I'm Paul Kaplan, research director at Morningstar Canada.
The Nobel Memorial Prize in Economic Sciences, the most prestigious prize in economics, was first awarded in 1969, But it wasn't until 1990 that the Nobel was awarded to economists for their work in finance and investing. Today I look back on the major contribution of one of the 1990 Nobel laureates: Harry Markowitz. He is deservedly called the father of Modern Portfolio Theory.
Markowitz's groundbreaking research dates back to the 1950s, when he developed a theory for the allocation of risky financial assets. Known as the theory of portfolio choice, this theory analyzes how wealth can be optimally invested in assets which differ with regard to their expected return and risk.
As the Nobel committee noted, on a general level, investment managers and academic economists have long been aware of the necessity of taking risk as well as expected return into account when constructing portfolios.
Markowitz's primary contribution consisted of developing a rigorously formulated, operational theory for portfolio selection. This theory evolved into a foundation for further research in financial economics.
Markowitz showed that under certain given conditions, an investor's portfolio choice can be reduced to balancing two dimensions.
One is the expected return of the portfolio. The other is the variance of those returns – in other words, its risk. Markowitz proved that the risk of the portfolio does not depend only on the individual variances of the return on different assets. It also depends on how the returns of asset classes are correlated with each other.
Markowitz also found that diversification of risks has its limits. Risk can never be totally eliminated, regardless of how many types of securities are represented in a portfolio. That's because the returns on different assets are correlated.
While not all investors construct their portfolios using the Markowitz optimization program, all investors should apply the principles embodied in Markowitz’s model. One of these principles is risk control through diversification. The other is that the only way to increase expected return -- given a fully diversified portfolio -- is to take on more risk. These are key principles that should guide all investors.
