How we got there before we got here


The misapplication of portfolio theory
I'm taking care of some of my older links. This one on portfolio theory definitely should be remembered. Emphasis added.

Mr. Markowitz doesn't excuse the financial engineers who bundled complex mortgage-based and other securities. They violated the first principle of his portfolio theory. "Diversifying sufficiently among uncorrelated risks can reduce portfolio risk toward zero," he says in an interview. "But financial engineers should know that's not true of a portfolio of correlated risks."

In traditional Markowitz-inspired investing, such as mutual funds and index funds, there is a discipline around variables such as asset classes and models of covariance. In contrast, collateralized mortgage obligations and related securities had no such discipline. These risks sank together. "Selling people what sellers and buyers don't understand," he says with understatement, "is not a good thing."

In a now-famous paper on portfolio selection in the Journal of Finance in 1952, Mr. Markowitz wrote that risks that are not correlated with one another work best, while investments that move together -- owning both Ford and GM -- are riskier. This idea, which seems obvious now, was so novel then that when Milton Friedman reviewed Mr. Markowitz's University of Chicago Ph.D. dissertation, he half-joked it couldn't lead to a degree in economics because the topic was not economics. Mr. Markowitz got the degree and in 1990 shared the Nobel Prize in economics for portfolio theory.

As with all new information tools at our disposal, applying portfolio theory to investing entails its share of trial and error. Mr. Markowitz admits some people might object to asking him how to repair the credit crisis. "You, Harry Markowitz, brought math into the investment process," he imagines some people thinking. "It is fancy math that brought on this crisis. What makes you think now that you can solve it?"

He draws a line between his portfolio theory and its later misapplication. "Not all financial engineering is always bad," he says, "but the layers of financially engineered products of recent years, combined with high levels of leverage, have proved to be too much of a good thing." In contrast, classic investment portfolios such as mutual funds and index funds continue to reduce risk.

It makes sense when you think about it. To minimize risk, you don't want all car companies or all hotel companies. A more primitive version of the same idea is the Dow Jones industrial average, which draws from the best performers of several industries.

— NeoWayland

Posted: Sat - November 15, 2008 at 01:19 PM  Tag


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