The Markowitz Conundrum Part II

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Our article, The Markowitz Conundrum, highlighted Harry Markowitz’s own personal tension as he reflected upon the way his 1952 work, Portfolio Selection1, was being applied by advisors for individuals. In 1991, Markowitz2 wrote that most investment advisors implement portfolios as if individual clients were institutions. The institutions Markowitz was originally trying to help were in the mutual fund industry.

By contrasting multiple features of Markowitz 1952 with Markowitz 1991, we offer an evaluation matrix as a tool that challenges the suitability of the advisory industry’s application of modern portfolio theory (MPT) investing for an individual’s portfolio. We hope this comparison matrix will encourage advisors to re-think the current default application of MPT for the individual investor.

MPT is rooted in utility theory’s view of the world. One of the core tenets of utility theory is that investors are rational. When the term, “investors” is applied to institutions, the investor can properly be described as rational. Institutions typically manage portfolios in perpetuity by policies and through a governance structure of highly trained and sophisticated boards.

Yet, one of the outgrowths of MPT has been the broad acceptance by all sorts of investors, without distinction to whether an investor is an institution or an individual.

In 1991, Markowitz distinctly pointed out that the term “investor” has been potentially mis-applied to also include individuals. In his words:

The “investing institution” which I had most in mind when developing portfolio theory for my dissertation was the open-end investment company or “mutual fund.”

Additionally, individuals do not typically order their personal investments through a governance structure or for a permanent time horizon. The connection between institutions and individuals is stark. Institutions are rational. However, individuals need a planning and investment approach that cannot only accommodate individual needs, emotions, and behavior, but also has been built directly for individuals, taking into considerations that they may not always behave in the same manner as institutions.