell us whether they included Beyonce tickets in the data. There needs to be a Beyonce adjusted consumer price index. I think so. We need transparency. Yes. There's a Nobel Prize waiting to be won here, and it's a mighty disappointment that no statistician is on this. All right, Alex, thanks for being here. We'll have you back very soon. And listeners, we'll be back in your feed on Tuesday with another episode of Unhedged. Catch you then.

13:01Unhedged is produced by Jake Harper and edited by Brian Erstad. Our executive producer is Jacob Goldstein. We had additional help from Topher Forhez. Cheryl Brumley is the FT's global head of audio. Special thanks to Laura Clark, Alistair Mackey, John Schnarz, Eric Sandler, and Jess Trulia. FT premium subscribers can get the Unhedged newsletter for free, and a 90-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Ethan Wu. Thanks for listening.