The Markowitz Conundrum

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Acknowledgments: We extend our gratitude to Dr. Stephen Huxley and J. Brent Burns for their helpful comments during the writing process.

Harry Markowitz, whose name every financial planner knows, published two papers, one in 1952 and the other in 1991. The latter sought to correct misunderstandings that arose from the former. Together they provide a valuable, yet incomplete, architecture for guiding individual investment decisions.

The first paper, Portfolio Selection, is by far the most famous and considered the origin of “modern portfolio theory” (MPT)[1]. Though it was only 15 pages and included a lot of images, the paper was fairly easy to follow. He pointed out that the standard approach to investing at that time – that investors should seek the single stock with the highest expected return – was wrong because it failed to take into consideration the variance of the returns. He posited that investors viewed variance as an “undesirable thing” and any theory attempting to explain how to construct a portfolio should factor both return and variance into its calculations.

Markowitz used the word “investor” without specifying the investor. Large Wall Street brokerage houses picked up on the work in their eagerness to gain market share in the personal investing business. MPT offered academic prestige to a particular approach for investing that was easy to explain. It could be standardized to allow scale and it gave Wall Street brokers a script to follow.

MPT provided a coherent mechanism for top-down control over brokers through model portfolios[2].

During the 1970s, MPT blossomed into the reigning paradigm for personal, as well as institutional, investing, despite the fact that Markowitz never anticipated, nor advocated, for such an adaptation. Individuals seeking advice from different firms could be offered drastically different portfolio modeling solutions, all using MPT.