On behalf of ORTEC, Mathijs Rotteveel spoke with the “Father of portfolio theory” Harry Markowitz: Nobel Laureate in Economics and Professor of finance at the Rady School of Management at the University of California, San Diego. ORTEC and Markowitz are partners in: ProbabilityManagement.org and discuss portfolio management and uncertainty.
In the early 1950s, Harry Markowitz was studying economics at the University of Chicago when by chance he met a stockbroker. When Markowitz told the broker he was looking for an area of economics on which to write his dissertation, the broker told him to write about stock prices and the risks in investing. That brief encounter ultimately led to the revolutionary Modern Portfolio Theory, which explains how to create diversified portfolios that reduce risk and maximize return.
Some sixty years later, Markowitz can still laugh about this incident. “I think I spent more time thinking about what to eat for lunch that day than about choosing the right topic for my dissertation. I have to thank that guy. It was the best advice a stockbroker ever gave me.’ And again Markowitz laughs heartily.
But then, Harry Markowitz has many reasons to be happy. At 86 years old the Nobel Laureate still behaves like somebody in the prime of his life. He divides his time between teaching at the University of California, San Diego and consulting out of his Harry Markowitz Company offices on business optimization. He is also co-founder and Chief Architect of managed accounts provider GuidedChoice, and is currently writing a four volume book on investment under uncertainty. Over the phone from his office in San Diego Dr. Markowitz takes all the time needed to tell about his work, spread the word on diversification and give this writer a few free lessons in uncertainty management.
“What is uncertainty?” he asks. Then it’s quiet for a while until, just when it seems like the phone has become disconnected, he continues. “Let me not define it, but instead suggest a series of essays: Descartes’ Meditations. Descartes asks himself the question: ‘What do I know?’” And then the line goes quiet again…
Knock, knock, knock… ‘I’m knocking on this table over here in California and it sounds solid. So now I know it’s solid. Or at least I think it’s solid. But maybe there are a lot of tiny holes in it that I can’t see. Who knows? Maybe I’m talking to you, but maybe I’m just dreaming. And I thought I just heard the voice of my secretary. So I think I know she’s still here, but the door to her office is closed. So I think I know she’s here, but she could be long gone.”
Descartes concludes his Meditations with the famous phrase ‘I think, therefore I am’ (‘Cogito ergo sum’). A quote close to Markowitz’ heart. “This shows how big the lack of certainty is in the models we carry around in our minds and our computers.”
The best business managers, he thinks, are the ones who cope best with their lack of knowledge. “As a manager, you need to go through different layers when you have to deal with uncertainties. First you have to understand that you don’t have information, you have data.” Markowitz gives as an example the earnings figures for IBM that we can find in the Wall Street Journal. “You might think these numbers are facts, but what if it’s a misprint? It could also be a lie: the president of that company might be a crook and the numbers false. Maybe the president isn’t lying, but got the wrong numbers from someone down in the company who’s afraid he might lose his job. Managers should be aware of their lack of knowledge.”
In his 1952 paper ‘Modern Portfolio Theory’ Markowitz showed how to construct a portfolio of financial assets in a way that would maximize expected return for any given level of risk. This idea has inspired much investing theory and practice at all levels. And in 1990 it earned him the Nobel Prize for Economics.
‘Don’t put all your eggs in one basket’ is the layman’s expression encouraging diversification. And as he has done in finance, Markowitz also advises business managers not to put all their eggs in that single container.
“How do you manage uncertain situations? Consider the actions you could take, and diversify. It might not be the one answer to all your business problems, but take the risk of cyber attacks. What can companies do? Of course they can harden their firewalls. But one of the key tools available to them is diversification of data storage. That’s my portfolio theory. It’s not only applicable to finance but also cyber attacks, agriculture and more areas than you can imagine.” Or as Descartes might have put it, ‘I diversify, therefore I reduce risk’.