Harry Markowitz found a free lunch in finance

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Ethan Wu (0:36)

Thank Pushkin.

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 would 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. I am reporter Ethan Wu, joined today in the New York studio by Alphabet reporter, Alex Scaggs, who has just emerged from the dusty tomes of the academic financial literature to talk to other human beings.

Alex Scaggs (1:30)

Yeah, it's very exciting to just like be with a person, again, you know.

Ethan Wu (1:34)

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, right? 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?

Alex Scaggs (2:14)

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.

Ethan Wu (2:30)

Yeah, like the way it works in my head is you'd go to the richest guy in town who was also the stockbroker, he had 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 you'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.

Alex Scaggs (2:45)

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. There 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.

Ethan Wu (3:25)

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? More 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.

Alex Scaggs (4:06)

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?